This article is excerpted from a letter authored by Samer Hakoura, principal at Alphyn Capital Management, based in New York.
Some companies with advantaged business models can safely leverage alternative third-party sources of capital or operations to generate significant incremental income. I broadly refer to this as “synthetic leverage.” Probably the best-known example is Warren Buffett financing his investments at Berkshire Hathaway with insurance float. While it is standard practice for insurance companies to invest their float in relatively safe fixed income, Buffett excelled at using float to invest in equities and buy whole companies.
Over 70% of our portfolio is invested in companies that have “synthetic leverage.” Leverage is of course the use of borrowed capital to amplify investment returns. Investors can borrow against the value of the assets they are buying, for example with real estate, or use margin loans in the case of public securities. Companies can fund their operations through debt, with the goal of enhancing return on capital while avoiding dilution associated with equity raises. The major drawbacks are the costs to service loans, and the often severe consequences of failing to do so (having debts called, the risk of bankruptcy), as well as the threat of margin calls on public security investors when the value of their investments deteriorates, forcing liquidations often at precisely the wrong time. In contrast, synthetic leverage has fewer of these downsides.
In a 2018 paper researchers from AQR Capital Management analyzed Berkshire Hathaway’s record from 1976 to 2017 in search of factors that contributed to Warrant Buffett’s remarkable investment performance. They note that while Berkshire was still subject to “significant risk and periods of losses and significant drawdowns,” Buffett’s outperformance was largely due to his use of leverage of about 1.7-to-1, combined with his fortitude to stick with “a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift.” The “good strategy” refers to buying high quality companies cheaply, and the authors caution that making mediocre investments with leverage mostly serves to amplify both risk and volatility.
A significant proportion of Berkshire’s financing, in addition to standard equity and debt, was in the form of insurance float. Insurance businesses collect premiums upfront and later pay a diversified set of claims extended over the lifetime of the policies written. Float is the money they get to hold between the time customers pay premiums and the time they make claims on their policies. This money is similar to taking a loan, but notably, these “loans” are not subject to margin calls and are cheap; Berkshire’s average annual cost of float was 1.72% or 3 percentage points below the average T-bill rate over the 41-year period analyzed in the paper. Berkshire has made occasional use of other more esoteric sources of low risk leverage, such as collecting premiums from selling index put options and credit default contracts that contained no collateral posting requirements. Regular investors do not have the luxury of selling put options without posting collateral. As the AQR paper states, Berkshire’s derivative contracts served as sources of both revenue and safe financing.
Inspired by this story, I have intentionally looked to invest in companies that have access to “synthetic leverage” and will highlight a few types of synthetic leverage used by companies we own in the portfolio.
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