In this article, I’m going to explain in more detail how we think about debt in Alpha Rock Capital. This topic was briefly mentioned in a previous article, Keys to Money Management, but I think it deserves a deeper look.
When deciding whether to borrow money, we consider the following seven factors.
Factor 1 – Expected Returns
It may seem like borrowing money makes sense as long as the expected returns of investing it are higher than the interest rate paid. For example, you borrow at 5% annual interest for your business, and you expect to make 10% out of that money, so you would pocket the difference, 5%.
However, in practice, returns are just “expected”, while loan instalments are certain. If returns end up being lower than the interest rate you are paying, that loan would end up making you lose money, it decapitalizes you and can potentially bankrupt you.
When considering whether to accept a loan or to keep it instead of prepaying it, a useful exercise is to think about the other side of the deal. Would you be happier getting 100% sure and stable 5% annual returns or, maybe, making 10% with the possibility of making less or even losing money?
The 5% return is 100% sure because it’s an expense that you would avoid by not taking this loan. “A bird in the hand is worth two in the bush” may apply here.
Factor 2 – Volatility of Returns
There’s another factor to consider, which is the volatility of those returns. The less volatile your income is, the more aggressive you can be when borrowing money. Think about getting a mortgage to buy an apartment with the idea of renting it and paying the monthly mortgage instalments with the rent. That income is, in theory, relatively stable so it may make sense to accept that loan even if the difference between expected returns and interest rate is low.
Now imagine that you have found a system that you think has high expected returns but a lottery-like payout structure. For example, a long volatility strategy that makes enormous profits once every 20 years but you lose 95% of the years. This doesn’t play well with having to regularly make loan payments (or any kind of frequent costs in general) as most of the time you are losing money and can’t make the payments, which could result in decapitalization or losing everything when the strategy was actually good.
The more volatile and skewed your returns are, the more conservative you have to be with loans. People tend to underestimate the volatility of their income and borrow more money than they should. Borrowing money is often a result of overoptimism or not having Skin in the Game (“heads I win, tails you lose”).
Let’s modify our proverb to: “A bird a year in the hand is worth an average of three birds a year in the bush”.
Factor 3 – Actual Interest Rate
I would like to introduce another term, which I will call “actual interest rate” (I liked “effective interest rate” more but it seems to be taken).
To avoid short-term cash flow issues, you want to keep some months worth of expected expenses as a reserve. This includes loan instalments. So, when you borrow money, you keep a part of the loan as a reserve. You are, then, also paying interest for that money that you are not using, that you are keeping in the bank “just in case”. The actual interest rate is the result of dividing the interest rate by the percentage of the remaining loan principal that you are investing.
I will use an example to explain what this means in practice. Imagine you borrow $1,000 for 12 months at 10% annual interest. You pay it back monthly, a constant instalment of $87,92. You want to keep 3 months worth of instalments as a reserve, which would be $263.75. Therefore, you only invest $736.25 of the $1,000 you borrowed.
The actual interest rate would be \[Actual\;Interest\;Rate = {{0.1} \over {736.25 \over 1000}} = 13.58\%\]
One month later, you are still saving $263.75 for future payments, but the principal is down to $920.42, so now you are paying an actual interest rate of
\[Actual\;Interest\;Rate = {{0.1} \over {656.67 \over 920.42}} = 14.02\%\]
Six months later, it would be 20.61%, more than double. You can see the rest of the values in this spreadsheet. As months pass, as the ratio between the invested amount and the saved amount is smaller, the higher the actual interest rate is.
This is a problem with short-term loans, that a high percentage of them has to be kept as a reserve, and therefore the interest rate that you are paying is higher than it seems. Therefore, the sooner you have to pay back a loan, the lower you need its interest rate to be.
Factor 4 – Instalment Amounts vs Expected Income
The higher your instalments to income ratio is, the higher the probability of not being able to make a payment is. When you don’t make a payment, bad things happen. Depending on how the loan is structured this could mean different things.
At first, this could mean that you may start accumulating debt at a higher interest rate, a “late-payment rate”. This makes it more likely that you keep being unable to pay.
It could also mean that you have to decapitalize. You may have to sell some of your productive assets or give them to the lender. This also makes it more likely that you will not be able to make future payments as your income decreases.
Eventually, you would trigger the ugliest parts of that contract. Maybe that means losing all your company assets, or even some personal ones even if you were borrowing under your company name.
Therefore, you want to keep the likelihood of not being able to make a payment very low, as when it happens the costs are very big and you can trigger a vicious circle that ends in a catastrophe.
If you have a good investment idea, with decent expected returns, excessive leverage may actually lower its expected returns (expected bankroll growth to be more specific), possibly making them even negative. In the Risk of Ruin article, I explain this concept in more detail.
Factor 5 – Collateral
Collateral is what you have to give up if you can’t fulfil your debt payments. As explained before, this may not trigger the first time you can’t pay an instalment, it depends on the loan conditions, but it’s what eventually happens if you can’t pay repeatedly.
What the collateral is in a loan is very important because a drawdown is likely to be something temporary. If you just lose a part of the company (like going through some dilution by creating some new shares for the lender) when you can’t pay back, you would still benefit from part of the upside when things improve. If instead, you have to give up your full company, you forfeit all our upside potential.
Therefore, the more you lose when bad things happen, the more cautious you have to be when borrowing money. There’s a 100% likelihood that, eventually, something bad happens. You have to be able to recover from that. Otherwise, all your previous effort would have been a waste of resources.
Factor 6 – Time
As in any obligation, you would like it to be valid for the minimum possible amount of time. This applies to a loan as well. The longer-term a loan is, the more likely it is that at some point you struggle financially. While you can’t know how much money you will be making a month five years from now, if you are accepting a five years loan you know perfectly that someone is going to ask you for a payment five years from now (and every month before that). This is related to the first and second factors. You are accepting a certain cost while our benefit is uncertain (in size and volatility).
You may have noticed a problem here. The sooner you have to pay back, the higher your actual interest rate is. So you have to take both things into account. If you have to choose between two loans with a similar actual interest rate, you would prefer the one that is paid back sooner, as that makes it less likely that at some point you can’t fulfil your financial obligations. You prefer having the option to “roll-over” a short-term loan, depending on the circumstances at the expiration date, instead of getting from the start into a very long-term obligation that you don’t know if you will like in the future.
Factor 7 – Alignment
This seventh factor only applies when you have the option of selling equity instead of borrowing money. This is an option we have in Alpha Rock Capital. Potential investors frequently ask us why we prefer selling shares instead of just borrowing money, which doesn’t involve dilution. On top of all the previous factors, which make borrowing money sensible only on some very specific occasions and on a small scale, there’s another reason why we prefer selling shares.
When someone lends money to us, we are encouraged to have stable returns even if that’s detrimental long term. It’s likely that by being able to increase our volatility, our long-term returns are higher. I’m not talking just about extreme payouts structures like the long volatility trader that makes money once every 20 years. I’m referring to things like making an investment that won’t start making money until 2 years from now. The higher our monthly financial obligations are (including loan payments), the more likely it is that we are forced to skip some investments that would have been good long term but the returns of which are either volatile or can’t be realized in the short term.
Therefore, our expected returns are likely to be lower than they could have been if we, instead, sold shares. Having lenders also creates possible misalignment that wouldn’t occur if everyone involved just cares about the long term even if that means less stable results during the short term.
If you agree with this approach or want to discuss any of the points, please post a comment or contact us.