Wednesday’s Word: Leverage

Law IACBy Robert Noens, Spring 2017 Student Intern

As an aside, I want to mention that I began this Wednesday’s Word with a different term. I originally wanted to define Business Development Company, or “BDC” in the investing world. So, like any good Investor Advocacy Clinic Student Intern, I began my search on FINRA’s website, and, according to FINRA:

BDCs are typically closed-ended investment companies. Some BDCs primarily invest in the corporate debt and equity of private companies and may offer attractive yields generated through high credit risk exposure amplified through leverage. As with other high-yield investments, such as floating-rate/leveraged loan funds, private REITs and limited partnerships, investors are exposed to significant market, credit and liquidity risks. In addition, fueled by the availability of low-cost financing, BDCs run the risk of over-leveraging their relatively illiquid portfolios.

Now, after reading that definition, I knew one thing: I had bitten off more than I could chew for a blog post that had to be completed in under 1000 words. For one thing, the definition and operation of a BDC seemed to largely rest on the concept of leverage, but what is leverage? Well, as it turns out, a simple Google search of the word “leverage” can quickly lead one down a rabbit hole investment vehicles and terms. Leverage is everywhere. And before I set out my overly eager and foolhardy task to create a BDC’s guide dummies again anytime soon, I must first conquer the definition of leverage.

Leverage, in the most simple of terms, means riskier than average.  Additionally, the term leverage is almost always followed by one of a few other terms, i.e. finance, lending, or loan. According to Ian Giddy, the reason for this association between these words is that, when put together, all one is saying is that they have either borrowed or lent money knowing that the entity borrowing the money has more debt than “would be considered normal for the industry.” In return, for providing loans, bonds, financing or lending to these “high-risk” entities, the investor/lender is rewarded with higher yields or interests rates when it comes time to be paid back. The relationship is mutual beneficial. Investors get high returns on investments, and in exchange the borrowers get necessary capital for business ventures.

That said, things do not always go as planned, and big returns do not always materialize. As any investor knows, with greater reward, comes greater risk. Entities that are carrying debt are more likely to default. Moreover, according to the Comptroller’s Handbook, because leverage is usually associated with loans, investments can be illiquid, and one cannot simply opt out of the investment at any time like they could a stock.  Thus, the potential to lose most or all of one’s investment is much greater. This relationship of high risk and reward lending has a name, and that name is leverage.