17 Jun Business Owners: How Much Debt is Too Much Debt?
By Michael McAdams, President, Pasadena Private Lending
Unlike many thought pieces that unveil an answer at the end, the answer to the question posed by the title is a simple, “it depends.” But how you get to the decision is the point.
Much is written by lenders and investors about how to manage risks of a portfolio of debt instruments over economic cycles. Be they traditional bank lenders (and their regulators), non-bank lenders, bond holders and credit grantors, they all need to decide when to “step on the brakes and when to step on the accelerator” in managing risk and return. More academically, both respected and “out of the box thinking” economists and theorists offer absolutes as well as multivariate formulas to optimize credit utilization. And then, there are “old timers” who will share countless stories they have lived through and dealt with over cycles as well as the unexpected war stories from both the good and bad calls.
The result: there are about as many opinions on how to anticipate and weather economic storms as there are consultants and pundits. Likewise, there are as many winners as losers from debt use where the outcomes can seem as random as coin flips.
But what about the borrower, where do they get practical help? Unlike “professionals” it is their money; they are betting with their children’s inheritance as well as their own legacies. Few have (or want) a high-priced consultant or private equity sponsor partner to steer them. And as small business owners they often also have the titles of head of sales, chief of engineering, distribution manager… as well as weekend soccer or little-league ball coaches. Where is there time to consider such a subjective topic as “how much business risk to take?” They could also talk to their accountant or trusted peer met through a trade association and those interactions are few and usually focused on immediate issues.
That leaves their most obvious resources: their lenders and maybe a wealth manager. Unfortunately, many lenders, especially traditional bank lenders, have one product (credit) to sell so their solution to problems is borrowing. And many personal wealth managers are not sophisticated enough to integrate personal and business wealth planning.
In the end, the buck stops with the CEO deciding how much expansion to do, what capital investments can be afforded, how much financing will come out of cash flow and how much will come from dipping into business or owner’s savings vs. borrowing. Their decisions are often based on a combination of years of running their business, a simple spreadsheet, a family meeting and some gut feel.
Looking for guidance more broadly, I recently read a newsletter from Oaktree Capital’s Howard Marks. In it he mentions Japan’s many “shinise” companies that have been around and successful for centuries by carefully balancing growth, debt and liquidity. That doesn’t mean observing some fixed percentage of debt or even no debt any more than no growth or consistently seeking to maximize growth. It means a bias toward conservatism coupled with cautious opportunism when unique opportunities allow.
Another perspective on when to be aggressive is the classic wisdom from the team of Buffet and Munger; “we like to walk in when others are rushing out and walk out when others are rushing in.” That is, they have used their considerable experience and judgement coupled with an honest perspective on current market conditions to decide just how aggressive to be. And, importantly, is THIS, the right time.
I have known prior generations that refused to get a mortgage on their home(s) for their entire life and were immensely proud of that fact. They were also aghast at how their grandchildren had become so comfortable with mortgage debt. Of course, that view was a result of first and second-hand experiences from the Great Depression. But when those same elders came to understand the amount of money their kids and grandkids had put away by prudently borrowing at mortgage rates and investing at investment rates over time they were flabbergasted and embarrassed at the missed opportunity.
So in the end, it comes back to the job of individual analysis. That is, “there is a season, a time for every activity,” to include leverage and no leverage. And while there are times where “Debt + Volatility = Dynamite,” there are also times when honest analysis of risk, opportunity and consideration of both upside and downside may argue for prudent use of leverage.
At Pasadena Private Lending, we typically lend a maximum 3x cash flow (assuming all other credit factors are acceptable); this is a third to a half of the leverage encouraged by some lenders to their business borrowers. While we may seem restrictive, we want to be our clients’ lender throughout economic cycles and are prepared to flex our facilities when necessary for special opportunities or unforeseen challenges. This opportunistic flexibility can only be offered if we keep the leverage lower than other lenders might allow it to be at the outset of a relationship. That is not to say we do not try to meet a prospective borrower’s needs, but we endeavor to be truly flexible and responsive through custom structures as much as through absolute maximum amounts of debt that we might make available to our clients.
I invite you to explore the possibilities by further exploring our website where we share our credit process, spotlight our team and when the time is right, contacting us however best serves you.
Until then, stay well and financially nimble.