Thu 2 Aug 2007
Here’s an interesting trick, in a roundabout explanation thanks to the latest GMO Quarterly Letter – investing without margin calls.
Imagine this, you’re a wealthy investor and have confidence in the long term growth of the economy and the markets. You want to get leveraged long as much as possible to benefit from this long term growth, but know that the inevitable dips and swoons are a threat to using too much margin.
Enter the concept of investing without margin calls. Think it’s not possible? Think again — it’s been happening at a record pace in the last year in the form of Leveraged Buy Outs (LBOs). The long-term investors who buy these companies are sometimes able to lever up as much as 10 to 1, so they might put up $100 million to buy a $1 billion company. They sell bonds (backed by the company’s assets and earning power) to cover the rest of the $900 million difference, and are able to get much more leverage than if they were simply getting 50% margin (2 to 1 leverage) from their stock broker.
But there are plenty of risks, such as the cost of? servicing all that debt, getting the company to grow as much as it would have under public ownership, etc.
It’s an interesting trick if you have enough money to pull it off.? It’s effectively a risk-reversal where the risk of a margin call is shifted from the equity owner to the debt buyer.