First of all: Yes, there is a pun in this title and it is intended. But as with most jokes, there is a truth to it. The use of the term leverage in daily conversation, will usually care a negative connotation. Leverage gets a bad rap, you could say.
The cause of this, I guess, is because most people will associate leverage with debt. And although debt is definitely a form of debt, not all leverage is debt. In the world of engineering, the term leverage simply means the exertion of force by means of a lever.
The Law of the Lever, which was proven by Archimedes using geometric reasoning, shows that if the distance a from a fulcrum to where the input force is applied is greater than the distance from the fulcrum to where the output force is applied, then the lever amplifies the input force. “Give me a place to stand on, and I will move the Earth”, Archimedes is famously quoted.
Leverage and Investing
When we think about investing and business in general, leverage tends to mean financial leverage. But not all leverage is created equal. There are many types of leverage and those different types of leverage have different kinds of qualitative attributes.
Many investors use leverage and there are probably more types and forms of leverage at your disposal than you can imagine. Savvy investors and entrepreneurs excel when it comes to creative use of leverage.
Different Types of Leverage
Once you start looking for leverage, you will start seeing it everywhere. Operating leverage, for example, is a generally under-appreciated form of leverage. Many of the most successful businesses in the world have been able to use operational leverage on favourable terms. Operational leverage is a necessary ingredient in any venture trying to scale fast.
When we think of Financial Leverage, we tend to think about loans. But there are other forms of financial leverage, such as derivative instruments.
- Other People’s Assets (think marketplaces and aggregators)
- Other People’s Money (think asset management companies)
- Negative Working Capital (think insurance float)
- User-base leverage (think new products to your existing user base)
- Unsecured Notes
- Margin Loans
The Beauty of Non-Recourse Leverage
Determining whether leverage is recourse or non-recourse is crucial to any reward/reward assessment. The beauty of non-recourse leverage is that it is asymmetric. If you invest in a stock, the most you can lose is the money you put up. The upside, however, is infinite, theoretically speaking. If you start a limited liability company, your theoretical upside is infinite, but you can only lose the equity you put up (unless you are providing personal collateral).
Non-recourse leverage often comes at a price. If you buy a call option, you have to pay for it. The further out-the-money it is, the cheaper the price. Unsecured loans are more expensive than secured loans. Etc, etc.
Finding a mispriced, perpetual, non-recourse option on something is the holy grail of fundamental investing. This is how the best investors and most savvy business people create wealth for themselves.
Read more on Leverage and Optionality
- Embedded Optionality: A Case Study of FRMO Corp
- The Value of Leverage: On Leverage and Arbitrage
- Why is Chuck Royce such a Good Investor? (Hint: Embedded Call Options)