Why Debt Can Be A Source of Alpha
Whenever private equity returns are compared alongside public equities returns, many investors chalk up any PE outperformance as “levered beta” or infer that, because of the use of debt, the returns don’t count.
That narrative treats debt as if it’s a simple multiplier, a button you press to amplify returns. But anyone who has actually borrowed and managed debt for privately held assets knows it’s the opposite – it’s an entire process that requires active management.
The cost and quality of debt can be significantly improved through judgment, experience, and skill, which is why I believe debt can be a source of alpha (market outperformance).
Debt management as a discipline
I’ve been regularly borrowing money and managing debt my entire career – first with real estate and now private equity. I can tell you firsthand that this is no easy process, and there are wide-ranging structures and outcomes. Borrowing money is a skillset that compounds with time and experience.
Here are some factors that can materially influence the quality and effectiveness of leverage:
- Managing relationships – lending is a people business disguised as a numbers business. Even within the same lending institution, the right contact can make a huge difference. With time, your rolodex grows, and this becomes a big advantage in being able to borrow well.
- Choosing the right partner – some institutions have reputations for being more borrower-friendly, while others have reputations for being more aggressive and hostile. This critical intel is gathered with experience and scuttlebutt.
- Choosing the right type of debt – cash flow loan or an asset-backed facility? Amortizing or interest-only? Long or short dated? Senior, subordinated, and or mezzanine? Matching the right debt type to your asset strategy is critical. The wrong debt structure could impair your strategy and ultimately the investment returns.
- Negotiating cost and terms – negotiating interest rates down is important, but two loans with identical interest rates can be polar opposites in quality. The difference lies in the structure and terms: covenants, callability, amortization profile, cures, prepayment penalties, floating/fixed rate, term length, etc. These terms can dramatically alter the risk profile of the loan and the outcome for equity.
- Amount of debt – this is what most outsiders mostly focus on, the quantum of debt. Obviously, very important, and experience will tell you how much debt to utilize given the specific asset or situation. Sizing debt is not a spreadsheet decision; it’s a judgment decision.
- Refinancing strategically – knowing when to refinance or roll the debt over to optimize your capital structure requires active management and thoughtful decision-making. The timing alone can create or protect a significant amount of equity value.
Combine all these factors, and it becomes obvious how active and shrewd debt management can deliver significantly better outcomes. It’s not a simple push of a button, it’s a honed skill.
“Alpha” incorrectly ignores cost of capital
In the traditional sense, alpha only gives credit for picking and managing the right assets. It gives no credit for picking and managing the right debt/leverage, even though both can materially shape net returns.
If an investor can consistently access a below-average cost of capital, or secure better terms that reduce risk and extend duration, in order to deliver above-average net returns… why shouldn’t that be considered alpha?
Buffett, who’s been leveraged his entire career, understands this better than anyone else. Berkshire Hathaway and its pursuit to maintain a profitable insurance float (through conservative underwriting) has enabled Buffett to access cheap, non-callable, and long-term debt to invest. This leverage has given Berkshire a structural advantage to generate above-average returns for decades.
Structural advantage for equity returns
The whole point of utilizing debt is to enhance risk-adjusted equity returns. I will argue that asset classes that have access to quality debt, like PE, have a structural advantage to generate attractive equity returns.
Debt doesn’t create alpha on its own. But managing debt well absolutely can.