The Difference Between Good Debt and Bad Debt
While I generally appreciate why financial gurus like Dave Ramsey are so anti-debt, and why plenty of people get themselves into trouble by acquiring too much debt…
When you look at all the richest people in the world, they typically have one thing in common: they borrow a LOT of money.
More specifically, they understand that we exist in a debt-driven financial system, and how to use debt to acquire assets that build wealth (“good debt”)… not acquire liabilities that destroy wealth (“bad debt”).
Good debt is debt taken on to acquire an asset or invest in a business that is expected to produce income greater than the interest-cost of the debt.
Some examples include:
The key features of good debt are that it is used to acquire income-producing assets and has a reasonable cost structure compared to the expected returns.
If this is the case, that is how debt leads to greater wealth creation.
Bad debt does not help generate income or acquire appreciating assets. Instead, it is used for consumption.
Some examples include,
The key distinction is that good debt has a clear productive purpose while bad debt is taken on to fund consumption and lifestyle inflation. Avoiding bad debt and using strategic good debt helps magnify wealth.
But hey, I know you don’t read Private Capital Insider to get some cookie cutter answer you could google yourself…
You want to know about those juicy “Insider” secrets that you’re not going to find anywhere else.
And even though you might be happy living an all-cash lifestyle…
If you want to build true generational wealth, the #1 skill you’re going to need to develop is allocating capital towards productive investments.
Why? Because money is a commodity that can be bought and sold at a variety of prices (“cost of capital”).
And once you understand that the secret to building wealth is to play the Game of Money the way bankers do, you’ll see why debt is such a powerful tool.
With that in mind, let’s talk about how Private Equity firms have traditionally used debt to unlock one of the craziest money-making opportunities in finance: the Leveraged Buyout.
How Private Equity Gets Rich with Debt-Fueled Leveraged Buyouts
As a quick refresher – generally speaking, there are two main reasons people invest:
Bankers (i.e., “Insiders”) want their Money Now. But the general public (i.e., “Outsiders”) has been conditioned by financial institutions to buy, hold, and otherwise hope for Money Later.
So how do Bankers create Money Now, more commonly called cash flow?
In one word: Arbitrage
To create an arbitrage opportunity, you need to have the following criteria in place:
This, in a nutshell, is the secret to passive income.
But the devil is always in the details. Namely, collateral and leverage.
More specifically, whose collateral is being used, and who is responsible for paying back the debt borrowed against it?
It is this devil that non-bank lenders (like Private Equity firms) are exceptionally well-experienced at using to their own advantage.
Enter: The Leveraged Buyout
Private equity firms are financial actors that sponsor investment funds that raise billions of dollars each year.
The hallmark deal structure of a Private Equity firm (or “sponsor”) is something called a Leveraged Buyout (LBO)...
A strategy for buying established companies using a large amount of debt – as much as 90% of the purchase price – with the plan to resell that company 3-5 years later for a profit.
Some of the most iconic LBOs occurred in the 1980s, fueled by the availability of junk bonds and loose lending standards.
The LBO process is similar to buying a house with regards to how the collateral and leverage works.
For example, in many cases, an individual can buy a house by putting down 5-10% of the purchase price (equity), and borrowing the rest of the money from the bank (debt).
As a condition of that loan, the bank requires you to pledge the asset as collateral. However, that debt needs to be serviced – which refers to the money required to cover the interest payments on that loan.
The ability to service debt is a key factor when borrowing money –which makes sense, because the lender wants to know if the borrower is going to be able to make their monthly payments.
The same logic applies to buying a multi-billion dollar company using a LOT of debt.
The sponsor is going to borrow as much money as they possibly can, and then use the revenues of the business they are buying to service the debt.
The logic behind an LBO is simple:
For those who’ve read our article on the Buy, Borrow, Die strategy – which takes advantage of the fact that borrowed money is not counted as taxable income.
This is more like Borrow, Buy, Sell.
Actually, to be more accurate, it’s more like Borrow, Buy, Plunder, Sell, or Bankrupt (whichever is more profitable).
And here’s where those devilish details come into play.
After loading a company up with debt through an LBO, PE firms can then strip assets, sell off divisions, and cut costs aggressively to rapidly pay themselves back.
To make things even sweeter, PE firms often structure deals with "payment-in-kind" features that allow the company to pay interest on the debt, by issuing even more debt.
As a reward for loading the company up with even more debt, the PE firm can then use that money to pay their management fees, and issue special dividends to themselves…
Even if the company is struggling to service its debt and could go bankrupt.
But a company going bankrupt isn’t necessarily a bad thing.
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In fact, the sponsor could actually stand to make more money by bankrupting the company than it would stand to gain by doing a pure “fix and flip.”
Here’s why…
A key advantage for private equity firms is that the debt used to fund LBOs is taken on by the acquired company, not the private equity fund itself.
This means if the deal goes south, the PE firm is not directly liable for the debts –only the company that borrowed the money is.
In fact, this is arguably a feature of the LBO model.
Why? If the overloaded company does go bankrupt, the PE firm can then take advantage of tax credits for canceled debt, which can then be used to offset the tax they would otherwise pay from the profits they just made plundering the company!
If that isn’t the definition of “heads I win, tails you lose” I don’t know what is.
As a matter of disclaimer, I don’t think all Private Equity firms are evil, bloodsucking capitalists who are a blight on society, and do far more harm than good…
But it’s hard to ignore the rather concerning examples of how these firms make huge sums of money through no actual value creation, but rather, through financial engineering and extraction.
For example:
Yet, private equity and its leaders continue to prosper, and executives of the top firms are billionaires many times over.
Even crazier? Because of the way these deals are structured, these sponsors are basically immune to any legal liability, and wind up getting massive tax benefits from their prolific use of debt (not to mention the lower tax rate they pay on the “carried interest” they earn).
We can see similar stories to this one happen over and over again, across every industry that Private Equity touches.
And even though this is a well-known problem, there is no shortage of lobbying done on behalf of the industry to protect their favored tax treatments and limited liability.
Ironically, these PE funds came to prominence because pension funds –who, thanks to decades of poor management – need substantial, above-market returns to make up their funding shortfalls…
They seek to obtain those gains through a predatory practice that often results in stripping employees of their livelihood, and destroying their pension plans.
Final Thoughts: Be Careful Using Leverage
As much as I’d love to see some huge, fast gains in the “private equity” portion of my portfolio that would presumably come from a private sale…
As a co-founder at Equifund, and someone who considers himself a decent human being, I believe that better outcomes are produced when you invest in management teams focused on building an enduring, and eventually publicly traded, company that provides true value to the market…
Not a thinly veiled scheme that eventually leaves retail investors holding the bag.
Now, to be clear, I’m not saying that using leverage –in itself –is a bad idea.
But without proper governance –and a management team who believes in doing the right thing –it’s all too easy to go broke by acting irresponsibly with debt.
As Charlie Munger reportedly said, there are only three ways a smart person goes broke –liquor, ladies, and leverage.
