CPD QUALIFYING WHITE PAPER
Debating leverage embedded within Business Relief investment services- appropriate or not?
Many Business Relief (BR) services are targeted at investors looking for a low volatility proposition that generates modest returns from income and capital. These investors are also typically more mature and more risk averse. However, as highlighted last month by a leading industry commentator, many are investing their money in BR services with embedded longer term leverage i.e. debt is built within the very structure of the investment over a period of multiple years. Is this use of leverage appropriate given the attitudes and risk tolerance of the client base?
• In this white paper we examine the possible impacts of embedding leverage within the asset backed trades that BR solutions typically invest in.
• We use illustrations to demonstrate the possible gains alongside the risks leverage presents.
• We discuss how the spectre of rising interest rates against a backdrop of a maturing economic cycle could impact investors’ returns.
• We also examine the additional complications of using long term leverage to boost returns from investments in renewable energy assets, drilling down into the possible impact of falling energy prices on the investor.
• We end with a consideration of the risk tolerance of the average investor in BR solutions- taking a closer look at how these investors may view leverage and volatility.
• We close with an attempt to grapple with the question of whether embedding leverage within BR services really reflects the risk profile of the average BR investor.
At the end of the global financial crisis (GFC) in the last decade many observers started to debate the virtues and vices of leverage. Many of the corporate implosions which occurred during the GFC had – it seemed in hindsight – been caused by complicated financial structures which boasted high levels of embedded leverage. Arguably the best explanation of these concerns came in the film The Big Short which explained how complex financial structures such as CLOs and mortgage backed securities had caused massive volatility within the US financial system – all accomplished using actress Margot Robbie memorably reclining in a bubble bath sipping champagne whilst explaining the logic of financial engineering. Its not so subliminal message was that embedded leverage might encourage speculation which in turn would result in bubble-like valuations, with inevitable downside volatility once that bubble burst.
But embedding long-term leverage within asset backed structures – typically involving less than liquid tangible assets such as property or renewable assets – can in some circumstances work to the investor’s favour. The challenge however is for the investor to understand and evaluate the risks that accompany these financial engineered structures. To illustrate this point, consider the following scenario.