Blue Elephant Capital Management

Leverage Long and Prosper

Blue Elephant Consumer Fund priced its first ever ABS transaction on Tuesday, March 17. This is a great thing for our investors, as we have effectively locked in the financing rate on our leverage for the life of the loans that serve as collateral. It also serves as a good time to bring up a question we are asked often by investors — why use leverage at all?
Leverage is one of those terms that people have been taught to be afraid of, generally because they equate the term with ‘risk’. Of course, that ignores that idea that ‘risk’ often comes with ‘reward.’ Leveraging assets in a smart way can seriously augment investor returns. It is easy to understand that using borrowed money increases your return in positive scenarios and lowers them in negative ones. If you have to put up less capital to buy an asset and it generates a positive return profile – this will be reflected in a higher return on equity.
We’ve chosen to use leverage at this point in the cycle because we believe that the positive performance likely from well-underwritten loans made to worthy creditors is worth amplifying. Our investors know that we plan on moving leverage lower when this view changes – but for now, we will take the leverage risk over, say, going down in credit quality. Any manager employing leverage will fall into the trap of saying “We don’t take too much risk.” It is a little silly – like telling your barber “don’t make it too short!” Obviously everyone wants just the right amount of leverage (and the perfect haircut). We can agree that leverage does inherently increase your upside return and increases your losses in an adverse scenario. But the real nuance embedded in that comment is the risk of ruin. Are we running the risk of losing all of our capital and not being able to play again?
That sounds very risky, mostly because it is. The most common example of the adverse effects of leverage is not being able to meet a margin call. Margin leverage is calculated daily, but the underlying investment, usually has a duration much longer than that. So even if the investment eventually recovers, you have already lost most of your equity. But what if you the nature of your liability is matched to your assets? If you can’t get stopped out of your trade – then you are in the same position as funding the position without leverage from a path dependency perspective. If you get to hold through the downside and are around to capture the upside, leverage looks a lot less risky.
Here is an understandable example of term leverage. Most homeowners have a mortgage on their primary residence, which is a form of leverage. In 2008, everyone’s home fell dramatically in value. The bank didn’t get to foreclose on you simply because the value of your asset fell below the value of the loan – that’s part of what can make a mortgage a smart use of leverage. As we think about leverage, not all leverage is created equal from a risk standpoint. This is path dependence – it is best to employ leverage where your debt partner cannot force your hand.
This is where the Blue Elephant securitization serves as a good example. Our current leverage facility has a two-year term and must be renewed after that period. Our assets, on the other hand, are 3 to 5 year loans. Securitization solves the timing issue – anything that goes into the securitization trust has locked in financing for the life of the assets. With the rating agencies getting involved, Blue Elephant will be able to move to this term-financing model, which gives us the best of all worlds – lower, fixed-rate funding without a risk that the financing ends before the loans mature.
We see this type of leverage as getting our investors excellent reward for the risk. Note that we do not leverage our small business loans any of non-dollar book – we only use leverage on the high quality US assets.
At the Elephant we understand nuance and balance and manage it. Our securitization shows that and keeps us on the cutting edge of this ever-growing industry. Stay tuned.