No matter the investment, it’s important for advisors to ensure investors understand the different types of risk involved, writes JT Dhoot
Imagine you have a client, Cindy, who is considering purchasing a business. Cindy thinks she's getting a steal because, among other reasons, she only needs to invest $50,000 in cash to buy the company. The remainder of the $1 million purchase price would be financed by a combination of third-party lender financing and through a vendor-take-back (VTB) provided by the seller. What are some of the things Cindy should consider as she evaluates this opportunity?
First, she needs to remember that her at-risk capital is not limited to her $50,000 cash investment because, irrespective of how the business performs, Cindy must repay her lenders. Although this might not be a problem if Cindy's projections play out as planned, what happens if things go sideways? Does Cindy have the financial resources to satisfy any shortfalls that might arise if the business struggles?
Second, Cindy should understand that financial risk and business risk are related yet distinct concepts. Financial risk arises when an investor uses debt to finance an investment. All else being equal, more debt means more financial risk due to a higher probability of defaulting on loan payments. In contrast, business risk relates to supply and demand for the company's products and services, changes in the regulatory environment that could harm its prospects, and many other factors, all of which are unrelated to the company's capital structure.
A simple real estate analogy can help explain the difference between financial risk and business risk. The value of a house at a specific point in time depends on housing inventory levels, current and anticipated population growth, current and forecasted employment levels, and various other demographic and economic factors. These factors are analogous to business risks, insofar as they influence the value of the home.
Conversely, how a particular homeowner chooses to finance his or her home reflects financial risk, not business risk, as it does not affect the house’s value. In other words, the house is worth what the house is worth because anyone purchasing the house can choose to finance the acquisition how he or she sees fit. One person may be wiling to take on more debt (and financial risk) than the next person, but this has no bearing on the home’s value.
In theory, the optimal amount of financial leverage and the resultant overall cost of capital for a specific investment is a function of the investment, not the advisor. Generally speaking, businesses with tangible assets and stable cash flows can service more debt than those with fewer tangible assets and erratic cash flows. While estimating the optimal amount of financial leverage for a specific investment is a complex exercise, what is clear is that excessive debt increases the risk of bankruptcy.
In summary, financial leverage is akin to a double-edged sword in that it cuts both ways. Just as greater leverage magnifies equity returns when an investment performs well, losses can also widen in cases where targeted returns (cash flows) fail to materialize. How much and on what terms debt should be used to finance an investment will vary from company to company; however, investors must remember that the expected reward for accepting greater financial risk should adequately compensate them for the added risk of doing so. The proposed purchase price and capital structure in Cindy’s case may or may not be reasonable, but differentiating between business and financial risk will help Cindy evaluate her options and make an informed decision.
JT Dhoot is a Chartered Business Valuator and Accredited Appraiser with more than 12 years of experience in valuations, real estate development and private equity across Canada.