We watch in disbelief as financial markets retreat and the investment banking industry morphs into something yet to be determined. We are witnessing the dark side of financial leverage. While “de-leveraging” has become the buzzword du jour, we may miss the real lessons of the current crisis and the real opportunities for leverage.
The lure and risks of financial leverage
Financial leverage is a powerful accelerant in growing markets. Companies can extend their reach far more rapidly by borrowing other people’s money. They can also generate much higher returns for the equity investors if companies have opportunities for profitable growth. This is especially true when companies operate in an environment with relatively low interest rates and significant growth in global liquidity, as we have had over the past decade or so.
At every level of our society - individual, firm and government - financial leverage has proven very seductive. To given an idea of how seductive , the total amount of credit market debt in the U.S. in 1980 was about the same as our GDP but, by 2007, it had increased to 350% of GDP.
But, as we are learning, financial leverage has a significant downside as well. If the “real” economy turns down or the company fails to appropriately assess the risks with its growth strategy, financial leverage quickly becomes an albatross. The company is stuck with fixed interest payments that have to be covered every quarter. If the value of the assets being financed also deteriorates the company gets a double whammy when it comes time to refinance. And if liquidity dries up, the company is vulnerable to a triple whammy.
Financial leverage is challenging enough at an individual company level. It becomes even more challenging in our highly connected global economy, as our current crisis illustrates. When many companies are highly leveraged, if one company runs into financial trouble, it can generate a domino effect as each company struggles to cover its debt obligations and puts pressure on the companies that have borrowed from it. This is the scramble to “de-leverage” that we are now witnessing. Cash is king and leverage, once worshipped as a god, now becomes the devil.
One option - capability leverage
But, as we begin to see the very real downsides of financial leverage, we might want to explore other forms of leverage that are far more robust in times of economic downturn. For example, capability leverage—the ability to access and mobilize the resources of other companies to add more value to customers—is a powerful force for creating value in markets. Rather than one company trying to do everything, it can mobilize a broader network of participants to deliver highly specialized and flexibly tailored value to individual customers.
This approach frees up each company to focus its own resources on what it does best while accessing the world-class capability of other companies in the network. Rather than relying on a few select business partners, companies can now employ innovative new management techniques to create and coordinate networks of thousands of business partners that provide far more leverage than ever possible before. I explored this opportunity in an article on Leveraged Growth in Harvard Business Review.
Financial leverage is insidious because, unless carefully monitored, it can undermine incentives to pursue capability leverage. If a company has ready access to cash through various forms of debt, it is much more likely to feel that it can support a much broader range of business initiatives than if cash is tight. As a result, it is much easier to support a “not invented here” culture and attempt to do everything oneself. It is no accident that some of the most sophisticated examples of capability leverage have emerged among entrepreneurial companies in Asia that did not have access to financial capital.
Another option - learning leverage
Yet there’s an even more powerful form of leverage for companies to tap into: learning leverage. Learning leverage seeks to build relationships with other companies that help each company get better faster by working with others. Rather than treating existing resources as fixed, learning leverage recognizes the value for everyone in finding ways to continually push the performance envelope for all participants. In rapidly changing global markets, learning leverage provides a powerful approach to increase value delivered to customers. Learning leverage introduces a powerful compounding effect – not only does the value delivered increase with the number and diversity of participants, but more value is created by each participant over time.
Comparing the three forms of leverage
Here’s one way to look at the three forms of leverage. Financial leverage magnifies returns, but does not increase the value delivered to the marketplace. Capability leverage increases the value delivered by flexibly connecting resources that otherwise might not be accessible to customers or that might require great effort by customers to assemble on their own. Learning leverage adds even more value by enabling individual participants to deliver higher levels of performance to the marketplace as they learn more rapidly from each other.
Capability leverage and learning leverage amplify value in times of economic prosperity, but they are even more valuable in times of margin pressure. Rather than requiring one company to bear the brunt of this margin pressure, these forms of leverage make it easier for the company to focus on investments that can enhance differentiation while relying on others to deliver complementary value to the customer. In contrast to financial leverage, these forms of leverage alleviate and diffuse pressure during economic downturns, rather than magnifying pressure on the leveraged company.
With some notable exceptions in arenas like high tech and biotech, most Western companies are still just scratching the surface of the potential for capability leverage and learning leverage. Perhaps during this challenging economic time companies will have much greater incentive to explore these alternative forms of leverage. They may find that capability and learning leverage trump financial leverage.