Use other people’s money - Recap of discussion

I was very glad to see a keen interest in my recent topic of discussion – “Buy a company with debt or with cash?” I hinted that there may be a personal finance lesson to be learned, and I will speak to that below.

The company-buying scenario proffered in my previous post is one that I lived through (of course I changed the names to protect the innocent). I joined a company several years ago that had been purchased by some venture capitalists, and by an individual for whom I had worked previously. I joined as the deal was being consummated, and dealt with a lot of buyer/seller issues. It was awkward at times, as I was clearly pro-buyer (that’s who hired me), but I still had to deal with the sellers at times. The motto “It’s just business” sometimes didn’t seem to fit. Things got nasty – I sometimes wonder why rich people squabble over very small sums of money. Perhaps that’s how they got where they are?

The interesting part of the whole transaction was where the money was coming from.

First off, the two previous owners were forced, through negotiation, to give the new company a 5-year, interest-only loan. This was a very successful business, so they could be reasonably assured that their money was safe. Plus, they were each pulling in a massive interest check each month. It provided more than enough spending money for their months in Florida. : ) Even more interesting was that the buyers made it an interest-only loan. I had previously worked for another company that had an interest-only loan on their building, and quite obviously, they weren’t building much equity in the place, besides a bit of appreciation. When it comes to a transaction like a mortgage on our house, we are told by every expert that an interest-only loan is just unhealthy (and I agree). I know they are used in San Francisco and other red-hot markets, because otherwise young people can’t buy a house. Nevertheless, I feel pain for people that use such loans. And yet, an interest-only loan was used to partially finance this purchase.

Secondly, and much more interestingly, the venture capitalists were handling the money of some extremely wealthy folks about town. These were the “blue bloods” of my hometown – people with net worth’s of $50-600 million. Big, big-time cash. This transaction was rather small for guys like this. This VC firm was put together and funded to buy small to medium-sized companies, with the intent of holding them for awhile. They felt this size of business was not normally targeted by private equity, and they wanted to profit from it. I agree with them – these folks are going to make a lot of money at this.

But then I thought to myself, “Why even bother borrowing here?” I mean, really, what’s the point? One guy in the group had a $600 million net worth. Their combined net worth easily exceeded $1 billion. Why are the VC’s over at the bank borrowing $10-20 million? Why are they negotiating tooth-and-nail with the former owners over a small, interest-only loan? Why don’t they just put up the cash, own it outright, and take in the profits? It’s streamlined, it’s simple, and you’re beholden to no one.

The answer was two-fold: Return on Invested Capital, and taxes. I will speak more extensively on ROIC, but these guys paid a helluva lot of attention to taxes. I don’t have as extensive an understanding of taxes as they and their tax accountants do (as a CPA, I worked in the audit department of my old CPA firm), but I can tell you that they structured this thing to be as tax-efficient as possible. My two scenarios were entirely based on pre-tax calculations, for discussion purposes.

The real reason you borrow in this case is to achieve the highest Return on Invested Capital you can. There is a way to annually make money, and own a business, using less of your capital. You go to the bank and you borrow. By borrowing, you are able to control an asset, and profit from it, using the least amount of up-front cash as possible. As the poor simpletons we are (sorry, it’s hard to match wits with $600 million!!!), we do the exact same thing when we buy a house. Most of us use a mortgage because that’s all we can afford to do. But as I’ve pointed out here, if you absolutely have to have a house, a mortgage could end up being the most profitable way to do it. It allows you to retain more of your cash now, which can be used to invest in stocks and/or rental real estate.

Plonkee nailed it right on the head – when you borrow (option 2), you get a year 1 Return on Invested Capital of 37.8%, before taxes. Option 1 yields a year 1 ROIC of 17%, and is less tax efficient. These ultra-wealthy folks look at this, and the choice is simple – borrow. Use other people’s money to achieve a superior return. For folks like this, emotions do not factor in – they run the numbers, they trust their advisors, and they gun for maximum return.

Full disclosure: company cash flow suffers a bit in option 2, as you’re making a large loan payment ON TIME each month. This business was a cash cow – we had a few struggles, but they were mostly timing issues - nothing we couldn’t handle.

There is another aspect of option 2 that I find very interesting. Each year, as you pay off the 7-year term loan, you own more and more of the company. In year one, you generate a before-tax profit of $3.78 million, but you also build $2.57 million in equity. If you combine those two numbers, you earn a first year return of 64%! I think you have to figure that in. You put in $10 million, and after one year, you now have $16.35 million. It wallops the return of option 1.

My apartment building is much the same way. I put approximately $60,000 down on a $300,000 building, and besides repairs and maintenance (which can admittedly be a bit costly every once in awhile), that’s the last bit of capital I will put in the building. The business itself makes the payments (rents from the tenants). So I put $60,000 in, and in 30 years I will own a building that will probably be worth $400,000. Not to mention the excess cash it generates each month and the big depreciation tax write-off.

When choosing option 2, where you’re investing $10,000,000 instead of $36,000,000, some people wondered if you could earn an equal or greater return with the rest of that unspent $26,000,000. I do not live the lives these people live, but I would have to guess yes. Personally, I would not be concerned with this. My approach would be to invest the right amount of money, in the right places, for the right returns, and at the right time.

That’s the lesson I take from this experience - invest the right amount of money, in the right places, for the right returns, and at the right time. One might argue that middle class folks cannot afford to make financial decisions in the same manner that rich people do. I argue that you cannot afford NOT to emulate them.

Right now I have a 5.5% 30-year mortgage. Due to some previous prepayments, I’m probably ten years along on the amortization schedule. We itemize on our taxes, so I am able to take the mortgage interest deduction, and we are in the 28% tax bracket. That means that any prepayments I make on my mortgage would generate an after-tax return of 3.96%. I CAN BEAT THAT! Let’s be clear - when I have that damn mortgage paid off, it will feel better than watching Paris Hilton return to jail – this will be an emotional day! However, if I run the numbers and keep my emotions out of it, I realize that my excess month-to-month cash can be put to work a lot harder than prepaying on my mortgage. So we stopped prepaying years ago.

Why are people averse to debt? Simply put, debt equals risk. And risk = increased blood pressure. It is better, or it feels better, to owe no one anything. I look forward to the day when all mortgages are paid off – I will probably be a wealthy guy by then, and with no monthly mortgage payment, I will have a myriad of life’s options in front of me. But I cannot be in a rush to pay off a mortgage that in effect produces a 3.96% return for me. There is a better way.

As we invest our cash in the smartest ways I can dream up, I am giving myself the very best chance to be sitting on a big brokerage account 10-15 years from now. And 20 years from now, when the mortgage is finally paid off? Who knows how much we’ll have by then?!?!?

Thanks to everyone that commented in the previous post. It’s great to have you all here as readers. Cheers!