“You can’t spell ‘McClendon’ without ‘lend.’”
Oklahoma Gazette
We live in an era of debt. From governments, to companies big and small, to households and individuals-debt has surged to levels past generations would have been shocked by. This is largely due to the fact that, for a long time, debt has seemingly worked. Assets, from residential and investment real estate to stocks, have been rallying for years, and interest rates have fallen to historically low levels. This has been a magic combination for those using leverage to accumulate assets, and seems to validate the notion of leveraging-up your balance sheet to maximize your lifestyle and net worth. Given the prevalence of this view, it is an opportune time to take a hard look at debt and the proper role it should play in your unique financial life.
A Wall Street Journal article, “The Truth About Wealth”, published in 2011, looked at how affluent households were affected by the financial crisis. According to the article, the top 1% of income earners saw their incomes fall by more than 30% from 2007 to 2009. In contrast, the bottom 90% experienced only a 3% drop. In terms of net worth, the top 1% also suffered much larger losses, due to its much heavier exposure to volatile assets. Fully one-third of these households fell out of the 1% over the period in terms of net worth. It is not surprising that the income and wealth of the affluent is more volatile-this has been the case for long periods of time. What is unusual is the increasing degree of that volatility. According to a Northwestern University study, the financial volatility of the top 1% has quadrupled since the early 1980s.
While there are many factors behind this, I believe a core reason has been the wealthy’s increasing use of debt. Prior to the 1980s, the 1% was heavily populated with inherited wealth and the owners of businesses. Both groups tended to have conservative balance sheets with low debt levels. Since then, the 1% has been comprised increasingly by those in the technology, finance (particularly private equity, hedge funds, and venture capital), and real estate industries. All three industries are volatile, and with the exception of tech, have a business model based on highly leveraging assets.
Leverage, at its core, magnifies outcomes; making good outcomes better, and bad outcomes worse. When debt works, it really works. However, when taken too far, and it’s only clear what’s too far in hindsight-it can cause financial devastation. I believe the remarkable story of Aubrey McClendon, an admittedly extreme example, can serve to illustrate the two-sided face of leverage. McClendon, a pioneer in natural gas fracking, founded and built Chesapeake Energy into a leader in this nascent field. He had the vision and courage to buy up huge tracts of land, and to fund the massively expensive task of drilling, based on his near religious faith in the future of fracking, his own entrepreneurial drive and financial wizardry. At his peak, McClendon was worth more than $2 billion, and had a reputation as a maverick who could seemingly do no wrong.
And yet this remarkable success story of incredible-and rapid-wealth creation was built on a very fragile foundation. First, the vast majority of McClendon’s assets was largely dependent on a stable natural gas price-a notoriously volatile commodity. He had so much conviction in the future of natural gas, that he relentlessly leveraged those assets to buy even more-thereby increasing his leverage and concentration. Over time, virtually every asset McClendon owned was pledged as collateral against loans, eventually getting to the point where he even pledged his homes, wine collection, and stake in the Oklahoma Thunder basketball team.
Eventually, like Icarus, McClendon flew too close to the sun. The factors which served to create his wealth and success were the same ones that undid him. The collapse of natural gas prices crushed the values of McClendon’s investments and assets. This caused his creditors to demand increased capital or collateral on his debts, and the eventual forced sales of assets into an already distressed market. With almost unbelievable speed, the vast majority of his wealth was vaporized. Shortly thereafter McClendon was killed in a car accident. It was a tragic end to a brilliant and tumultuous career. Over three years have passed since his death, and his creditors continue to fight over what remains of his estate.
There are many lessons from this very unfortunate story. For our clients, business owners and professionals in mid-career, I’ll focus on a few:
-More volatility = less debt: McClendon put huge leverage on hyper-volatile assets. This is not a game worth playing. Volatility, in itself, is not bad. It is much better to have your income and net worth growing at a lumpy 15% over time, than a smooth 5%. But that degree of volatility impacts the degree of leverage you can prudently carry.
-More concentration and illiquidity = less debt: McClendon’s assets were overwhelmingly concentrated in natural gas assets, many of which were illiquid. This is a dangerous combination to lever. The more concentrated and illiquid your assets, the less overall leverage you should have.
-Balance conviction with prudence: McClendon couldn’t conceive of his judgment being wrong, which obscured the risks he took on. Life doesn’t always work out as we anticipate. None of us have a crystal ball. Many natural risk-seekers look at debt in the context of best case outcomes. While they may occur, it is not advisable. We advocate stress testing client finances in challenging environments to determine the appropriate debt levels.
Make sure your debt levels are appropriate and suitable for your unique financial situation and psychology. Don’t be a member of what the media calls the “high beta rich.”
Visit www.dolanpartners.com to learn more.