Is it that uncommon for businesses like the ones Donald Trump runs to owe $650m in debt? originally appeared on Quora - the knowledge sharing network where compelling questions are answered by people with unique insights.
Answer by Peter Lynch, VP Private Equity; formerly at JPMorgan and Rabobank; founded ASimpleModel.com, on Quora:
It is very common for a business to employ leverage (debt) in an effort to reduce the overall cost of capital and to boost returns to shareholders. The decision to assume debt should follow a very careful evaluation of the company's cash generation, and potential to maintain appropriate levels of liquidity moving forward. From what I read, it appears this last step is where Trump struggles.
Often debt is secured by a lien on assets, and in the case of real estate this can often extend to personal assets as well. What does that mean? If you secure a loan from a bank to purchase land and build a casino, for example, you are effectively making a promise (actually a legal obligation) to pay interest on this loan and repay principal (the amount of the loan) over time.
Cash flow, frequently referred to as the "life blood" of a business, is essential because it permits you to stay current on your obligations. If you fail to make these payments (default), the bank can take legal action to recover the balance owed. The challenge for creditors comes when the collateral used to secure the loan isn't sufficient to recover the balance owed. Seizing and liquidating assets is not attractive if it is done at a loss.
I have seen investment groups use this to their advantage. In one example, a large private equity fund convinced lenders not to pursue legal remedies, and instead offered to sell the business and use the proceeds to pay off the remaining debt obligations owed to the lender. I had an opportunity to review the financials, and there was no chance the business sold for more than the amount of debt remaining on the balance sheet; however, the private equity group convinced the lenders to let them keep 10% of the sale proceeds anyway for their efforts.
Generally, when this happens enough times lenders stop lending to the groups with a history of defaulting. For this reason I might argue that while common for businesses, it is uncommon for businesses like the ones Donald Trump runs. Or perhaps it just should be. Fortunately for these groups, financial memories are short and the promise "of this time is different" rings true even when investors and creditors should know better. Trump is no stranger to bankruptcy: "I am the king of debt. I love debt." he once said on CNN. But in his career, debt has sometimes gotten the better of him, leading to at least four business bankruptcies.
With mounting frequency, these actions cannot be without consequence. Howard Marks, founder of Oaktree Capital Management, released an interesting memo recently where he touches on Trump's approach to debt:
Finally, I'll mention Trump's most unrealistic claim: that he could trim the federal debt by negotiating the ability to pay it off at a reduced amount. He built his net worth in part by borrowing money and not paying it back, and he seems proud of his companies' repeated use of bankruptcy as a strategic tool. But Trump doesn't have an ongoing need to tap the world capital markets, as the U.S. does (he now operates under an asset-lite business model that emphasizes licensing fees rather than asset ownership; perhaps this is because his multiple defaults have caused the credit window to be closed to him). The United States could refuse to pay its debts in full - that's called "rescheduling" or "default" - but we'd be unlikely to have the same access to the credit markets, and we would certainly cease to enjoy the benefits of a high credit rating and resulting low interest rates.
Marks was focused on the election, but I found this language interesting: that without access to credit, Trump has had to transition to an asset-lite model. What frustrates me is that Trump is referred to in the press as a New York City businessman, even in publications that clearly do not support him. To my mind, the term businessman implies some sense of financial acumen where the positive outcome is not limited to the sole individual. Whether it's a business or a building, a lot of parties are involved in successfully financing, building, and maintaining attractive assets. It is why a great business can have an incredible impact on a community as revenue growth brings jobs and increased salaries for employees. Using inherited wealth, excessive debt and bankruptcy as a tool to expand personal net worth should not share this association.
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