(GuruFocus) "Leverage is like Russian Roulette; 99% of the time it works, but neither 83.3% or 99% is good enough when there is no gain to offset the risk of loss," Warren Buffett explained at the 1999 Berkshire Hathaway annual meeting of shareholders.
Buffett was discussing the collapse of hedge fund Long Term Capital Management at the time, describing to his audience why it never made sense for the 16 highly intelligent people who set up the fund in the first place to borrow so much money.
A magic solution
Long Term Capital Management grew rapidly in the first three years of its existence. From a standing start, the hedge fund grew from launch to over $100 billion in assets in less than three years, generating 40%+ returns on capital along the way.
However, the company was accumulating huge liabilities in its quest for market-beating gains.
By 1998, Wall Street had exposure of more than $1 trillion to Long Term Capital Management. In 1999, the firm lost $4.4 billion of its $4.7 billion in capital and had to be bailed out by the Federal Reserve and a consortium of Wall Street banks.
Berkshire Hathaway did put in a bid for the portfolio of derivatives, but the hedge fund's management ultimately rejected it as being too low. Maybe Buffett had a lucky escape.
Avoiding leverage
Talking about the scenario at the 1999 annual meeting, Buffett presented his thoughts on why borrowing money is so nonsensical, and these thoughts remain relevant even today.
After outlining why Long Term Capital Management failed, he went on to talk about the perils of leverage, stating:
"Whenever a bright person, a really bright person, goes broke that has a lot of money, it's because of leverage. It -- you simply -- you basically can't -- it would be almost impossible to go broke without borrowed money being in the equation."
He went on to ask, "What's two percentage points more, you know, on a given year, that year?" Why run the "risk of real failure" just for a few extra percentage points of performance?
Even though the risks far outweigh the rewards, "very bright people do it, and they do it consistently, and they will continue to do it. And as long as explosive-type instruments are out there, they will gravitate toward them," Buffett said.
The CEO of Berkshire has stressed his desire to remain debt-free on multiple occasions in the past. For example, in his 1989 letter to investors, Buffett wrote:
"A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds - though we have learned to live with those also."
And in his 2018 letter, Buffett once again reminded us why he does not like to borrow:
"We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time.
At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal.
A Russian-roulette equation - usually win, occasionally die - may make financial sense for someone who gets a piece of a company's upside but does not share in its downside. But that strategy would be madness for Berkshire.
Rational people don't risk what they have and need for what they don't have and don't need."
This is something investors need to understand not just when they're looking at potential investments, but in their personal lives as well. Borrowing should be avoided at all costs.
