FrameworkCase studyCreditRiskCapital allocation
The duration and covenants of a loan matter as much as the amount of leverage
Bruce Flatt · Brookfield Asset Management's 2008 letter to shareholders · 2009
The idea
Brookfield's 2008 letter explains how an owner of real assets financed itself to survive a credit crisis. The debt was asset-specific mortgages at around half of value, with recourse only to the asset, so a problem in one building could not reach the rest of the company. Flatt's argument is that the amount borrowed is only one dimension: a loan that comes due in a crisis, or whose covenants trip on a temporary fall in value, is dangerous at any size, while long, non-recourse debt lets an owner wait. The same letter shows what waiting bought: asset sales for cash, shares repurchased cheaply, and a forecast that the next two years would be a very favourable time to invest.
Ask when the debt comes due, what it can reach, and what trips it, before asking how much there is.
When it works
Real estate, infrastructure and any capital structure question where leverage is measured only as a ratio.
When it may fail
Non-recourse debt costs more and lenders have learned to ask for guarantees. The structure is cheaper to describe than to obtain, and 2008 was a test it passed once.
How to use it
In the Covenant Headroom lab, hold leverage fixed and vary maturity and covenant tightness. The exercise shows how two companies with the same debt ratio can have entirely different survival odds.
Where it came from
Letter Brookfield Asset Management's 2008 letter to shareholders · Bruce Flatt
What the source says. Flatt describes financing by asset-specific mortgages averaging about 50 percent loan to value with recourse only to the asset, and argues that a loan's duration and covenants matter as much as the amount of leverage; Brookfield raised about $1.5 billion of net cash from asset sales in 2008 and repurchased 14.2 million shares.
“the duration and covenants of the loan are as important as the amount of leverage itself” · Bruce Flatt
Connected ideas
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Private credit lends larger, with thinner coverage and lower recoveriesPrivate credit's borrowers are more levered and its recoveries lower than the syndicated market's, and the capital waiting to be deployed is what pressures underwriting.
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In a crash, long-duration cash flows move far less than the price, if you stay solventState the liquidity first, because the argument that prices overshoot value is only available to those who can wait.
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Concepts
Put it to work on L3VLUP
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