Leveraged equity is the stock of a company that has significant debt, which is also known as leverage. Because the company operates primarily by using debt, leveraged equity carries more risk than traditional equity. Depending upon the amount of leverage a company has, it can be as risky as debt. The risk lies in the company’s ability to finance the debt. If the debt cannot be financed from operations, either because sales decline or costs go up, the company will go bankrupt.
Companies use financial leverage in order to increase value for their shareholders. By borrowing money, a company can often obtain more capital than it would be able to obtain if it were to try to sell more shares of stock. If a company takes on too much debt, however, it risks seeing its stock price decline because of the belief that the company is over-leveraged, or has too much debt. It is a balancing act for companies to carry sufficient debt to expand their operations, while not acquiring so much debt that the company appears to be unstable.
If a company wants to acquire another company, it would be quite difficult and time consuming for most companies to raise enough money through equity. Most companies will borrow the money needed to finance the acquisition. This is known as a leveraged buyout. Most leveraged buyouts are financed by 10 percent equity and 90 percent debt, or leverage. Bonds that are used to finance a leveraged buyout are quite risky, and are sometimes referred to as junk bonds. The stock in such a company would be considered leveraged equity.
Mutual funds can also take advantage of leveraged equity to increase their returns. Most investors would expect to find leveraged mutual funds in relatively volatile asset categories such as small- to mid-cap growth funds, but leverage can be used in funds of any class, including bond funds. These funds can increase return if the fund performs well, but investors can also suffer significant losses if the fund declines.
Individual investors can also use leverage to increase their buying power. When an investor purchases stock on margin, he is borrowing the funds from his broker to make the purchase. This is considered to be leverage. Options are also a use of leverage by the individual investor. Because any kind of leverage is risky, leverage should be viewed as a kind of supplement investment, and not as the predominant investment type in an investor’s portfolio.