A Practitioners’ Guide to Leverage through Downturns

There is extensive research addressing questions of optimal capital structure. Studies typically focus on estimating the appropriate level of debt and the factors associated with financial leverage. This paper addresses a slightly different question: how does a company’s choice of leverage affect its performance through an economic downturn and ensuing recovery?

This is precisely the question many companies were asking in 2019 when this paper was written, over a decade after the last recession. Corporate managers are increasingly trying to incorporate the possibility of a downturn in capital structure decisions today.

The author summarizes the findings of his analysis of the relative performance of three large-cap portfolios constructed on the basis of leverage: high, medium, and low. It focuses on measuring both financial (share price return) and fundamental (growth and margins) performance.

During the period 2006-2012, which aims to encompass a full downturn and recovery cycle, higher leverage had the expected effect of magnifying share price movements in both bull and bear markets. Nevertheless, these swings in share prices appear to have significantly exaggerated what amounted to negligible differences in the fundamental operating metrics that are most commonly associated with valuation.

The author’s policy prescription: Despite the temptation to reduce leverage to reduce potential share price declines, management teams should not prioritize debt reduction over investment in anticipation of economic downturns. Instead, articulate a clear leverage policy that supports an overall growth strategy and stick with it. The risk of short-term share price declines pales in comparison to the risk of prolonged subpar growth from underinvestment.