The Value of Debt

How to Manage Both Sides of a Balance Sheet to Maximize Wealth

Thomas J. Anderson

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118758519
• Edition: 1
• Topic: Business
• Subtopic: Finanza
• Index: Business

A New York Times bestseller and one of the Ten Best Business Books of 2013 by WealthManagement.com, this book brings anew vision of the value of debt in the management of individual and family wealth

In this groundbreaking book, author Tom Anderson argues that, despite the reflex aversion most people have to debt—an aversion that is vociferously preached by most personal finance authors—wealthy individuals and families, as well as their financial advisors, have everything to gain and nothing to lose by learning to think holistically about debt.

Anderson explains why, if strategically deployed, debt can be of enormous long-term benefit in the management of individual and family wealth. More importantly, he schools you in time-tested strategies for using debt to steadily build wealth, to generate tax-efficient retirement income, to provide a reliable source of funds in times of crisis and financial setback, and more.

• Takes a "strategic debt" approach to personal wealth management, emphasizing the need to appreciate the value of "indebted strengths" and for acquiring the tools needed to take advantage of those strengths
• Addresses how to determine your optimal debt ratio, or your debt "sweet spot"
• A companion website contains a proprietary tool for calculating your own optimal debt ratio, which enables you to develop a personal wealth balance sheet

Offering a bold new vision of debt as a strategic asset in the management of individual and family wealth, The Value of Debt is an important resource for financial advisors, wealthy families, family offices, and professional investors.

Part 1

The Value of Debt in the Management of Wealth

Ignorance is the curse of God; knowledge is the wing wherewith we fly to heaven.

—William Shakespeare, Henry VI, Part 2

Chapter 1

Strategic Debt Philosophy: An Overview

How This Book Can Add Value to Your Life

This book aims to bring forth a new vision of the value of debt in the management of individual and family wealth. On the one hand, virtually every company already looks at both sides of its balance sheet—assets and debts—and consciously strives to come up with an optimal debt ratio.1 On the other hand, the vast majority of individuals, wealthy or not, are either dramatically overleveraged (have too much debt) or, at the other extreme, are substantially underleveraged (have no debt at all).2 Those in this second camp typically hold the notion that debt is always bad, should almost always be avoided, and if taken on, should be paid off as soon as humanly possible.

There is a reason, however, why practically all companies acknowledge the value of debt and seek to have an optimal debt ratio in place.3 Simply put, by strategically taking on and managing debt, these companies realize that they can take advantage of what we’ll call the Indebted Strengths that come along with that debt, which, as we’ll describe shortly, include Increased Liquidity, Increased Flexibility, Increased Leverage, and Increased Survivability.

As it turns out, despite the general antidebt knee-jerk reaction that most people have, many wealthy individuals and families—from the moderately affluent to the ultra-affluent—can also make use of these Indebted Strengths to their own substantial long-term advantage. For starters—in later chapters I will get into the details on all of these and more—the strategic use of debt can help enable you and your family to do the following:

• Quickly come up with the funds needed to respond to natural disasters, health crises, or personal difficulties of nearly any kind.
• Generate tax-efficient income in retirement (and potentially access your money tax free).
• Purchase a second home in a much less expensive manner.
• Become progressively wealthier by “capturing the spread” between the cost of debt and the return on investment that you can likely generate through appropriate low-risk investing strategies.

The Five Tenets (or Action Principles) of Strategic Debt Philosophy

There are five tenets—or action principles—that form the core of Strategic Debt Philosophy:

1. Adopt a Holistic—Not Atomistic—Approach

2. Explore Thinking and Acting Like a Company

3. Understand Limitations on Commonly Held Views of Personal Debt

4. Set Your Sights on an Optimal Personal Debt Ratio

5. Stay Open-Minded, Ask Questions, and Verify What Works

Each of the five action principles is expressed as a kind of injunction, starting with words like adopt, explore, and understand—words that tell you to do something specific. This is done to let you know that while this may be a chapter on the philosophy of Strategic Debt, it is not meant to be a vague, head-in-the-clouds type of exercise. There is real work—internal thinking and questioning, consulting first with one’s spouse and family members and then with one’s professional advisors—that is absolutely necessary before going forward with any of the specific Strategic Debt Practices recommended in this book. Let’s, then, now turn to the five tenets.

First Tenet: Adopt a Holistic (Comprehensive)—Not Atomistic—Approach

The first tenet of Strategic Debt Philosophy—and for that matter, the first tenet of all true wealth management philosophies—is to adopt a holistic approach. Merriam-Webster.com defines holistic as “Relating to or concerned with wholes or with complete systems rather than with the analysis of, treatment of, or dissection into parts.” Similarly, TheFreeDictionary.com defines holistic as “Emphasizing the importance of the whole and the interdependence of its parts.”

For purposes of this book, the terms holistic and comprehensive will be treated as synonymous. A holistic wealth management approach, then, is one that goes far beyond the typical investment portfolio approach. Instead, it starts with the needs, goals, and dreams of an individual or family, then looks not only at their immediate financial situation but also the entirety of their wealth, and then takes into account everything from estate and retirement planning to taxes and insurance to end-of-life concerns (health care, residency, medical powers of attorney, etc.), and then, finally, methodically backs out cash-flow needs and projections.

What’s important about a holistic approach is that it doesn’t separate analysis and action into atomistic silos, where decisions on everything from buying a car to making long-term investments are made without taking into account the impacts and effects of that decision on the entirety of an individual’s or family’s wealth. A holistic approach does its best to take everything into account (as well as how everything interacts with everything else) and does so on many levels, from the most general to the most detailed. This often means calling in experts—like high-level tax accountants, lawyers, insurance experts, and so on—to ensure that the best possible informed choices are made.

Adopting a holistic—and not atomistic or fragmented—approach to the value of debt has a number of consequences and implications. First, it brings to the table the critical importance of looking at both assets and debts, as we’ll continue to explore throughout this chapter and the rest of this book. Second, without a holistic approach to wealth management that does indeed take into account both assets and debts, it is very difficult if not impossible to adopt and follow through on a holistic wealth management philosophy overall. That is, thoughtfully considering and factoring in everything that is known about debt, as well as what is known about assets, is essential to deriving maximum value from a comprehensive wealth management approach. Finally, a holistic approach to Strategic Debt Philosophy enables the exploration of the four Indebted Strengths that will be explored in detail in Chapter 2.

Second Tenet: Explore Thinking and Acting Like a Company

According to Corporate Finance (Ross, Westerfield, and Jaffe 2013),

The goal of financial management is to make money or add value for the owners.4

A company is generally focused on gaining profits. That is, with the exception of nonprofit and not-for-profit companies, in the vast majority of cases the raison d’être—reason for being—of a company is to do well financially.5 One would think, then, that when it comes to money, companies would tend to know what they are doing, which is one reason why it’s important for wealthy individuals and families to explore thinking and acting the way that companies do.

One objection to thinking and acting like a company may be that, indeed, individuals and families are not companies, and their main purpose is not to gain profits. While that’s quite true, it’s also true that the exploration of thinking and acting like a company can have many benefits for individuals and families. Importantly, companies are often much more objective about financial-related matters than are individuals and families. So while their ultimate goals may differ, there is a lot of good learning that can come from exploring how companies think and what they do. Put differently, while you as an individual or family may not be primarily focused on making a profit, you nonetheless constitute an organized system of inputs and outputs that absolutely relies on having sufficient financial resources at the ready in order to get on with “the business of life.”

A related factor is that companies have specialized financial leaders—chief financial officers, or CFOs—who are very clear about what does and doesn’t work in the financial realm.6 Much training, much education, and much knowledge about best practices reside within these individuals. If the vast majority of CFOs follow a particular practice, you can bet there’s a good reason why.

A second objection to thinking and acting like a company can also be raised: In the pursuit of profits, companies may ultimately be much more willing to go bankrupt than you, as an individual or family, are willing to take a chance on. That is, for the most part, companies are so ultimately focused on making a profit that they engage in certain types of behaviors that you, as an individual or family, might not be willing to risk. This may or may not be true and it still doesn’t mean that there aren’t some huge lessons to be learned from at least the simple exploration of thinking and acting like a company.

Now that we’ve looked at the general reasons and objections as to why you could explore thinking and acting like a company, let’s turn toward what it is, in particular, that sets companies apart in the realm of a holistic approach to Strategic Debt Philosophy. First, and most importantly, consider the following true proposition:

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Virtually every company of any size chooses a holistic approach to its balance sheet that embraces having both assets and debts.7

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In fact, as of this writing, there are four U.S. publicly traded companies that have a AAA rating (and even they use different forms of debt!).8 This is not because there aren’t many companies that are big enough and wealthy enough to pay off their debt entirely. (Could Coca-Cola, Walmart, or Procter & Gamble, for example, pay off all of their debt if they wanted to? Of course they could . . . but they don’t, and they won’t.) Instead, it’s because companies—which are all about doing well financially—consciously choose to have an optimal amount of debt.

Yes, they are mindful of how much debt they have and how that debt is structured, but they take on debt and keep debt on their balance sheet on purpose. They do this so they can make use of what I will later define as their various Indebted Strengths, that is, to increase their liquidity, the amount of capital they have to work with, their long-term survivability, and so on. Companies, then, go out of their way not just to embrace debt where it is useful—for example, by issuing debt to buy back more of the company’s publicly traded stock—but to determine and make use of their optimal debt ratio, that is, the optimal ratio between their assets and their debts.9

A great deal of research has gone into what the optimal debt ratio is for companies. As Eugene Brigham and Joel Houston explain in Fundamentals of Financial Management (2004), “The optimal capital structure must strike a balance between risk and return so as to maximize the firm’s stock price.” In just a little while, we’ll discuss what average company debt ratios tend to actually look like in the real world.10

If you think about it, there is no question that shareholders of all companies want, need...