How Leverage Can Help Increase Return
At its most basic level, leverage is the concept of using borrowed money to increase the rate of return on an investment. Leverage can be used in a variety of different instances—alternative investing being one of them. Let’s take a quick look at the concept of leverage, how it works, and how it’s relevant to Yieldstreet investments.
How does leverage work?
In terms of debt (or fixed-income) investing, a Lender may use borrowed money or debt (leverage) to finance a loan to a Borrower. Though using leverage can increase return, it does, however, also increase the Lender’s risk.
To fully understand how leverage works, let’s first take a look at the participants of a debt-related investment that could be offered on the Yieldstreet platform:
Borrower: An individual or entity looking to take out a loan. A borrower signs a contract to repay the amount of the loan with an agreed-upon rate of interest.
Lender: An individual or entity that provides funds to a borrower under the stipulation that these funds will be paid back with interest.
Leverage Provider: An individual or entity that provides funds to a lender. This money, along with money from the Lender is provided to the Borrower.
Now that you understand the players in a potential case of leverage, let’s take a look at how it works in terms of a hypothetical Yieldstreet offering. In this scenario, Yieldstreet is working as the Lender:
- Yieldstreet plans on making a $10M loan to a Borrower at 8% interest. This loan will result in $800,000 of interest per year.
- For Yieldstreet to fund this loan, we’ll raise $4M on our platform and borrow the remaining $6M at a 5% interest rate per year from a Leverage Provider.
- Out of the $800,000 in interest on the full $10M loan, Yieldstreet will need to pay the Leverage Provider its $300,000 in interest, leaving us with $500,000.
- By Yieldstreet using leverage, our investors have essentially earned $500,000 on their $4M investment. This results in an interest rate equivalent of 12.5%, as opposed to the initial 8% on the original loan.
In this scenario, the use of leverage allows Yieldstreet to increase the return on investment for our investors by 4.5%. Another word to describe the increased return is “Levered Return” and the synonym for the original 8% return on investment is “Unlevered Return.” But remember, in increasing this return on investment, the Lender is also increasing their risk.
How exactly does leverage increase risk?
Though Yieldstreet in this scenario is increasing our investors’ return, we are increasing our risk by taking on a more junior position in the capital stack. The Leverage Provider is always paid back first due to their senior position in the capital stack. This means is that if the Borrower is not able to make payments, the Leverage Provider (who has a more senior position on the capital stack) is paid back first. Then, only after the Leverage Provider is fully paid, will our investors be paid. However, in a healthy investment, the Borrower is expected to be able to make all payments and return the loan with interest.
Then why take the risk?
Taking on additional risk shouldn’t be seen as either good or bad. It all comes down to whether the reward justifies the risk. At Yieldstreet, we recognize that each individual is different and with that, so is their risk profile.
To help further meet the needs and risk profiles of all our investors, Yieldstreet is now offering a wider selection of investments—some of which take advantage of leverage—that sit in different positions within the capital stack. For additional information related to leverage, check out our article on What is the capital stack?
This communication and the information contained in this article are provided for general informational purposes only and should neither be construed nor intended to be a recommendation to purchase, sell or hold any security or otherwise to be investment, tax, financial, accounting, legal, regulatory or compliance advice. Any link to a third-party website (or article contained therein) is not an endorsement, authorization or representation of our affiliation with that third party (or article). We do not exercise control over third-party websites, and we are not responsible or liable for the accuracy, legality, appropriateness or any other aspect of such website (or article contained therein).
What's Yieldstreet?
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.
2 Represents an net annualized return, using an internal rate of return (IRR) methodology, with respect to the matured investments shown in your Portfolio experience, utilizing the effective dates and amounts of subscriptions and distributions to and from the investments, net of management fees and all other expenses charged to the investments.[read more]