Lesson 3 of 10 · All lessons in this module
  1. Why appraisal is harder: the life cycle and the J-curveVideo lesson
  2. Measuring returns: IRR versus MOICVideo lesson
  3. Leverage: magnifying gains and losses
  4. Valuation: fair value levels and smoothed returns
  5. Fees, custom terms and redemption provisions
  6. Hurdle rates, catch-up, waterfalls and clawbackVideo lesson
  7. High-water marks, investor timing and either/or feesVideo lesson
  8. Integrated case: hurdle rate and high-water mark in one fee
  9. Integrated case: three investors, one fund, four years
  10. Funds of funds, benchmarks and index biases

Lesson 3 of 10 · 11 min

Leverage: magnifying gains and losses

Borrowing lets a fund hold a position larger than its own capital, so the leveraged return equals the asset return plus a magnified spread between that return and the borrowing rate.

In short

  • With own capital VcV_c, borrowed funds VbV_b at rate rbr_b and asset return r: rL=r+VbVc(r−rb)r_L = r + \frac{V_b}{V_c}(r - r_b).
  • Leverage helps only when the asset return exceeds the borrowing rate; at r=rbr = r_b the investor is indifferent.
  • Hedge funds borrow through prime brokers (margin financing) or use derivatives.
  • Falling equity in the margin account triggers a margin call; forced selling can lock in or deepen losses.
  • Access to borrowing, on what terms, is an important risk factor in its own right.

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