The Owner vs The Lender
Equity and debt investing are as fundamentally different as farming and mining. The owner is like a farmer who plants seeds, nurtures growth, and hopes for an abundant harvest. The lender is like a miner who carefully extracts a predetermined amount of value, with precise tools and clear expectations.
Two Different Universes
According to Howard Marks, “ownership and lending have nothing in common:
- Owners put their money at risk with no promise of a return. They acquire a piece of a business or other asset and are entitled to their proportional share of any residual that remains after the necessary payments have been made to employees, providers of raw materials, landlords, tax authorities, and, of course, lenders. If there’s something left over, it’s called profit or cash flow, and the owners have the right to share in whatever part of it is paid out. And if there’s profit or cash flow (or the potential for it in the future), the business will have “enterprise value,” in which the owners also share.
- Lenders typically provide funds to help owners purchase or operate businesses or other assets and, in exchange, are promised periodic interest and the repayment of principal at the end. The relationship between borrower and lender is contractual, and the resulting return is known in advance as described above, again assuming the borrower makes the promised payments when due. That’s why this kind of investing is called “fixed income” – the income is fixed. … It might help to think of it as “fixed outcome” investing.
This isn’t a difference in degree; it’s a difference in kind.”
The Owner’s World
As equity investors, we live in a world of:
- Unlimited Upside: We have no ceiling on our returns. A company can grow 15x, far exceeding our initial projections.
- Indefinite Time Horizons: We never truly know when our journey as owners will end.
- Variable Cash Flows: Dividends can be feast or famine, often reinvested for growth.
- Active Participation: We attend board meetings, shape strategy, and influence key hires.
- Subordinate Position: We’re last in line during difficulties, but that’s the trade-off of unlimited upside.
- Terminal Value Focus: Much of our return often comes from the final sale or liquidity event.
The Lender’s World
As lenders, we operate in a completely different universe:
- Capped Returns: Our best-case scenario is getting our money back with the promised interest.
- Defined Timelines: We know exactly when we expect to be repaid.
- Contractual Cash Flows: Interest payments are legally mandated, not optional.
- Passive Monitoring: We watch from a distance, only engaging when covenants are at risk.
- Senior Position: We get paid before equity holders, with legal protections.
- Current Income Focus: Our returns come steadily through interest payments.
The Mathematics Tell the Story
To illustrate through an example:
We have $10 million to deploy in a growing software company. We could either:
Option A: Equity Investment
- Purchase 20% ownership
- No current income
- Exit in 2023 for $45 million (a home run)
- IRR: 35%
Option B: Mezzanine Debt
- $10 million loan at 12% interest
- Quarterly payments
- 2% equity kicker
- Full repayment in 2023
- IRR: 14%
We choose to split our investment: $6 million in equity and $4 million in debt. Here’s why:
The Equity Story
- Years 1-2: No return, company reinvesting
- Year 3: Small dividend
- Year 4: Larger dividend
- Year 5: Exit at 4.5x
The Debt Story
- Years 1-5: Clockwork 12% interest payments
- Year 2: Successful covenant modification during COVID
- Year 5: Full principal repayment + equity kicker
Risk Profiles: Different Species Entirely
Equity Risk
- Business Risk: Full exposure to business performance
- Market Risk: Valuation multiples can compress
- Liquidity Risk: Can’t easily exit
- Control Risk: Other shareholders can dilute or oppose us
- Timing Risk: Exit timing uncertain
Debt Risk
- Credit Risk: Focus on debt service coverage
- Collateral Risk: Asset value preservation
- Interest Rate Risk: Locked-in returns may lag market
- Documentation Risk: Quality of legal protections
- Duration Risk: Known but still exposed to rate changes
The Information Game
Perhaps the most striking difference lies in the information we need for each type of investment:
Equity Due Diligence
- Market size and growth
- Competitive advantages
- Management team quality
- Growth opportunities
- Exit opportunities
- Customer concentration
- R&D pipeline
- Brand value
- Intellectual property
Debt Due Diligence
- Historical cash flows
- Asset coverage ratios
- Debt service coverage
- Collateral quality
- Bank relationships
- Working capital cycle
- Fixed charge coverage
- Prior debt history
- Covenant compliance
Different Skills, Different Teams
We’ve learned that successful equity and debt investing require entirely different skill sets:
Equity Investors Need
- Vision to see potential
- Patience through volatility
- Strategic thinking
- Industry expertise
- Network for exits
- Operational knowledge
Debt Investors Need
- Credit analysis expertise
- Legal knowledge
- Cash flow modeling
- Collateral valuation
- Restructuring experience
- Documentation skills
Looking Forward: The Beauty of Both
While equity and debt are different universes, mastering both has made us better investors overall. Debt discipline improves our equity underwriting, and equity vision helps us spot better lending opportunities.
The key is recognising these are fundamentally different activities requiring different:
- Skills
- Teams
- Time horizons
- Return expectations
- Risk management approaches
- Legal frameworks
- Monitoring systems
Like a balanced ecosystem, both types of capital serve vital but distinct functions in the financial world. Success is found not in choosing between them, but in deeply understanding their differences and using each tool for its intended purpose.
