How Deadly is Financial Leverage?

Financial leverage is built on the idea of spending money to make money – buying a home or investing in a business, for example. This blog by IFT PhD student Philipp Wirth summarises a recent seminar on the “deadly” nature of financial leverage when applied to COVID-19 and care home deaths. The paper by Peter Morris and Ludovic Phalippou (Said Business School, Oxford) and Betty Wu (Adam Smith Business School, Glasgow) examples how and why leverage must be calculated properly to support future policy responses. 

March 2020 proved to be a defining month for humanity all around the world. COVID-19 would affect hundreds of millions of people in the months and years to come, but March was the month that the UK, like many other countries, introduced a nationwide lockdown to stop the disease from spreading. The most vulnerable members of our society were the elderly, the demographic which still accounts for most COVID-19-related deaths. A recent report of the ONS shows that for 2021, COVID-19 was the second highest cause of death among care home residents in England and Wales.  

Debt is an important financial instrument in public and private sectors with significant influences on stakeholders. But debt isn’t the issue per se. Research has shown the level of leverage to be relevant because entities going through financial distress might engage in activities such as cost-cutting to reduce the leverage they’re exposed to. In terms of care homes, this could indirectly lead to an increase in the death rate amongst the residents due to understaffing or a lack of personnel protective equipment. The authors of this paper make two assumptions about death rates in care homes during the COVID-19 pandemic:  

1. The relationship between leverage and death rates should be higher during the first wave because of the generally higher death rates, but also due to the financial support scheme for care homes kicking in just after the first wave.
2. During non-peak crisis times, the death rates between highly and low-levered companies shouldn’t differ as much, if at all.

To check for these assumptions, the authors had to collect data on the leverage of care homes, which was obtained by using the public records including companies registered at Companies House and the FCA. Ultimately, the final data sample contains over 98.6% of all beds operated in England by incorporated providers.  

Results

Using the available financial information for care home providers and diverting the providers into provider groups as well as different ownership types, the authors first computed the leverage based on the simple yet (in the literature) prevailing method of book value of debt over book value of total assets. Based on this calculation, the authors found that death rates and financial leverage were completely unrelated during the first wave and financial leverage had not affected death rates. 

When adjusting for ownership structures, however, the results look significantly different. Care homes controlled by private equity firms exhibited a far higher mortality rate during the first wave than all other ownership structures. In fact, the death rate in PE-controlled homes was over 50% higher than the average death rate across all care homes. While some of the spread can be explained by certain characteristics such as size and the fragility of residents in PE-controlled homes, the ownership effect remains relevant after these controls. 

In a second step, the authors moved away from the individual provider level as many care homes belong to a larger group. It could make sense to account for group leverage rather than for provider leverage. When aggregating the accounts of all group members, simple group leverage remains weakly related to death rates. What this simple leverage calculation does not account for, however, is so-called “off-balance sheet” debt – operating leases, in the context of this paper.  

The authors found that lease rental expenses existed for over 69% of the groups managing more than 1000 beds with an average ratio of lease rental expenses to total assets being around 16%. Across the whole sample, this ratio is significantly smaller at only 1.6%. Despite the small value over the sample, the influence on the capital structure of care home groups is si

gnificant. In fact, adjusting for operating leases shows that group leverage is indeed strongly related to death rates. This result holds even when changing the end dates of mortality waves or including all deaths in care homes.

Conclusion  

To answer the question raised in the title, financial leverage can be quite deadly. This is if the leverage is calculated appropriately. The authors contributed to the broader literature by doing exactly that. One of their findings was that PE-owned care homes were showing much higher mortality rates than other ownership types during the first COVID-19 wave when not accounting for off-balance sheet debt. Yet including this kind of debt turns the picture around: not-for-profit organisations and private providers actually showed higher mortality rates than PE-owned care homes during the first wave. The omission of operating leases from financial analysis could therefore have severe impacts on the results. This can not only lead to false conclusions, but also inaccurate policy responses.