Double Gearing

A form of leveraged investing where an investor borrows money against one asset to buy shares of others

Double Gearing is a high-risk, high-reward strategy. Double gearing refers to a form of leveraged investing where an investor borrows money against one asset to buy shares of others and then borrows more money on those shares to set up a margin loan that can eventually be used to buy more shares. 

Double gearing

Caution to lenders to perform their due diligence before sanctioning loans to borrowers. If lenders perform a perfect background check and see if the client meets all the requirements, they may be able to reduce the risk for both parties. 

Paul Getty quotes, "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem."

Relating to the above quote, it is good if banks play safely on their part and check borrowers don't overburden themselves with loans.

Double gearing by companies

Companies pool their resources together to mitigate risk. Companies may artificially skew the accounts and manipulate them to appear financially healthy. 

Coins

Double gearing is common among companies with complex corporate structures, where the parent company owns multiple subsidiaries but with different balance sheets for each holding. 

Companies adopting this strategy loan funds to one another to increase assets on the balance sheet while not being subjected to actual risks and manipulating financial statements.

  • Understanding double gearing among companies:

Companies operating in the same industry or sector usually share their resources, notably capital, to mitigate risk. 

Risk mitigation can't be the only motive behind this, and the corporate world also uses this to window dress their financial statements and make them appear financially healthy.

When funds move around different accounts in the same group, it becomes difficult to assess a company's financial health. 

Individual balance sheets may appear sound with adequate capital to run business operations, but if analyzed as a single entity, it may reveal over-leveraged positions.

Why is this strategy risky?

It's a high-risk, high-reward strategy in which borrowers keep getting loans on the same assets and then leverage to take more loans on the prior loan. 

Thus, it is considered risky because it may lead investors to significant problems if they cannot generate optimal results to cover their huge loans.

Risk

  • Regulatory impact on double gearing: 

One of the most significant regulatory impacts on corporations' double gearing occurred in 2016 when the Australian Securities and Investment Commission (ASIC) found out that five lenders, representing 90% of the market, were double geared.

After a warning by ASIC, margin lenders were asked to take action and change their practices towards approving and checking double-geared loans. 

While they were allowed to continue with their operations, one of the lenders ended the practice while others took steps to ensure margin loans were approved with caution of double gearing.

Example of double gearing:

The following is an example of double gearing.

Apex Holdings, the parent company of subsidiaries Delta Agency and Tiago Solutions, performed the following transactions and formulated a balance sheet afterward:

Example

  • Apex holdings lend Delta agency a certain amount of money, X, which appears as an asset on its balance sheet.

  • Delta agency bought shares of Tiago Solutions afterward with the amount it got from Apex holdings as a loan. They also list these shares as assets on their balance sheet.

  • Tiago Solutions got money by selling shares to Delta Agency and bought debt securities from Apex with that money.

  • Now, the money Apex lent out to Delta has come back to Apex in the form of money received by the sale of debt securities.

From the above example, one could find out how Apex holdings manipulated its financial statements and circulated funds in various forms through its subsidiaries, effectively double gearing. 

Key Takeaways

  • Companies using this strategy are over-leveraged and are at risk of defaulting.

  • Companies with complex corporate structures will find it easier to use this strategy.

  • Double gearing can skew company financial statements through window dressing.

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Researched and authored by "Arshnoor Kamboj"LinkedIn 

Reviewed and edited by James Fazeli-SinakiLinkedIn

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