Question

You are arranging 100% financing to acquire your aircraft from the manufacturer. Your Equity Investor has agreed to provide you with 20% of the funding amount. For the 80% portion, you have arranged a loan with Bank A.

Because the amount of the loan is higher than the Bank A’s lending limit, Bank A agrees to syndicate the loan among a small group friendly banks as a Club Loan. Bank A will be the Senior lender and the remaining banks will be the subordinate lenders. Is the Senior lender more risk-adverse or less risk-adverse? Are the subordinate lenders more risk-adverse or less risk-adverse? How does the Equity Investor mitigate their risk? Explain your answer.

Answer 1

Definition: A risk averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks. In other words, among various investments giving the same return with different level of risks, this investor always prefers the alternative with least interest.

Description: A risk averse investor avoids risks. S/he stays away from high-risk investments and prefers investments which provide a sure shot return. Such investors like to invest in government bonds, debentures and index funds.
Senior lender here is less risk averse and he has the risk of repayment by the client for which he has to repay subordinates as well.
subordinates are high risk averse as they’re double secured.

An investor can reduce the overall portfolio risk by diversifying across instruments or asset classes. The fundamental underlying principle of this theory is that markets are always efficient and it is almost impossible to find anything investible that has low risk and high return. But if one looks at the real world, does this relationship hold up? If it were true, then the most successful investor would be the one taking the highest risk. But we know it is the reverse. Almost all successful investors, and successful businessmen too, are highly risk averse. They give topmost priority to protecting capital, but that does not mean that they generate low returns. On the other hand, those taking high risks repeatedly end up going bankrupt.