Leveraged finance was established to oversee and expand the role of a bank in the leveraged finance market. Most of the companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity.
Leveraged finance is funding a company or business unit with more debt than the normal considered by a company or an industry. Leverage refers to the ratio of debt capital, such as bank loans and bonds to equity capital in which the money is invested in the shares of a target company. The funding is riskier and therefore more costly than the normal borrowing of fund. Leveraged finance is used to achieve temporary objectives, such as financing and acquisitions, leveraged buyout, re-purchase of shares, funding a one-time dividend, and investing in a self-sustaining asset.
Leveraged finance includes two main products, namely, leveraged loans and high-yield bonds.
Leveraged loans are high-yield loans that reflect the higher risk assumed by the borrower. A high-yield bond is a bond issued by a company that is considered as a higher credit risk.
Mezzanine debt: It literally means in-between or intermediate debt. Mezzanine debt instruments are issued by the mid cap companies, which are too small to tap the bond market. These products rank below the senior bank debts and hence have a higher risk. The investors are rewarded with equity-like returns averaging between 15 and 20 per cent.
High-yield bonds: They are junk bonds that are rated as Below Investment Grade. They offer higher yields than other fixed income investments or instruments but are correspondingly riskier. High-yield bonds include bonds with ratings less than BBB.
Leveraged finance is classified into leveraged acquisition finance, leveraged re-capitalization, leveraged corporate credits, and leveraged asset-based finance.
Leveraged acquisition finance
It funds acquisitions of companies or parts of companies. It is used to finance an acquisition either by an existing internal management team, external management team, or a third party. Here, the existing internal management team is related to the management buy-out. The external management team and third party are related to management buy-in and acquisition, respectively.
Since the leverage in financing an acquisition is extensively high, debt servicing is also high. In acquisition finance, the debt servicing forms a major portion of cash outflows. Thus, a higher risk is taken by the investors and a higher return is expected.
The other types of leveraged financing are displayed here.
Click the relevant items for additional information on the types of leveraged finance.
Leveraged recapitalization is used by listed companies to pay off outstanding dividends or repurchasing shares. These dividends and shares act as a shark repellant against hostile takeovers.
Leverage corporate credits are credit products like bank loans offered by investment banks to the companies, which are below the investment grade.
Leverage asset-based financing involves raising debt capital for companies based on an asset or defined contractual cash flows that the company is expecting. Leasing, project financing, and whole business securitization are examples of leveraged asset-based financing.
Leveraged finance is a high-risk investment. Structuring leveraged finance involves identifying, analyzing, and solving risks.
The leveraged financiers determine how each type of finance should be raised. If they overestimate the ability of the company to service its debt, they may lend too much at a low margin. Hence, the leveraged financiers may be left holding loans or bonds, which cannot be sold to the market.
In contrast, the deal may be lost if the value of the company is underestimated.
Credit risk: It arises from the fact that the borrower may default. The probability of the leveraged debt is higher than that of the normal debt because the instruments are designed for high-risk corporate.
Financial risks: They are not specific to deals. These are risks within the economy, such as interest rates, foreign exchange, and tax rates.
Structural risks: They arise due to the actual provision of finance including legal, documentation, and settlement risks. Structural risks exist because of the different layers of finance, which exist in a leveraged financing deal.