What is Leveraged Finance?
Leveraged finance refers to the process of funding a business/ company that is in a much higher debt than normal. Since the debt is more than normal, sponsoring such a business/ company is riskier and costlier. Because of the increased risk and cost involved, leveraged finance is usually only used to achieve temporary objectives like:
- Making an acquisition
- Effecting a buyout
- Repurchasing shares
- Funding a one-time dividend
- Investing in a self-sustaining cash-generating asset
Who are the participants in leveraged finance?
The issuers and investors are the parties that participate in leveraged finance. Both these participants want incredibly high returns. They get this through:
- Capital structures that have a huge debt
- Less than investment-grade credit
How is leverage finance different from other debt-raising activities?
The main difference is in the investment grade of the issuing company. An investment-grade is a rating that tells you if a municipal/corporate bond has a low risk of default or not. Many firms like Moody’s and Standard & Poor’s rate the bonds to denote their credit quality rating.
The issuing company of these bonds usually has ratings below BBB, making it difficult for them to raise capital. When these company issue debt via Leveraged Finance, it is used for the following purposes:
- Asset purchases
- Leveraged buyouts
When talking about leveraged finance, banks usually mean different things. However, leveraged finance typically includes two main products:
- Leveraged lending or leveraged loans
- High-yield bonds
What is leverage lending?
Leveraged lending is a common debt instrument used for leveraged finance.
The commercial loans given to companies that are either already in long-term or short-term debt, or have poor credit rating, are called leveraged lending. Considering the bad financial health of such a company, lending money to it is very risky. Therefore, any financial group/bank that lends money to such a company demands higher interest rates. That’s why leveraged lending is costlier than other types of loans.
What is leveraged lending used for?
Leveraged lending is used for the following purposes:
- Financing mergers and acquisitions (M&As), which often take the form of LBOs (Leveraged Buyouts)
- Refinancing a business or company’s current debt
- Recapitalizing the balance sheet of a company
- Buying new plant/properties or equipment for business
- Expanding a business
Classifying leveraged lending
Leveraged lending doesn’t have a fixed universal definition and classification. The loans rated below the investment-grade level are usually defined as leveraged loans by credit rating agencies. Generally, these two ways are used to qualify a loan as ‘leveraged’:
- Using a spread cut-off: A loan would be categorized as ‘leveraged’ if it has a spread of at least LIBOR+125 or LIBOR+150.
- Using a rating criterion: For example, if a loan has a Moody’s rating of Ba3 or a Standard and Poor’s rating of BB or lower, it will qualify as a leveraged loan.