What is Leveraged Finance?

by Prof. Ian Giddy, New York University -------------------------------------------------------------------------------- Leveraged Finance Defined Leveraged finance is funding a company or business unit with more debt than would be considered normal for that company or industry. More-than-normal debt implies that the funding is riskier, and therefore more costly, than normal borrowing. As a result, levered finance is commonly employed to achieve a specific, often temporary, objective: to make an acquisition, to effect a buy-out, to repurchase shares or fund a one-time dividend, or to invest in a self-sustaining cash-generating asset. Although different banks mean different things when they talk about leveraged finance, it generally includes two main products - leveraged loans and high-yield bonds. Leveraged loans, which are often defined as credits priced 150 basis points or more over the London interbank offered rate, are essentially loans with a high rate of interest to reflect a higher risk posed by the borrower. High-yield or junk bonds are those that are rated below "investment grade," i.e. less than triple-B. A key instrument in much of leveraged finance, particularly in leveraged buy-outs, is mezzanine or "in between" debt. Mezzanine debt has long been used by mid-cap companies in Europe and the US as a funding alternative to high yield bonds or bank debt. The product ranks between senior bank debt and equity in a company's capital structure, and mezzanine investors take higher risks than bond buyers but are rewarded with equity-like returns averaging between 10 and 20 per cent. Companies that are too small to tap the bond market have been the traditional users of mezzanine debt, but it is increasingly being used as part of the financing package for larger leveraged acquisition deals. Although mezzanine has been more expensive for companies to use than junk bonds, the low coupons coupled with high returns often makes some sort of mezzanine or hybrid debt an essential buffer between senior lenders and the equity investors. There are often different layers of finance involved in leveraged financing. These range from a senior secured bank loan or bond to a subordinated loan or bond. A large part of the role of leveraged financiers is to calculate 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 and be left holding loans or bonds they cannot sell to the market. If the value of the company is underestimated, the deal may be lost. Leveraged Acquisition Finance Leveraged acquisition finance is the provision of bank loans and the issue of high yield bonds to fund acquisitions of companies or parts of companies by an existing internal management team (a management buy-out), an external management team (a management buy-in) or a third party (an acquisition). The leverage of a transaction refers to the ratio of debt capital (bank loans, bonds and subordinated mezzanine instruments) to equity capital (money invested in the shares of the target company). In a leveraged financing, this ratio is unusually high. As a result, the level of debt service (payment of interest and repayment of principal) absorbs a very large part of the cashflow produced by the business. Consequently, the risk of the company not being able to service the debt is higher and thus the position of the lenders is riskier than in a conventional acquisition. The interest rate on the debt will be high. Leveraged Recapitalizations A technique whereby a company takes on significant additional debt with the purpose of either paying an extraordinary dividend or repurchasing shares, leaving the remaining shareholders with a continuing interest in a more financially-leveraged company. This is often used as a "shark repellant" to ward off a hostile takeover, or as an interim means of cashing in on the comapny's performance following a leveraged buyout. Leveraged Asset-Based Finance Leveraged asset-based finance entails raising debt capital for companies where the physical assets or a defined, contractual cash flow form the basis for highly levered non- or limited-recourse funding of assets or projects. Leasing, project financing and whole business securitization are examples of these techniques. Leveraged finance, like other parts of structured finance, primarily involves identifying, analysing and solving risks. These risks can be arranged into the following groups: Leveraged Finance Risks Credit risks are concerned with the business and its market. Financial risks which lie within the economy as a whole, for instance, interest rates, foreign exchange rates and tax rates. Structural risks are risks created by the actual provision of finance including legal, documentation and settlement risks. Liquidity risks are those associated with the inability of a leveraged company to refinance itseld in tight credit conditions http://giddy.org/dbs/structured/LevFinarticle.htm