Leveraged Finance Meaning Explained Example Groups

Leveraged Finance Meaning

This financing is extended to the speculative-grade companies—with a credit rating of BB, BA, or even lower. For the banks, these are high-risk investments. At the same time, these debts are opportunities for yielding high interests.

Key Takeaways

Leveraged Finance (LevFin) is a form of debt offered by institutional investors and banks. The borrowers are speculative-grade companies—private equity firms. The loans are availed for a specific purpose in lieu of high interests.The leveraged finance group (LFG) is a specialized investment banking division that extends LevFin. The LevFin group undertakes planning, structuring, and managing of debt financing for its clients.Leveraged financing is executed in three ways—leveraged loans, mezzanine finance, and high-yield bonds.

Leveraged Finance Explained

Leveraged finance groups are specialized departments of investment banking. The leveraged finance division (LFD) is responsible for providing overall debt financing solutions to clients. This involves planning, structuring, and managing of leveraged loans. Private Equity FirmsPrivate Equity FirmsPrivate equity firms are investment managers who invest in many corporations’ private equities using various strategies such as leveraged buyouts, growth capital, and venture capital. The top private equity firms include Apollo Global Management LLC, Blackstone Group LP, Carlyle Group, and KKR & Company LP.read more and Leveraged Buyout Firms finance their customized projects aggressively—they use high leverage in their portfolio to enhance their returns. Investors use the cost of equity capital Cost Of Equity CapitalCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more to measure the present value of a company.

Corporate funding of private equity firms witnesses higher-than-normal debt proportions (instead of equity or cash). This impacts the company’s cash flow and net profit and may lead to lower Earnings Per Share EPSEPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more and dividends for the shareholders. However, to maximize the impact on Profit after TaxProfit After Tax Profit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business.read more for a given change in operating profits (EBIT), higher fixed costs are used. Hence, using more Financial LeverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively.read more within a capital structure may enhance some financial ratios like return on equity.

The amount of financial leverage in business is usually a strategic choice. In contrast, an amount of operating leverageOperating LeverageOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.read more is driven by the prevalent business model in each industry. Hence, firms should limit the use of leverage in their capital structure—to limit risks. Or else stakeholders would fear potential solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more. However, some businesses use manufacturing plants, land, and equipment for the collateralization of borrowings; such firms use more financial leverage than their counterparts.

Leveraged Finance Products

The different kinds of leveraged financing used in business are as follows:

#1 – Institutional Term Loans and Leveraged Loans

Institutional investors offer term B loans to companies, and the borrowers repay according to the repayment schedule. The borrower repays a very little amount every year, and the remaining loan amount is to be repaid on maturity. A leveraged loan is allowed as debt—to individuals and corporations that have low credit scores. The lenders collaborate with leading banks to offer commercial loans and syndicated loans.

#2 – High Yield Bonds

These Junk Bonds are below investment gradeInvestment GradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments.read more, i.e., having a credit rating below BBB/Baa. The issuing companies cannot tap into bond markets and, therefore, raise capital through this mode of financing. As these bonds involve a risk of defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more, they are extended at a higher coupon rate. In addition, some of these bonds might come with negative covenantsNegative CovenantsA negative or restrictive covenant is a bond covenant that prohibits one party from taking certain actions, or, to put it another way, it is a pledge made by a firm to not exceed certain financial ratios unless and until the bondholders agree. Non-disclosure, non-solicitation, and non-competition are it’s three types.read more—no additional borrowing until the repayment of the previously issued bonds.

#3 – Mezzanine Finance

Mezzanine FinancingMezzanine FinancingMezzanine financing is a type of financing that combines the characteristics of debt and equity financing by granting lenders the right to convert their loan into equity in the event of a default (only after other senior debts are paid off).read more is a hybrid method of raising capital for the company. In this method, the lender can transform debt into equity. It is a bridge between short-term financing and long-term financing Long-term FinancingLong term financing means financing by loan or borrowing for a term of more than one year by way of issuing equity shares, by the form of debt financing, by long term loans, leases or bonds, done for usually extensive projects financing and expansion of the company.read more—mostly used by small and medium-sized companies. It is very cost-efficient.

Leveraged Finance Example

Let us go through an example to understand the concept of Leveraged Finance:

Scenario 1: Buy a Company for $100 million in cash

Suppose there is an investment opportunity to buy a company— for $100 million in cash. Analysis shows a resale valuation of $200 million after 5 years. The reseller can potentially avail a handsome return of 2x in 5 years.

Based on calculations, the Internal Rate of ReturnInternal Rate Of ReturnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more for scenario 1 is 15%.

Scenario 2: – 50% cash and 50% Debt Financing

Let us assume a change; the deal is now financed with 50% cash and 50% debt. The selling price is still $200 million.

We also assume that the total payment of $5 million is made each year. This five million includes both the interest payment and the principal repayment.At the end of the five years, the remaining debt is $39 million.If the company is sold at $200 million, the reseller avails a net amount of $200 million – $39 million = $161 million.In this case, the IRR is 21% (much higher than an all-cash deal)

Predictable cash flows provide estimates on returns and are hence, very crucial for analyzing leveraged finance.

Advantages and Disadvantages

Leveraged finance is a high-risk, high-return debt, and it has several benefits for both investors and borrowers. Given below are the various advantages of LevFin:

Through LevFin, speculative-grade companies can easily avail high capital investment. Without this provision, firms with low credit ratings struggle to get funds.These investments provide higher than normal returns to banks and investors—due to increased default risk.A LevFin can be used for high-value projects—mergers, acquisitions, leveraged buyouts, debt refinancing, and recapitalizations.

LevFin has the following limitations:

There is considerable financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more; speculative-grade borrowers have a BB or BA credit rating.It leads to a higher debt-to-equity ratio. Higher debts mean more financial obligations—fixed interest and principal repayment. The borrowing firm must fulfill obligations irrespective of profits, or else they become insolvent.LevFin brings down the liquidity of the companyThe Liquidity Of The CompanyLiquidity is the ease of converting assets or securities into cash.read more. This raises questions about the firm’s long-term solvency.The impact of macroeconomic factorsMacroeconomic FactorsMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more like recession or depression impacts leveraged firms more seriously—increasing the chances of default.

Leveraged Finance Meaning Explained Example Groups