Leveraged Loans Definition Types Advantages And Disadvantages

Leveraged Loans Definition

In simple words, it refers to loans extended to individuals or companies with a poor credit history or already burdened with a significant amount of debt. Due to a higher risk of default, such loans are usually more costly for the borrower, i.e., individuals or companies availing of such loans have to pay interest rates higher than typical loans. Leveraged loans are also known as senior secured credits. These loans are used for refinancing the existing capital structure or supporting a full recapitalizationA Full RecapitalizationA recapitalization is a method of restructuring the ratios of various capital-generating modes, such as debt, equity, and preference shares, based on WACC and other company requirements, such as desired control level.read more, while it is primarily used for funding mergers and acquisitions (M&A) activities.

Types of Leveraged Loans Syndication

It can be categorized into three major types – Underwritten deal, Best-efforts syndication, and Club deal. Now, let us have a look at each of them separately:

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#1 – Underwritten Deal

The underwriter or arrangers use the deal for leveraged loan syndication predominantly in Europe. In this type of loan syndication, the arranger is committed to selling the entire loan amount if the underwriter fails to get enough investors to fully subscribe to the loan. As per commitment, they are obligated to purchase the remaining unsubscribed portion of the loan, which they may sell in the market later. The lower subscription is seen in case the market is bearish or the creditor’s fundamentals are weak. If the market continues to be bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more, the underwriter is forced to sell the unsubscribed option at a discount and book the loss on the paper as “selling through fees.”

Despite such a high risk of losses, underwritersUnderwritersThe underwriters take the financial risk of their client in return of a financial fee. Market Makers like financial institution and large banks ensure that there is enough amount of liquidity in the market by ensuring that enough trading volume is there.read more are always on the look for such loans for two primary reasons:

Underwriting such loans can make the financial institution look more competitive, which can eventually help them win future mandates.Given the risk associated with leveraged loans, underwriting such loans usually result in more lucrative fees.

#2 – Best-Efforts Syndication

The best-efforts syndication is predominant in the United States. In this type of loan syndicationLoan SyndicationWhere a group of lenders usually collaborates through an intermediary being a lead financial institution, or syndicate agent, which organizes and administers the transaction, including repayments, fees, etc. to provide financial requirements to a single larger borrower (usually out of the capacity of a single lender) where the division of risk and returns takes place between each other takes place is known as loan syndication.read more, the arranger is not obligated to underwrite the entire loan amount. If the loan amount is undersubscribed, then the credit may not close or may be taken up further adjustments to take advantage of the variation in the market. However, suppose the loan continues to be undersubscribed even after the changes. In that case, the borrower may have to accept the lower loan amount because otherwise, the deal may go off the table entirely.

#3 – Club Deal

A club deal is a transaction type where many lenders (usually private equityPrivate EquityPrivate equity (PE) refers to a financing approach where companies acquire funds from firms or accredited investors instead of stock marketsread more) extend the loan for an M&A activity. The loan size is typically larger than what anyone’s lenders could fund on their own. The striking feature of a club deal is that it allows the private equity players to acquire targets that were once only available to larger strategic players while distributing the exposure risk across the lender group. The lead arranger and the other members of the club deal consortium have an almost equal share of the fees charged on the leveraged loan. A club deal usually entails a smaller loan amount, typically between $25 million and $100 million, although it sometimes goes as high as $150 million. A club deal is also referred to as a syndicated investment.

Advantages

It gives access to capital, which can be used to accomplish a business feat that would not be possible without the injection of leverage. As we know that 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 can multiply every dollar put to work if executed successfully.This kind of credit is ideal for acquisitions and buyouts. However, leveraged loans are best suited for short-term business requirements because of the higher cost of borrowing and the risk of bulking up on debt.

Disadvantages

Even though such loans can help a business grow more quickly, it is considered one of the riskiest forms of finance. The reason is that a higher-than-normal debt level can put a business under significant solvency risk, i.e., the borrower may fail to repay the liabilities.Leveraged financeLeveraged FinanceLeveraged finance is the process by which a company raises funds through debt instruments or from outside the entity rather than through equity. It usually has a fixed periodic repayment schedule and an agreed-upon interest rate.read more products, such as high yield bonds and leveraged loans, are a very costly form of financing as the borrower is required to pay higher interest rates to make up for the higher risks the investors take.Such loans usually have a complex structure, such as subordinated mezzanine debtMezzanine DebtMezzanine 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, which eventually results in additional management time and involves various risks.

Leveraged Loans Definition Types Advantages And Disadvantages