Leveraged Finance Guide (LevFin)

“Covenant lite” leveraged loans

Leveraged loans have traditionally been secured with 1^st liens on the collateral and contain strict covenants (maintenance covenants which require regular compliance with various ratios).

Since the financial crisis, there has been a steady return to more lax lending standards in the leveraged loan market due to a borrower-friendly environment.

“Covenant-lite” loans, while still usually secured with 1^st liens, contain traditionally looser bond-like “incurrence” covenants, which require compliance with certain credit ratios only when taking a specified action like issuing new debt, dividends, or making an acquisition.

As a result, leveraged loans have become an increasingly popular option for borrowers compared to traditional leveraged loans (Table 6 below).

Table 6: Covenant lite loans as a % of total leveraged loans ⁶

Covenant lite loans have also overtaken high yield bonds in popularity with issuers (Table 7 below), increasing the loan portion of the capital structure relative to bonds. Leveraged loans are private transactions, which can be arranged more quickly that bonds, which require SEC registration.

Table 7: Covenant lite loan vs High yield bond volume ⁷

Second lien leveraged loans

Second lien loans are less common and riskier than 1st lien loans. IF a 2nd lien loan exists, it will sit below a 1^st lien leveraged loan in the capital structure and is secured only to the extent that there is excess collateral value after the 1^st lien lender is made whole in a bankruptcy.

Second lien priority ranking example

Imagine a company with $100 million in assets is going bankrupt and has the following capital structure:

1. $90 million Term Loan B (“TLb”), secured with a 1^st Lien on all assets
2. $50 million Term Loan C (“TLc”), secured with a 2^nd Lien on all assets
3. $40 million unsecured bonds

In this case, the $90 million goes to the TLb because it has a 1^st lien on the assets. Next, there is $10 million in excess asset value, which would go to the TLc since they have a 2^nd lien. Since there is no asset value left, the unsecured bonds get nothing. The recovery rates are therefore 100% to TLb, 20% to TLc ($10 million / $ 50 million) and 0% to the unsecured bonds.

Note: This example is a huge oversimplification of how recoveries are determined in a bankruptcy. To learn more about the financial restructuring process, enroll in our free financial restructuring basics course:

Free course: Financial Restructuring Basics 

The example above illustrates how the 2^nd liens add some protection as compared to unsecured, but not nearly as much as the 1^st liens.

Investors holding second liens (primarily CLO funds) experienced notoriously low recoveries in the 2008-2009 financial crisis and the market for them completely disappeared for a while.

While they remain relatively rate due to the higher risks than a traditional term loan, but they have started popping up again (Table 8 below).

Table 8: Second lien loan volume ⁸

Revolving credit facility

Revolving credit lines are like a corporate card, allowing companies to draw from it or pay it down based on the company’s short term working capital needs. Revolvers are often packaged with term loans and come from the same lenders (banks or institutional investors).

There are two types of revolvers:

Revolvers can be either secured or unsecured, but in the leveraged loan market, revolvers are almost always secured.

• Asset based loan (ABL): A revolver where the maximum amount that a borrower can borrow (“borrowing base”) depends on the current value of the company’s assets, most commonly accounts receivable and inventory. The revolver is usually secured by a 1^st lien on the very asset used in the borrowing base calculation, although sometimes additional assets are included as collateral.
• Cash flow revolver: This is the more traditional revolver, where the maximum amount that can be borrowed in any given period is simply based on the historical cash flows that the borrower has generated. While this means that costly and time-consuming monitoring of asset values isn’t necessary, cash flow revolvers tend to have more restrictive covenants. The cash flow revolver can be either secured or unsecured, but in the leveraged loan market, revolvers are almost always secured.

The asset-based revolver was once considered a loan of last resort as borrowers were loathe to put up their assets as collateral. However, ABL revolvers have grown in popularity by borrowers due to the relatively lower interest rates charged.

Leveraged term loan with revolver example

In Blackstone’s $5.4 billion LBO of Gates Global, the senior part of the capital structure included a 7-year $2.5 billion lite term loan, a $125 million cash-flow revolver, and a 5-year $325 million asset-based revolver.

Leveraged loan multiples and market dynamics

Because leveraged finance involves lending to highly leveraged companies, the amount of debt as a total part of the capital structure is sensitive to market dynamics. We’ve been in a borrower friendly market since the financial crisis and the amount of debt lenders are comfortable is growing, surpassing pre-crisis levels in absolute terms and getting close to pre-crisis levels when benchmarked against EBITDA (Tables 9-10 below). First lien tranches are making up a greater part of the overall debt composition.

Table 9: US leveraged loan issuance by use of proceeds ($ in billion) ⁹

Table 10: Average debt multiples of highly leveraged loans ¹⁰

Speculative-grade (“High Yield”) bonds

speculative-grade bonds, also called “junk” or “high yield” refers to bonds rated lower than BBB. High yield bonds enables borrowers to increase leverage to levels that leveraged loans won’t support. High yield bonds make up a small portion of the nearly $1.5 trillion in annual corporate bond issuances in the United States and represents the junior tiers of capital structure.

Table 11: Annual US Corporate Debt Issuance ¹¹

Below are typical features of a high yield bond:

1. Interest payment: Fixed coupon paid semiannually
2. Term: 5-10 years
3. Principal amortization: No principal pay-down until maturity (bullet payment)
4. Collateral: Unsecured (usually)
5. Public debt: Bonds are public debt requiring SEC registration (though often initially placed privately via Rule 144A to accelerate the issuance and later exchanged for registered debt)

Senior vs. subordinated bonds

High Yield Bonds are usually unsecured and can be either senior or subordinated to other bonds in the capital structure (Table 12 below).

Being senior or subordinated to another bond has nothing to do with being secured, but instead depends on whether there is an inter-creditor agreement in place between the two (or more) bond tranches.

Being senior or subordinated to another bond technically has nothing to do with being secured, but instead depends on whether there is an inter-creditor agreement in place between the two (or more) bond tranches.

This makes the senior bond senior only to the subordinated bond. The senior bond is still junior to any secured debt and is on equal footing with any other unsecured claim against the business that it does not have a specific inter-creditor agreement with.

Practically speaking, however, senior bonds usually recover more in a bankruptcy because they receive whatever recovery would have otherwise also gone to the subordinated debt. As a result, senior bonds are cheaper for borrowers.

Table 12: US High Yield Bond Issuance ¹²

Call protection (prepayment)

With leveraged loans, the borrower can usually prepay principal with no penalties. In debt-lingo, that’s called having no call protection. In other words, the lender is not protected from the possibility of the borrowing paying off the loan and the lender no longer getting interest payments. With bonds, however, call protection is common.

A typical example of a bond with call protection would be 2 or 3 years of call protection (noted as NC-2 or NC-3), where the borrower is not allowed to prepay. After the end of the call protection period, the bonds do become callable, but the borrower would have to pay a call premium, usually as a % of par value. For example, an 8 year 10% might follow the following schedule:

1. Not callable for 3 years (NC-3),
2. Year 4 at 105 of par
3. Year 5 at 103.3
4. Year 6 at 101.7
5. Year 7 and beyond at 100

This means that if the borrower wanted to prepay in year 4, it would need to repay 105% of the principal owed.

This is why, when building an LBO model or the debt schedule of a company with multiple tranches of debt, the model often uses excess cash flows to prepay bank debt (cash sweep) but does not touch the bonds due to the prepayment penalty.

Paid-in-kind (PIK) interest

Instead of paying interest with cash, the PIK toggle gave the borrower the option to pay cash interest or to let the interest accrue and grow the principal balance.

In 2006, when borrowing to finance LBOs was reaching frenzied levels, an “innovation” emerged to enable private equity firms to bring in additional debt to finance an LBO or to do a dividend recapitalization without having to pay cash interest immediately: The PIK-toggle. Instead of paying interest with cash, the PIK toggle gave the borrower the option to pay cash interest or to let the interest accrue and grow the principal balance. As an alternative to this binary option, notes were also sometimes structured with a predefined combination of cash and PIK interest. While PIK notes disappeared for a while following the financial crisis, they’ve had a modest resurgence, albeit with stricter investor protections and still amounting to a very small portion of overall high yield bond issuances volume (Table 13 below).

Table 13: US PIK Toggle Issuance ¹³

PIK toggle example

Here is an example of a $500 PIK-Toggle note issued by J. Crew in 2013 to fund a dividend recapitalization. Per S&P LCD:

“J.Crew is driving by with a $500 million offering of six-year (non-call one) senior PIK-toggle notes via bookrunners Goldman Sachs, Bank of America, Morgan Stanley, and Wells Fargo, and price talk is for a 7.75-8% coupon at 99.5, according to sources. The guidance works out to an approximate yield-to-worst range of roughly 7.875-8.125%.

Investors are guided toward issue ratings of CCC+/Caa1, while the borrower is rated B/B2. Proceeds will be used to fund a dividend. Take note that the first call premium is 102, followed by 101, then at par annually thereafter.”

Mezzanine Debt Structure

Mezzanine debt broadly describes financing between senior secured debt and equity, which would place 2^nd lien debt, senior and subordinated bonds into the category.

Unfortunately, in practice, that’s NOT what most people mean when they say mezzanine debt…

Mezzanine debt refers to financing with debt and equity like features, sitting below the traditional loans and bonds but right above common equity.

Mezzanine debt more commonly refers to securities that have both debt and equity like features, sitting below the traditional loans and bonds but right above common equity. This financing includes:

• Convertible debt
• Bonds with warrants
• Convertible preferred stock
• Preferred stock with warrants

Mezzanine Debt Characteristics

Because mezzanine debt is structured specifically for transactions, the characteristics can vary. However, the following generalities usually apply:

1. Purpose: Mezzanine financing is primarily used to fund leveraged buyouts, when the financial sponsors want more debt in the capital structure than conventional leveraged loans and bonds can offer.
2. Investors: Hedge funds and mezzanine funds are the primary mezzanine investors, often tailoring the investment to meet the specific needs of the deal and earning returns higher than those earned on high yield bonds.
3. Unsecured: Mezzanine debt is usually unsecured with few/any covenants.
4. Target returns of 10%-20%:  For the extra risk, Mezzanine investors often target a blended return of 10-20% on their investment.
5. Private transactions: Mezzanine financings are usually private transactions, so liquidity is lower than high yield bonds.
6. Call protection: Call protections vary, but usually similar to high yield bonds.

Oaktree Capital, one of the largest mezzanine funds, describes approaching Mezzanine debt investments in one of two ways:

1. With a credit emphasis, where a substantial portion of the return is in the form of a debt coupon supplemented by some equity upside,
2. With an equity emphasis, where the return is primarily driven by equity investments.”

As a result, cash interest is not the only source of return and includes:

• Paid-in-cash (PIK) interest: Rather than paying cash interest, the interest owed is accrued and becomes part of the principal owed.
• Preferred dividends: Another mezz financing structure is issuing preferred stock. Preferred stock generates cash and PIK dividends instead of interest

Equity Kicker

Mezzanine investors often like to juice an extra 100-200 basis points in returns by adding an “equity kicker” – the option to participate in the equity upside of the business being funded. There are three ways in which this is done:

1. Warrants: Mezzanine investors may seek to include warrants as part of the financing. Warrants act exactly like employee stock options such that the mezzanine investors have the option to exercise their options and turn them into common stock, usually amounting to 1-2% of the total equity of the borrower.
2. Co-invest: As part of the financing, Mezzanine investors may seek the right to co-invest equity alongside the controlling shareholder, such as the financial sponsor in the case of funding an LBO.
3. Conversion feature: Whether investors structure the financing as debt or preferred stock, making those investments convertible to common stock enables investors to participate in equity upside in addition to receiving structured dividends or interest payments.

Example of Mezzanine Debt

Here’s what a mezzanine note issued to fund a leveraged buyout might look like:

• Ranking: Subordinated and unsecured. Will sit below bank debt and a senior note and make up 10% of the total debt outstanding.
• Term: 7-years
• Semi-Annual Coupon:00%, 10.00% cash / 2.00% PIK
• Equity Kicker: Warrants amounting to 2% of the equity.
• Covenants: Incurrence covenants (like high-yield)
• Call protection: Noncallable for the first 2 years, and a call premium schedule thereafter

Debt Cheat Sheet

Putting it all together, below is a table outlining the typical features of debt used in leveraged finance:

Footnotes