What is Leveraged Finance?
Leveraged Finance (LevFin) refers to the financing of highly levered, speculative-grade companies. Within the investment bank, the Leveraged Finance (“LevFin”) group works with corporations and private equity firms to raise debt capital by syndicating loans and underwriting bond offerings to be used in LBOs, M&A, debt refinancing and recapitalizations.
The funds raised are used primarily for:
- Leveraged buyouts (LBOs): Financial sponsors need to raise debt to fund a leveraged buyout.
- Mergers & Acquisitions: Acquirers often borrow to pay acquisitions. When a lot of debt is needed, it falls under the leveraged finance umbrella.
- Recapitalizations: Companies borrow to pay dividends (“dividend recap”) or to buy back shares.
- Refinancing old debt: There is an old investment banking adage that says “the best thing about bonds is that they mature.” Once a company’s debt matures, the company will need to borrow again to pay for the old debt.
Investment-Grade vs. Speculative-Grade Debt
In the world of debt financing, there are two kinds of debt:
- Investment-grade debt (BBB/Baa credit rating or above): Debt issued by companies with a strong credit profile. Investment-grade debt is considered quite safe and default risk is very low.
- Speculative-grade debt (BB/Ba or below): Debt issued by highly leveraged companies and thus a riskier credit profile.
Speculative-grade debt is the world of leveraged finance.
One thing both investment-grade and speculative-grade firms have in common is that they can access two distinct debt structures:
Speculative-grade loans are called “leveraged loans.” Speculative-grade bonds are called “junk” or “high yield.”
- Loans: Term loans and revolvers issued privately by banks and institutional investors. Speculative-grade loans are called “leveraged loans.”
- Bonds: Fixed coupon-paying securities publicly registered with the SEC that are held and traded by institutional investors. Speculative-grade bonds are called “junk” or “high yield” bonds.
Below is a table showing where the investment-grade/speculative-grade divide occurs across the credit ratings spectrum:
As you would expect, investment-grade firms are far less leveraged (lower debt/EBITDA) and have higher interest coverage (EBIT/Interest):
As a result, defaults and bankruptcies are very rare for investment-grade firms. This enables those firms to borrow at very low interest rates. Below, you can see that the yield spreads (the “extra” interest above US Treasury yields) are always higher for speculative-grade bonds than for investment-grade bonds:
Investment-Grade Debt (BBB/Baa and above)
Before getting into the specifics of leveraged finance, let’s briefly look at investment-grade debt.
Loans from traditional banks
Loans to investment-grade firms usually come from traditional banks within the corporate banking division. They come in the form of low-interest term loans and revolvers/commercial paper.
Bank loans are the most senior in a company’s capital structure. Often, these loans are so safe that lenders don’t even require the loans to be secured.
Bonds from institutional investors
Bonds are fixed coupon securities with fewer strings attached at a still-low-but-slightly-higher interest rate
The relationship between loans and bonds is almost always organized such that loans are more senior than bonds. This is done through a variety of mechanisms that ensure loans will be paid out ahead of other debt (i.e. bonds) in the event of a bankruptcy.
The role of the investment bank: Debt capital markets
Within the investment bank, thegroup focuses on these investment-grade companies. They do this through:
- Loan syndication: Coordinate with a group of banks to package a revolving credit facility and term loan.
- Debt underwriting/origination: Structure, market and distribute a bond issuance to institutional investors
Speculative-grade debt (below BBB/Baa)
By contrast to investment-grade firms, speculative-grade firms are more highly levered, with more tranches of debt.
Higher leverage means higher risk of default and bankruptcy (Table 4), which means higher interest rates and more stringent protection mechanisms for the senior tranches of debt in the capital structure.
The higher risks involved in lending to highly levered firms means that the providers of capital tend to be a little more risk-tolerant:
Leveraged loans from institutional investors
Banks that are willing to lend to investment-grade companies are less comfortable with speculative-grade companies. As a result, most term loans and revolvers in the leveraged loan market are syndicated to institutional investors like hedge funds, CLOs, mutual funds and insurance companies (and some banks). Leveraged loans are usually secured by the company’s collateral and occupy the safest space for a lender in the company’s capital structure.
Bonds from institutional investors
On the bond side, pension funds, mutual funds, insurance companies, hedge funds and some banks make up the bulk of the investors willing to invest in the relatively riskier “high yield” bonds. Why would they take the risk? Remember that high risk = high return.
View Infographic: Buy side vs Sell side
Leveraged Loans: Senior Bank Debt
Leveraged loans (also called “bank debt” or “senior debt”) represent senior tranche(s) in a company’s capital structure, with bonds usually making up the junior tranches. Leveraged loans are term loans that are often packaged with a revolving credit facility and are syndicated by an investment bank to commercial banks or institutional investors.
Leveraged loans are distinct from high-yield bonds (”bonds” or “junior debt”). Loans usually make up the senior tranches, while bonds are make up the junior tranches of a company’s capital structure.
Leveraged loans typically have the following characteristics:
- Principal amortization: Term loans with required principal amortization (paydown)
- Secured: Secured (1st or 2nd lien) by the firm’s assets
- Floating rate: Priced as a floating rate (LIBOR + spread)
- Term: Structured with shorter maturity than bonds
- Covenants: More restrictive covenants
- Private: Private investments (free of SEC registration)
- Prepayment: Loans can be usually be prepaid by the borrower without penalty
LIBOR is going away. It’s being replaced by SOFR. Read more (Bloomberg)
Who are the investors in leveraged loans?
Until the early 2000s, leveraged loans primarily came from banks (called pro rata debt), while institutional investors provided the bonds. Since then, the proliferation of CLO funds and various other investment vehicles have brought institutional investors into the leveraged loan side. The conquest has been swift, with institutional loans making up most of the leveraged loan market (Table 5).
You can always tell whether a company’s leveraged loans are institutional or pro rata by their name:
- Term Loan A: Refers to pro rata bank debt
- Term Loan B/C/D: Refers to institutional loans
Despite that fact that institutional investors provide more leveraged loans than banks do (table 5 below), leveraged loans are often misleadingly called “bank debt” since banks are traditionally thought of as the primary providers of loans.
Leveraged loans are senior secured
Because of the higher default risk, the most senior tranches on a leveraged company’s balance sheet (the leveraged loans) will almost always require collateral to back up the debt (i.e. secured debt). That’s because owning secured debt is the key to determining if a lender is made whole in bankruptcy, and granting this security enables leveraged borrowers to raise a sizeable portion of its total debt at relatively low rates.