What is Leveraged Finance?
Leveraged Finance refers to the process of raising funds by a company using debt instruments or lending from outside entity rather than through equity and it generally carries a fixed periodic repayment schedule and rate of interest is also agreed upon beforehand where the money raised can be utilized for many purposes for example purchase of assets or paying off an expense or liability.
Leveraged Finance is described as funding a company or a business with more than normal proportions of debt (instead of equity or cash). Higher debts mean higher financial obligation in the form of fixed interest and principal repayment and corporate have to fulfill that obligation irrespective of profits to maintain its long-term solvency.
- Leveraged Finance directly impacts Cash Flow and Net Profit of the company and may lead to lower Earnings per Share (EPS) and Dividend in the hands of shareholders.
- Higher financial fixed costs are used to maximize the impact on Profit after Tax for a given change in Operating Profits (EBIT). Using more Financial Leverage within a capital structure may enhance some financial ratios of the company like Return on Equity.
Let us take a basic example to explain the concept of Leveraged Finance.
Scenario 1: – Buy a Company for $100 million in cash
Suppose there is an investment opportunity wherein you can buy the company for $100 million in cash. Your analysis shows that you can sell the company after 5 years for $200 million, thereby making a handsome return of 2x in 5 years.
When we calculate the Internal Rate of Return for scenario 1, it comes out to be 15%.
Scenario 2: – 50% cash and 50% Debt Financing
Let us now change the scenario and assume that the deal is financed by 50% cash and 50% debt and the selling price after 5 years is still $200 million.
- Here we also assume that the total payment of $5 million is made each year. This 5 million consists of the interest payment as well as principal repayment.
- At the end of the 5 year period, the total debt remaining is $39 million
- When you sell the company at $200 million, the net amount that you make is $200 million – $39 million = $161 million
- In this case, the IRR comes out to be 21% (much higher than all-cash deal)
One thing that you may want to remember is that, in order to go for leveraged finance, the predictable cash flows are essential. And this is the reason why target companies are usually a mature business that has proven themselves over the years.
Impact of Leveraged Finance
- Using high financial leverage in the capital structure of a company leads to the higher debt to equity ratio and if in case a company is unable to generate adequate cash from its operating activities then it might default in repayment of interest and principal amount on due dates.
- It will further dissolve the financial liquidity of the company in the short-run and raise a question about its long-term financial solvency before the stakeholders.
- The bankruptcy of the company may occur in a difficult scenario.
- The macroeconomic factors will also make a substantial impact on leveraged finance companies and it may increase the chances of default just like the recession in an economy will cut down the operations of an organization which leads to lesser income from operations and hence defaults in repayment of loans will happen.
- There were many corporate defaulted worldwide in 2008 financial crises and many of them declared as insolvent.
Leveraged Finance in Investment Banking
Leveraged Finance is one of the essential departments of Investment Banking firms that help the corporate clients to provide leveraged loans for taking strategic decisions like acquiring a company, refinancing its debts, expansion of business operations, etc. The Leveraged Finance department is also responsible for planning, managing, structuring, and advising on the entire debt finance of their clients.
Leveraged Finance Products
Some of the common Leveraged Finance products are as follows:
#1 – Leveraged Loan
It is a kind of regular commercial loan that bank lent to borrowers that are already highly leveraged. Commercial Banks charge an extra interest to take risk of lending in those leverage projects or they may ask for additional securities to secure the loan amount in case of default occurs. To diversify the defaulting risk of the borrower, the banks use to finance those risky businesses by way of syndicate loans along with other commercial banks, those will participate in lending with Lead Bank.
#2 – High Yield Bonds
These are the bonds below investment grade i.e. having a credit rating below BBB/Baa. They are also called Junk Bonds. Usually below investment grade companies that are not able to tap the bond market will use this route of financing for specific objects of the company. As these are not investment-grade bonds and the risk of default is higher in these bonds, the borrower has to pay higher coupons to the bondholders. Some bonds might have stringent negative covenants like not to borrow additional funds unless these bonds are fully paid off.
#3 – Mezzanine Finance
As a name suggest, Mezzanine Financing is the short-term way of financing the companies which are in urgent need of money just to seize the best business opportunity. It is a bridge between short-term financing and long-term financing. It is mostly used by small and medium-sized companies to easily finance their projects in a cost-efficient way.
While analyzing a company, Leveraged Finance analyst needs to understand a company’s use of leverage to evaluate its returns. Leveraged Finance will help to measure its risk appetite and also estimate the projected future cash flows, earnings after tax, earnings per share, and returns on investments. Leverage is directly related to financial risk, beta and cost of equity capital which can be used to estimate the appropriate discount rate for measuring the present value of the company.
Using too much-leveraged finance can be dangerous for the firms unless it is properly planned and managed in an effective way. The amount of Financial Leverage is usually a deliberate choice of the management of the company, whereas an amount of operating leverage is driven by the prevalent business model in each industry. Hence, the corporation should set a limit on the use of leverage in its capital structure as a part of risk management activity, so that the stakeholder will not lose trust on the solvency of the company. However, businesses with plant, land, equipment that can be used to collateralize borrowings may be able to use more Financial Leverage than a business that doesn’t have such characteristics.
Leveraged Finance Video
This has been a guide to what is Leveraged Finance. Here we discuss types of leveraged finance product, its impact on the on equity returns along with practical examples. You may learn more about Corporate Finance from the following articles –
- What is the Degree of Financial Leverage Formula?
- Equity Ratio Calculation | Interpretation
- Definition of Loan Principal Amount
- Formula of Financial Ratios
- Calculate the Financial Leverage Formula
- Cost of Equity Formula
- Example of Land Depreciation
- Capital Gearing Ratio Example
- Debt vs Equity Differences (Infographics)
- Debt Yield Ratio
- Debt Covenants