Leveraged Loans

Updated on May 27, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Are Leveraged Loans?

Leveraged Loans refer to loans that carry a high risk of default in repayment as these loans are given to companies or an individual who already has considerable debts and may have a poor history or credit due to which such loans have a high rate of interest.

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 Explained

Leveraged loans, 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.

By the end of 2018, the outstanding balance of leveraged loans in the United States stood at $1.15Tn.

By 2018, the outstanding balance of leveraged loans in Europe stood at €180Bn.

According to a report by Leveraged Data & Commentary unit of S&P Global Market Intelligence, 85% of all such loans were “covenant-lite” as of 2018. Covenant-lite means that these loans do not require the borrower to maintain or meet certain financial benchmarks, which used to be the norm for traditional financing.

Video Explanation of Total Leverage

 

Types

The leveraged loans market can be categorized into three major types – Underwritten deal, Best-efforts syndication, and Club deal. Let us take a deeper look into each of these types to understand the concept in depth.

Leveraged Loans

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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.

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#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 & Disadvantages

To fully understand the movement in the leveraged market index, we must first understand the advantages and disadvantages of the concept. Let us do so through the explanation below.

Advantages

Disadvantages

Leveraged Loans Vs High Yield

Leveraged loans index is a widely discussed topic along with high yield bonds. These two concepts are somewhat discussed in close quarters with each other. Let us understand the differences through the comparison below.

Leveraged Loans

  • A floating interest rate is followed with a rating below investment grade.
  • The tenure for these loans is usually between five to nine years. The duration depends on the parties involved, and sometimes the jurisdiction as well.
  • The amortization requires quarterly payments towards the principal amount.

High Yield

  • High-yield bonds follow a fixed rate of interest with a rating below investment grade.
  • The tenure of these bonds is between seven to ten years.
  • The amortization schedule for these bonds is the form of bullet payments, made at maturity.

Recommended Articles

This has been a guide to what are Leveraged Loans. Here we explain its types, advantages, disadvantages, and compared it with high yield. You can learn more about financing from the following articles –

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