Leveraged Loans Definition
The term “Leveraged Loans” refers to those type of loans which are extended to such individuals or companies that have 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 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 recapitalization, while it is primarily used for funding mergers and acquisitions (M&A) activities.
Types of Leveraged Loans Syndication
The Leveraged Loans syndication 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:
#1 – Underwritten Deal
The underwriter or arrangers use the underwritten deal for leveraged loan syndication predominantly in Europe. In this type of loan syndication, the arranger is committed to sell the entire amount of loan. In case the underwriter fails to get enough investors to fully subscribe the loan, then as per commitment, they are obligated to purchase the remaining unsubscribed portion of the loan themselves, which they may sell in the market later. The lower subscription is seen in case the market itself is bearish or the creditor’s fundamentals are weak. If the market continues to be bearish, the underwriter is then forced to sell the unsubscribed potion at a discount and book the loss on the paper as “selling through fees”.
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Despite such a high risk of losses, underwriters are always on the look for such leveraged loans for two primary reasons:
- Underwriting such loans can make the financial institution look more competitive that 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 syndication, the arranger is not obligated to underwrite the entire amount of the loan. In fact, 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, if the loan continues to be undersubscribed even after the changes, then 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 a large number of lenders (usually private equity) extend the loan for an M&A activity. The size of the loan is typically larger than what anyone 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 that are charged on the leveraged loan. A club deal usually entails a smaller loan amount typically between $25 million and $100 million, although at times it goes as high as $150 million. A club deal is also referred to as a syndicated investment.
Now, let us have a look at some of the advantages of Leveraged Loans:
- It gives access to capital which can be used to accomplish a business feat which would not possible without the injection of leverage. As we know that financial leverage 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 requirement because of the higher cost of borrowing and risk of bulking up on debt.
Now, let us have a look at some of the disadvantages of Leveraged Loans:
- Despite the fact that such loans can help a business grow more quickly, it is considered one of the riskiest form of finance. The reason is that at times higher-than-normal debt level can put a business under significant solvency risk i.e. the borrower may fail to repay the liabilities.
- Leveraged finance 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 taken by the investors.
- Leveraged loans usually have a complex structure, such as subordinated mezzanine debt, which eventually results in additional management time and involves various risks.
Important Points to Note about Leveraged Loans
Let us now update ourselves with some of the market information pertaining to Leveraged Loans:
- By the end of 2018, the outstanding balance of leveraged loans in the United States stood at $1.15Tn.
- By the end of 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 leveraged loans were “covenant-lite,” as of the end of the year 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.
This has been a guide to Leveraged Loans and its definition. Here we discuss the types of leveraged loans along with its advantages and disadvantages. You can learn more about financing from the following articles –