What is Leveraged Finance?

Prof. Ian Giddy, New York University

Leveraged Finance Defined

Leveraged finance is funding a company or business unit with more debt than would be considered normal for that company or industry. More-than-normal debt implies that the funding is riskier, and therefore more costly, than normal borrowing. As a result, levered finance is commonly employed to achieve a specific, often temporary, objective: to make an acquisition, to effect a buy-out, to repurchase shares or fund a one-time dividend, or to invest in a self-sustaining cash-generating asset.

Although different banks mean different things when they talk leveraged finance, it generally includes two main products - leveraged loans and high-yield bonds. Leveraged loans, which are often defined as credits priced 125 basis points or more over the London interbank offered rate, are essentially loans with a high rate of interest to reflect a higher risk posed by the borrower. High-yield or junk bonds are those that are rated below "investment grade," i.e. less than triple-B.

A key instrument in much leveraged finance, particularly in leveraged buy-outs, is mezzanine or "in between" debt. Mezzanine debt has long been used by mid-cap companies in Europe and the US as a funding alternative to high yield bonds or bank debt. The product ranks between senior bank debt and equity in a company's capital structure, and mezzanine investors take higher risks than bond buyers but are rewarded with equity-like returns averaging between 15 and 20 per cent.

Companies that are too small to tap the bond market have been the traditional users of mezzanine debt, but it is increasingly being used as part of the financing package for larger leveraged acquisition deals. Although mezzanine has been more expensive for companies to use than junk bonds, the low coupons coupled with high returns often makes some sort of mezzanine or hybrid debt an essential buffer between senior lenders and the equity investors.

Leveraged Acquisition Finance

Leveraged Acquisition Finance is the provision of bank loans and the issue of high yield bonds to fund acquisitions of companies or parts of companies by an existing internal management team (a management buy-out), an external management team (a management buy-in) or a third party (an acquisition).

The leverage of a transaction refers to the ratio of debt capital (bank loans and bonds) to equity capital (money invested in the shares of the target company). In a leveraged financing, this ratio is unusually high. As a result, the level of debt service (payment of interest and repayment of principal) absorbs a very large part of the cashflow produced by the business. Consequently, the risk of the company not being able to service the debt is higher and thus the position of the lenders is riskier than in a conventional acquisition. The interest rate on the debt will be high.

Leveraged Recapitalizations

A technique whereby a public company takes on significant additional debt with the purpose of either paying an extraordinary dividend or repurchasing shares, leaving the public shareholders with a continuing interest in a more financially-leveraged company. This is often used as a "shark repellant" to ward off a hostile takeover.

Leveraged Corporate Credit

Leveraged corporate credit involves the provision and managment of credit products, including bank loans, bridge loans and high-yield debt, for below investment grade companies that rely heavily on debt financing.

Leveraged Asset-Based Finance

Leveraged asset-based finance entails raising debt capital for companies where the physical assets or a defined, contractual cash flow form the basis for highly levered non- or limited-recourse funding of assets or projects. Leasing, project financing and whole business securitization are examples of these techniques.

Leveraged finance, like other parts of structured finance, primarily involves identifying, analysing and solving risks. These risks can be arranged into the following groups:

Credit risks and financial risks

Credit risks are concerned with the business and its market. Financial risks which lie within the economy as a whole, for instance, interest rates, foreign exchange rates and tax rates.  

Structural risks

These are risks created by the actual provision of finance including legal, documentation and settlement risks.

There are often different layers of finance involved in leveraged financing. These range from a senior secured bank loan or bond to a subordinated loan or bond. A large part of the role of leveraged financiers is to calculate how each type of finance should be raised. If they overestimate the ability of the company to service its debt, they may lend too much at a low margin and be left holding loans or bonds they cannot sell to the market. If the value of the company is underestimated, the deal may be lost.


Course Outline: Leveraged Finance

 Prof. Ian Giddy

  • What is Leveraged Finance?
    • Applications of leveraged finance
    • Cost of capital and optimal capital structure analysis
    • Proactive leveraged finance: examples and applications
    • Deal-driven leveraged finance: examples and applications
    • Impact of leveraging up on bondholders and lenders
    • Impact of leveraging up on shareholders and share price
  • Valuation in Leveraged Finance: Tools and Applications
    • Asset-based and balance-sheet approaches
    • Comparables-based approaches
    • Measuring and predicting free cash flows to firm (FCFF) and to equity (FCFE)
    • Adjusting and using value of the future free cash flows
    • Establishing required rates of return
    • Sensitivity analysis
  • Leveraged Build-Ups and Leveraged Recapitalization
    • Measuring debt capacity
    • Leverage, tax shield, risk and shareholder value
    • Leveraged finance as a temporary capital structure
    • Impact of high leverage on business efficiency and shareholder risk
    • Leveraged recaps for ownership transition or cash-out
    • Leveraged recaps with share buybacks or special dividends to enhance shareholder value
  • Leveraged Acquisition Financing
    • Finding the optimal financing mix: debt, equity or mezzanine?
    • Corporate taxation and capital structure
    • Bridge financing
    • Subordinated seller financing
    • Bank financing
    • Bond financing
    • Mezzanine debt
    • Private equity
    • Public equity financing
    • Before-and-after divestiture analysis
  • Leveraged Buy-Outs
    • The Essential Role of Leverage and Structured Securities in M&A
    • Example of Spreadsheet-Based Debt Capacity Analysis for Leveraged Finance
    • Focus: Synthetic Ratings and Debt Pricing
    • How to Structure and Price the Leverage for an Acquisition or Buyout
    • Valuation in LBO: “The VC Method”
    • Design of equity or mezzanine participations
    • Paydown and exit analysis
    • Structuring the relationship between the partners
    • What can go wrong, and why
  • Negotiating a Leveraged Buy-Out: Hands-on Application
  • Summary and Conclusions | | | | contact
Copyright ©2005 Ian Giddy. All rights reserved.