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, 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.

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.

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.

#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 bearish, 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, underwriters 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.

#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 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 equity) 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.

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

• It gives access to capital, which can be used to accomplish a business feat that would not be 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 requirements because of the higher cost of borrowing and the risk of bulking up on debt.

Disadvantages

• Even though such loans can help a business grow more quickly, it is considered one of the riskiest forms of finance. The reason is that a 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 the investors take.
• Such loans usually have a complex structure, such as subordinated mezzanine debt, which eventually results in additional management time and involves various risks.

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.

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 –

• M&A Transaction Process
• Loan vs. Lease
• Secured Loans
• Leverage Ratios Calculations