Leverage Lending – Overview, Purpose, and Examples
Leveraged lending refers to commercial loans given to a company or business with a poor credit rating or a company or business already in long-term or short-term debt. A group of lenders mainly provides leveraged loans. Since the business or company is already undergoing one or both the financial issues mentioned above, it is risky to lend any more funds. Therefore, any bank or financial group that lends loans to such companies demands higher interest rates since the risk of losing the lent money is more elevated. It makes leveraged loans much costlier than regular loans.
What is leveraged lending used for?
Companies/businesses use leverage lending for various purposes:
– Financing mergers and acquisitions (M&As), which often take the form of LBOs (Leveraged Buyouts)
– Refinancing a business or company’s current debt
– Recapitalizing the balance sheet of a company
– For buying new plant/properties or equipment for business
– For expanding a business
It’s important to understand that Leveraged Buyouts occur when a public entity is bought by a private equity company and makes it a private entity.
At least one commercial/ investment bank is involved in structuring, arranging, and administering leveraged loans. These banks are called ‘arrangers.’ Some parts of leveraged loans are directly sold to investors like insurance companies, funds, etc. The other parts are packaged into collateralized loan obligations.
Different type of leverage lending
There are three types of leverage loans:
- Underwritten deals: In leveraged loans of this type, the arranger guarantees the entire loan amount by entering the underwriting deal.
- Best efforts: In these types of leveraged loans, the arranger underwrites an amount less than the entire amount.
- Club deal: Club deals are generally for private equity players.
Purpose of leveraged lending
When it comes to defining leveraged lending, the explanation varies according to different regulatory agencies. As such, leveraged lending doesn’t have a fixed universal definition. The loans rated below the investment-grade level are usually defined as leveraged loans by credit rating agencies. Generally, there are two ways of qualifying a loan as ‘leveraged’-
Using a spread cut-off: A loan would be categorized as ‘leveraged’ if it has a spread of at least LIBOR+125 or LIBOR+150.
Utilizing a rating criterion: For example, the following ratings would qualify a loan as ‘leveraged’:
– For Moody’s — Ba3
– For Standard and Poor’s — BB- or lower
Generally, a range of potential criteria is established by supervisory guidance. When they define leveraged credit within bank policies’ parameters, they consider things like loan pricing, overall borrower risk, measures of leverage, etc.
Example of leveraged lending
Let’s say there’s a company, XYZ, that is looking to acquire a new long-term asset. Company XYZ has already taken several long-term and short-term loans to fund this acquisition. To further support this acquisition, the company is planning to opt for a leveraged loan. For this, the company issues $2 million in bonds. The interest rate of the issues bongs is LIBOR+70.
When a company issues bonds with an interest rate to raise funds, it comes under non-investment grade. This loan would be considered a ‘leveraged loan’ as its rating is non-investment grade, which is BB+ or lower. This categorization is done using the criteria of S&P Global.
Pros and cons of leveraged lending
Advantages: If a business or company gets capital through leveraged loans, it can push its overall capital position, making it successful. There are certain cases when a business faces additional costs, and sometimes, the risk of accumulating debt. Leveraged loans are the best options for such cases if a company wants to buy back share, is opting for acquisition, or has the objective of a management buyout.
Disadvantages: A company takes leveraged loans along with short-term and long-term debts. It increases the debt level of the company. The interest rates of leveraged loans are much higher than regular loans, making it a costly affair for a business/company opting for this type of loan.
Every company or business needs to weigh the advantages and disadvantages of leveraged lending before opting for them. In some cases, leveraged loans are a better option. For example, when the financial need of a company or business is temporary. Make an informed decision by considering factors like the company’s requirement, position, budget, etc.