Introduction to Leveraged Loans
Suppose any business already has short-term or long-term debts in its books of accounts, and its history is poor along with a poor credit rating. In that case, they can take additional loans with a very high-interest rate and generally prove to be costlier to the borrower than other standard loans. Lenders consider it to carry a higher risk of default; such loans are called leveraged loans.
These are simple loans; their distribution and arrangement are the only difference. They are arranged for the companies already having debts and are set by the syndicate banks. These are managed by private equity firms, hedge funds, and other players.
Example of Leveraged Loans
Let’s take a company, ABC, that wants to acquire a long-term asset for its business. It has already taken several short-term and long-term debts for different activities and the acquisition of other assets. It is planning to raise funds by issuing bonds worth $5,000,000. The interest rate of the bonds is LIBOR+70. This raising of funds by issue of bonds with an interest rate is the leveraged loan, as it falls under non-investment grade. According to the definition of S&P Global, a non-investment grade loan is always a leveraged loan.
Types of Leverage Loans
There are three types :
- Underwritten Deals: In this type, the arranger guarantees the entire loan amount by entering into the underwriting deal. The arranger must bear any left-out loan if the investors do not subscribe to the loan amount. He can try to sell the remaining loan in the market later on. Even if the market conditions are down in the future, the arranger is the only one who bears losses by selling the loan even at a discounted rate.
- Best- Efforts: Contrary to the above, instead of committing the entire amount of underwriting of the loan, the arranger group commits to underwrite less than the whole amount. Any undersubscribed amount can be adjusted per the market variations, or it can be left as a credit. If, after the changes also, the loan continues to be unsubscribed, the lower amount of the loan has to be accepted by the borrower to close the deal.
- Club Deal: This type of deal is usually for private equity players. The private equity players can acquire targets previously held by more prominent strategic players anytime in the past while distributing the exposure risk. These are larger-sized loans than own funding by the lenders and are used for M&A activity.
Leveraged Loans Index
A leveraged loan index is a market-weighted index. Various institutions hold leveraged loans. The loans index undergoes the study of performances by those institutions. S&P/LSTA U.S Loan Index is the most widely used index among many other indexes present in the market.
Uses of Leveraged Loans
- There are many M&A deals where leveraged buyout (LBO) is used. Leveraged loans form an essential and significant portion of LBO. Hence, these are used in many M& A deals.
- The Loans are used to better prepare the company’s balance sheet in case of its stock repurchase.
- Debts of the companies can be refinanced with the help of these.
- The company can use it for its day-to-day operations and acquiring various long-term assets.
Leveraged Loans vs High Yield
- Leveraged Loans are secured loans guaranteed by the company’s assets, whereas high-yield bonds are not secured.
- As the Leveraged Loans are secured, they prioritize getting paid in case of the company’s insolvency, whereas the High Yield bonds are paid after the Leveraged Loans.
Advantages and Disadvantages
Below are the advantages and disadvantages:
- The loan amount obtained through these loans can push the company’s capital, and if that amount is used correctly, it can make the company achieve its dream heights.
- When the business has objectives of acquisition, management buyout, shares buy-back, or a one-time dividend, leveraged loans suit the best because there are additional costs and risks of bulking up on debt.
- The company takes these Loans in addition to other debts, i.e., short-term and long-term debts. It brings the company to a higher than average debt level, and in the long run, it possesses an increased leverage risk.
- The interest rates paid in these loans are higher; hence, this type of funding proves costly for the company.
- The process of taking, dealing with, and managing leveraged loans is much more complex; thus, the management must invest much time.
Before opting for Leveraged Loans, every company needs to assess its existing debts, activities, etc., and consider the advantages and disadvantages of leveraged loans. If the company has a temporary financial need, for example, the acquisition of long-term assets, it can go for a leveraged loan. If the company faces an acquisition or buyout in which many funds are required, it can opt for a leveraged loan. Considering the disadvantages also, the decision should be taken. If it is ok for the company to bear the increased cost, it can go for leveraged loans. Also, if the company is comfortable with the complexity and risk of leverage financing and management can invest their time to solve the complexities, it can opt for these loans. In Short, it all depends on the company’s requirement, current position, and study and budget to choose leveraged loans.
This is a guide to Leveraged Loans. Here we also discuss the introduction to leverage loans with their types, advantages, and disadvantages. You may also have a look at the following articles to learn more –
- Leveraged vs Unleveraged
- Commercial Bank vs Investment Bank
- What Makes Good Leverage Buyout
- Loan to Value Ratio