Introduction to Leveraged Loans
If any business already has debts whether short term debts or long term debts in their books of accounts and their history is poor along with the poor credit rating, they have the option of taking additional loans that bears the very high rate of interest and generally proves to be costlier to the borrower as compared to other normal loans and lenders considers it to carry a higher risk of default, such type of loans are called as leveraged loans.
These are simple loans; the only difference is its distribution and its arrangement. They are arranged for the companies already having debts and are arranged 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 who wants to acquire a long term asset for its business. It has already taken the number of short term and long term debts for different activities and acquisition of different assets. Now, it is planning to raise the funds by issue of bonds having value $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 nothing but the leverage loan, as it falls under non-investment grade and according to the definition of S&P global; a non-investment grade loan is always a leveraged loan.
Types of Leverage Loans
There are basically three types :
- Underwritten Deals: In this type, the entire amount of the loan is guaranteed by arranger by entering into the underwriting deal. If the entire amount of loan is not subscribed by the investors, then any left out amount of loan has to be beard by arranger himself. 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: In contrary to the above, instead of committing the entire amount of underwriting of the loan, the arranger group commits to underwrite less than the entire amount. Any undersubscribed amount can be adjusted as per the variations in the market or it can be left as a credit. If after the changes also, the loan continues to be unsubscribed, the lower amount of 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 are able to acquire those targets that were previously held by larger strategic players anytime in the past while distributing the exposure risk. These are larger sized loans than own funding by the lenders and basically used for M&A activity
Leveraged Loans Index
A leveraged loan index is a market-weighted index. The leveraged loans are held by various institutions. 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 important and large portion of LBO. Hence, these are used in many M& A deals.
- The Loans are used for better preparation of the balance sheet of the company in case of repurchase of its stock.
- Debts of the companies can be refinanced with the help of these.
- It can be used by the company for its day to day operations and for the acquisition of various long term assets.
Leveraged Loans vs High Yield
- Leveraged Loans are secured loans that are secured by the company’s assets whereas high yield bonds are not the secured ones.
- As the Leveraged Loans are secured, they have the priority to get paid in case of insolvency of the company whereas the High Yield bonds are paid after the Leveraged Loans.
Advantages and Disadvantages
Below are the advantages and disadvantages:
Some of the advantages are :
- The loan amount obtained through these loans can give the push to the company’s capital and if that amount is used in a proper way, 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.
Some of the disadvantages are:
- These Loans are taken in addition of other debts i.e. short term and long term debts by the company. It brings the company at higher than normal debt level and in the long run, it possesses a high risk of leverage on it.
- The interest rates paid in these loans are higher and hence this type of funding proves to be costly for the company.
- The process of taking as well as dealing and management of leveraged loan is much complex and thus the management has to invest much time
Before opting for the Leveraged Loans, every company needs to access itself in terms of its existing debts, activities, etc. and also considering the advantages and disadvantages of the leveraged loans. If the company has the temporary financial need, for example, acquisition of long term assets, it can go for the leveraged loan. If the company is facing any special situation like acquisition, buy out in which case a large amount of 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 also can invest their time for solving the complexities, it can opt for the these loans. In Short, it all depends on the company requirement, its current position, and its study and budget to choose leveraged loans.
This is a guide to Leveraged Loans. Here we also discuss the introduction to leverage loans along with types, advantages, and disadvantages. You may also have a look at the following articles to learn more –