First published on the BSPE blog
By Konstantin Barakos
What is Leveraged Finance? It’s actually fairly straightforward – the answer is right there in the name! Leveraged finance describes a corporate acquisition financed through leverage.
End of story; roll credits.
Ok, since I brought up the term credits, I should mention that Leveraged Finance participants (i.e. issuers and investors) have some unique needs: they have an appetite for extraordinarily high returns. This is satisfied by less than investment-grade credit and capital structures with disproportionate large amounts of debt (relative to a “normal” corporate capital structure). Thus, the big difference between Leveraged Finance and other debt raising activities lies in the investment grade of the issuing company. These issuers are particularly less-established firms with ratings below BBB-/Baa3 facing difficulties in raising capital. Debt issued through Leveraged Finance is used for a variety of purposes, including asset purchases, recapitalizations, refinancing and, most prominently, leveraged buyouts. Over the recent years, Leveraged Finance has become an integral part for many investment banks and a popular destination for talented graduates. But what is the role of investment banks in Leveraged Finance deals?
The role of investment banks in Leveraged Finance deals
Investment banks generally act as intermediaries between issuers and investors and aim to pair those willing to invest money in risky (or high-yield) debt with companies seeking to raise money through leveraged debt products. The overall deal process can essentially be divided into 3 core activities, namely the deal origination, execution and syndication. Initially, the investment bank screens the market for potential targets meeting the basic investment criteria of investors (e.g. having an appropriate debt capacity). After identifying a suitable candidate, the investment bank pitches the company to a pool of clients (e.g. private equity funds), which are typically within the bank’s network. Once there’s a match, the process advances to the execution phase. Here, the investment bankers conduct thorough due diligence involving consultants, accountants and lawyers to uncover any hidden faults or liabilities. This phase includes the determination of the adequate debt structure, obtained through in-depth financial modeling, a core exercise in Leveraged Finance.
After the terms and conditions of the loan have been negotiated, the syndication phase begins. This is the phase in which the coordinating investment bank (also known as lead arranger) underwrites the debt issue and subsequently sells it to a number of investors. These investors are represented by other banks, funds or institutional investors. Syndication allows a borrower to negotiate loan terms only once with the lead arranger, but still access multiple lenders simultaneously. From the perspective of the lead investment bank, syndication offers a convenient way of spreading risk. This is particularly important in Leveraged Finance, given the risky nature of the deals. Syndicated loans start at around USD 100m and climb into the billions. There may be upwards of 50 investors and beyond involved within a syndicate.
A critical factor of success in Leveraged Finance is to determine the correct level of debt. Debt issuers prefer higher levels, as they amplify the return-enhancing effects of leverage. This, however, increases the company’s probability of default, the primary concern for debt holders. The challenge for the lead arranger lies in striking the balance between these conflicting interests: if it does not offer an appetizing debt consideration to the sponsor, the bank won’t win the mandate. Yet, if the bank fails to syndicate the loan, it runs the risk of holding excessive levels of risky debt.
Common debt instruments used for Leveraged Financing
The story up until now is if the borrower issues a single loan – so it’s technically still an abridged version. The long answer involves a credit agreement usually containing a mix of two distinct debt instruments: leveraged loans and high-yield (or ”junk“) bonds. Leveraged loans represent the more senior tranches of debt and can further be differentiated between pro rata bank debt (aka term loan A or TLA), and institutional loans (aka term loan B or TLB). The former is a senior term loan that usually matures within 5 and 6 years. Conventional TLA tranches amortize over the years in increasing repayments equal to 5% to 20% of the principle. Conversely, TLB tranches typically mature within 6 and 7 years with minor, annual repayments of about 1% of the principal. Early prepayments are generally possible at a penalty equal to 1% to 2% of the principal. Interest payments for TLBs are generally higher than for TLAs, due to their subordinated repayment schedule. Loans are commonly considered leveraged if they have a spread of at least LIBOR + 125bps. In case the company is unrated, this measure is usually taken into account to differentiate an investment-grade from a speculative deal. Figure 1 illustrates the proportions between TLAs and TLBs of the total volume of leveraged loans issued.
Leveraged loans have traditionally been secured with liens (i.e. secured by some form of collateral) and strict covenants, enabling borrowers to raise a decent portion of debt at relatively low rates. However, leveraged loans have increasingly become covenant light (aka cov-lite) following the Global Financial Crisis. As figure 2 points out, around 80% of all leveraged loans were cov-lite in 2019. These loans are less protective as they lack the early warning signs that indicate a deterioration in the financial position of borrowers. The recurrence of cov-lite loans can be explained with the increasing competition in the loans market, resulting from more sophisticated methods of spreading risks (e.g. through structured products). Critics state that high levels of cov-lite loans decrease overall stability in financial markets. However, covenant-heavy lending agreements may also trigger corporate defaults, as companies are pressured to restructure quickly and thus lose flexibility.
Leveraged loans are often issued along with an even more senior revolving credit line – a sort of corporate credit card that allows the borrower to drawdown, repay or re-borrow money on a regular basis. It is mainly used to satisfy short-term working capital needs and is sourced from the same lenders. The credit limit is usually based on historical cash flows or on actual levels of working capital. Similar to term loans, revolving credits are often secured in the Leveraged Finance market.
Moving on… high-yield bonds represent the other core aspect of the debt raising spectrum. These are usually unsecured, risky bonds that enable borrowers to increase leverage to levels that loans wouldn‘t support. The associated risk stems from the fact that issuers may be characterized by high debt levels or may experience financial distress. However, they may also be smaller or emerging companies with unproven operating histories. High-yield bonds are usually termed for 5 to 10 years and entail fixed coupon payments, which are transferred semiannually to bond holders. In contrast to leveraged loans, high-yield bonds usually have a call protection, a restriction for early prepayments. This may hold for the first 2 or 3 years in which prepayments are not possible at all. After this period, prepayments may be possible with a premium of, say, 10% of the principal. This premium would then gradually decrease over the remaining years. Figure 3 illustrates the development of high-yield bonds in the US issued by seniority.
To increase leverage even further, companies can issue mezzanine debt, a subordinated debt form comprised by both equity and debt-like features. Common securities include convertible debts, bonds with warrants or convertible preferred stocks. These are particularly attractive to investors who target returns between 10% and 20% with room for even higher yields by obtaining the possibility to acquire equity stakes.
How investment banks organize their Leveraged Finance business
Now we’re closing in on a complete answer. It is important to note that the structure of the Leveraged Finance business varies widely with each address on Wall Street and post code in Canary Wharf. To recap, Leveraged Finance comprises all debt raising related to non-investment-grade issuers. It is not to be confused with DCM activities, which entail debt raising for investment-grade companies, i.e. with a credit rating of BBB-/Baa3 or above. Furthermore, it is not unusual that investment banks have both a Leveraged Finance and a Financial Sponsors group. This holds especially true for investment banks with large and respected Leveraged Finance competences. Both groups conduct Leveraged Finance activities in a broader sense, but there are important differences to respect: The Financial Sponsors group essentially represents a coverage group for financial sponsors and is interpreted rather as an industry team: it delivers a wide range of investment banking services for a specific industry. The Leveraged Finance group, however, is considered rather a pure product group with a portfolio of specialized debt raising capacities. Again, this may not hold true for every investment bank.
Key players in Leveraged Finance
Generally, (and finally) investment banks with larger balance sheets tend to have stronger Leveraged Finance teams, which makes sense since they have greater underwriting capacities. The Leveraged Finance market has traditionally been dominated by the likes of JP Morgan and BofA Securities (previously BAML) closely followed by Credit Suisse. The European global banks UBS, Barclays and Deutsche Bank as well as the Canadian investment bank RBC Capital Markets, also have respected Leveraged Finance practices. However, some top tier bulge bracket banks including Citi and Morgan Stanley are not necessarily regarded as Leveraged Finance banks, at least not in the past decades. The top league table positions in global sponsor-led loans for FY 2019 are held by 1) JP Morgan, 2) BofA Securities, 3) Goldman Sachs, 4) Credit Suisse and 5) Barclays. The top 5 ranking is identical for both book runner and mandated lead arranger activities.
Why you should consider entering the Leveraged Finance field as a graduate
First, transaction volume is high and you will spend less time pitching. In contrast to other investment banking deals, Leveraged Finance deals are significantly shorter in duration. Within the first year as an analyst, you may have worked on more than ten live deals, which is almost impossible in other product groups such as M&A or ECM.
Second, the nature of the Leveraged Finance deal will sharpen your technical knowledge more so than deals of many other product groups. You will undertake much in-depth financial modeling because you work with less creditworthy companies. You will spend more time building different financing scenarios using a variety of debt instruments (see above). You will also work hand-in-hand with financial sponsors, investors known for their expert knowledge and extremely high demands. If you have a quantitative mindset and prefer to work on numerous deals simultaneously (as opposed to working on a single, large deal over a prolonged period), chances are high that you will thrive in this field.
Lastly, Leveraged Finance jobs are associated with brilliant exit opportunities. Your technical foundation, financial markets knowledge, extensive track record and proven ability to work with sophisticated investors will naturally be appealing to private equity firms, hedge funds or mezzanine funds. Some professionals even say that a Leveraged Finance job is your fastest route into the private equity field – so you don’t have to take my word for it.
And there’s the uncondensed description so while it’s definitely not the end of the story for Leveraged Finance, the credits will keep on rolling….
Editor: Eric Peghini
Author: Konstantin Barakos