Leveraged finance depicts the financing of highly levered and speculative-grade companies. The lower the ratings of companies, the more leveraged the instrument becomes.
Leveraged finance typically works with corporations and private equity to raise debt by syndicating loans.
It is also entrusted with the responsibilities of underwriting bond offerings which are to be used in Leveraged buyouts, mergers and acquisitions, recapitalizations, and debt refinancing.
Effects of various classes of funds raised through leveraged finance deals
Leveraged finance deals to raise funds and all these types have their own uses as :
- Leveraged buyouts: Glazers Family bought Manchester united through LBO. This is typically equity buyout and part by taking debt. In short, financial sponsors need to raise debt to organize leveraged buyouts of the target company.
- Mergers and acquisitions: When the company needs cash infusion for corporate action of mergers and acquisitions, they need to borrow and raise debts on their books.
- Recapitalization: The companies may have cash in one country and to bring them to their origin country, it would be taxed. This happened in the case of Apple Inc where it has billions of cash offshore and had decided to go with buybacks due to the rise of an activist investor like Carl Icahn. They raised debt in the United States on basis of their balance sheet and used that to fund the buyback of shares and reward shareholders. Similarly, debts can be raised to pay dividend also.
- Debt refinancing: When the bonds mature, instead of redemption or payment of the same, the company can raise an equivalent amount of debt with terms and conditions. In such case, funds need not follow outwards and new debt would fit into the balance sheet like the old one. This is simply borrowing new debt to pay for the old debts.
The role of investment banks in Leveraged Finance deals
Leverage finance deals fall typically under the umbrella of investment banking. Investment banking has flourished over the past decade due to free trade and globalization. Investment banks act as the intermediary between deals.
They act as intermediaries between issuers and investors and match the companies that want to invest money in high-risk debt with companies that want to raise debts through leveraged debt products.
The role of investment banks can be classified into three processes namely origination, execution, and syndication which are described below:
- Origination: This is screening phase of leveraged finance deals. The investment banks maintain large data and have networks among various other investment banks as well. They work together to reach out to the companies that need to raise debts and who are able to invest for higher yields. Basically, it is the screening phase, where potential targets meet the basic criteria of investors and are promoted to the next stage of execution.
- Execution: After the identification of the target company, the investment bank pitches the company to a pool of investors like private equity guys that are within the network of the bank. Then. Execution is to be forwarded. Under this phase, investment banks conduct due diligence of consultants, and accountants to cover any hidden faults or liabilities. This phase involves the determination of a debt structure that is adequate and apt exercise is done to determine these aspects.
- Syndication: If the terms and conditions between the two parties have been negotiated, the phase for debt syndication begins. Under this, the investment bank also called the lead arranger underwrites the debt issue and sells to a number of prospective investors who have agreed to become investors. These investors are typically represented by banks or various funds.
Syndication allows negotiation terms with the lead arranger i.e. investment bank once and after it is agreed upon, funds can be raised through multiple lenders afterward.
Syndication is a means to spread risk. Under leveraged finance, syndication plays huge role.
For example, Sinra Inc agrees to raise debts through Morgan Stanley, an investment bank. Morgan Stanley brought in Carlyle Group, a private equity fund that has a pool of investors.
Sinra Inc has to deal with Morgan Stanley and Morgan Stanly deals with Carlyle group for syndication.
The number of investors like Carlyle Group can be high in syndication. It is a way of spreading the risk.
The most important aspect to determine the success of leveraged finance deals is to determine the optimum level of debt. This helps to amplify and enhance the return effects of leverage deals.
On the other hand, this also increases the risk aspect raising the probability of default, a concern for investors.
Hence, lead arrangers i.e. investment banks have to strike balance between risk, yield, and debt structure of the target company.