Leveraged Finance (LevFin) refers to the financing of highly levered, speculative-grade companies. Within the investment bank, the Leveraged Finance (“LevFin”) group works with corporations and private equity firms to raise debt capital by syndicating loans and underwriting bond offerings to be used in LBOs, M&A, debt refinancing and recapitalizations.
The funds raised are used primarily for:
In the world of debt financing, there are two kinds of debt:
Speculative-grade debt is the world of leveraged finance.
One thing both investment-grade and speculative-grade firms have in common is that they can access two distinct debt structures:
Speculative-grade loans are called “leveraged loans.” Speculative-grade bonds are called “junk” or “high yield.”
The table below from S&P Global shows where the investment-grade/speculative-grade divide occurs across the credit ratings spectrum:
S&P Credit Rating System (Source: S&P Global)
As you would expect, investment-grade firms are far less leveraged (lower debt/EBITDA) and have higher interest coverage (EBIT/Interest):
Credit Financial Metrics (Source: Moody’s)
As a result, defaults and bankruptcies are very rare for investment-grade firms. This enables those firms to borrow at very low interest rates. Below, you can see that the yield spreads (the “extra” interest above US Treasury yields) are always higher for speculative-grade bonds than for investment-grade bonds:
Default Spread (Source: Damodaran)
Before getting into the specifics of leveraged finance, let’s briefly look at investment-grade debt.
Loans to investment-grade firms usually come from traditional banks within the corporate banking division. They come in the form of low-interest term loans and revolvers/commercial paper.
Bank loans are the most senior in a company’s capital structure. Often, these loans are so safe that lenders don’t even require the loans to be secured.
Bonds are fixed coupon securities with fewer strings attached at a still-low-but-slightly-higher interest rate
The relationship between loans and bonds is almost always organized such that loans are more senior than bonds. This is done through a variety of mechanisms that ensure loans will be paid out ahead of other debt (i.e. bonds) in the event of a bankruptcy.
Within the investment bank, the Debt Capital Markets group focuses on these investment-grade companies. They do this through:
By contrast to investment-grade firms, speculative-grade firms are more highly levered, with more tranches of debt.
Higher leverage means higher risk of default and bankruptcy, which means higher interest rates and more stringent protection mechanisms for the senior tranches of debt in the capital structure.
Global Default Rates: Investment-Grade vs. Speculative-Grade (Source: S&P Global)
The higher risks involved in lending to highly levered firms means that the providers of capital tend to be a little more risk-tolerant:
Banks that are willing to lend to investment-grade companies are less comfortable with speculative-grade companies. As a result, most term loans and revolvers in the leveraged loan market are syndicated to institutional investors like hedge funds, CLOs, mutual funds and insurance companies (and some banks). Leveraged loans are usually secured by the company’s collateral and occupy the safest space for a lender in the company’s capital structure.
On the bond side, pension funds, mutual funds, insurance companies, hedge funds and some banks make up the bulk of the investors willing to invest in the relatively riskier “high yield” bonds. Why would they take the risk? Remember that high risk = high return.
Leveraged loans (also called “bank debt” or “senior debt”) represent senior tranche(s) in a company’s capital structure, with bonds usually making up the junior tranches. Leveraged loans are term loans that are often packaged with a revolving credit facility and are syndicated by an investment bank to commercial banks or institutional investors.
Leveraged loans are distinct from high-yield bonds (”bonds” or “junior debt”). Loans usually make up the senior tranches, while bonds are make up the junior tranches of a company’s capital structure.
Leveraged loans typically have the following characteristics:
Note: LIBOR is going away and being replaced by SOFR.
Until the early 2000s, leveraged loans primarily came from banks (called pro rata debt), while institutional investors provided the bonds. Since then, the proliferation of CLO funds and various other investment vehicles have brought institutional investors into the leveraged loan side. The conquest has been swift, with institutional loans making up most of the leveraged loan market.
You can always tell whether a company’s leveraged loans are institutional or pro rata by their name:
Despite that fact that institutional investors provide more leveraged loans than banks do, leveraged loans are often misleadingly called “bank debt” since banks are traditionally thought of as the primary providers of loans.
Because of the higher default risk, the most senior tranches on a leveraged company’s balance sheet (the leveraged loans) will almost always require collateral to back up the debt (i.e. secured debt). That’s because owning secured debt is the key to determining if a lender is made whole in bankruptcy, and granting this security enables leveraged borrowers to raise a sizeable portion of its total debt at relatively low rates.
Leveraged loans have traditionally been secured with 1 st liens on the collateral and contain strict covenants (maintenance covenants which require regular compliance with various ratios).
Since the financial crisis, there has been a steady return to more lax lending standards in the leveraged loan market due to a borrower-friendly environment.
“Covenant-lite” loans, while still usually secured wit h 1 st liens, contain traditionally looser bond-like “incurrence” covenants, which require compliance with certain credit ratios only when taking a specified action like issuing new debt, dividends, or making an acquisition.
As a result, leveraged loans have become an increasingly popular option for borrowers compared to traditional leveraged loans.
Covenant lite loans have also overtaken high yield bonds in popularity with issuers, increasing the loan portion of the capital structure relative to bonds. Leveraged loans are private transactions, which can be arranged more quickly that bonds, which require SEC registration.
US Cov-Lite Share of Institutional Loan Issuance (Source: White & Case – Debtwire and Xtract Research)
Second lien loans are less common and riskier than 1st lien loans. IF a 2nd lien loan exists, it will sit below a 1 st lien leveraged loan in the capital structure and is secured only to the extent that there is excess collateral value after the 1 st lien lender is made whole in a bankruptcy.
Imagine a company with $100 million in assets is going bankrupt and has the following capital structure:
In this case, the $90 million goes to the TLb because it has a 1 st lien on the assets. Next, there is $10 million in excess asset value, which would go to the TLc since they have a 2 nd lien. Since there is no asset value left, the unsecured bonds get nothing. The recovery rates are therefore 100% to TLb, 20% to TLc ($10 million / $ 50 million) and 0% to the unsecured bonds.
The example above illustrates how the 2 nd liens add some protection as compared to unsecured, but not nearly as much as the 1 st liens.
Investors holding second liens (primarily CLO funds) experienced notoriously low recoveries in the 2008-2009 financial crisis and the market for them completely disappeared for a while.
Revolving credit lines are like a corporate card, allowing companies to draw from it or pay it down based on the company’s short term working capital needs. Revolvers are often packaged with term loans and come from the same lenders (banks or institutional investors).
There are two types of revolvers:
Revolvers can be either secured or unsecured, but in the leveraged loan market, revolvers are almost always secured.
The asset-based revolver was once considered a loan of last resort as borrowers were loathe to put up their assets as collateral. However, ABL revolvers have grown in popularity by borrowers due to the relatively lower interest rates charged.
Click here to learn to model revolvers
In Blackstone’s $5.4 billion LBO of Gates Global, the senior part of the capital structure included a 7-year $2.5 billion lite term loan, a $125 million cash-flow revolver, and a 5-year $325 million asset-based revolver.
Because leveraged finance involves lending to highly leveraged companies, the amount of debt as a total part of the capital structure is sensitive to market dynamics. We’ve been in a borrower friendly market since the financial crisis and the amount of debt lenders are comfortable is growing, surpassing pre-crisis levels in absolute terms and getting close to pre-crisis levels when benchmarked against EBITDA. In riskier credit environments, the proportion of first lien tranches relative to the overall debt composition tend to increase, as observed in 2020 amid COVID.
Decline in Loan Leverage Multiples (Source: William Blair – LCD)
Speculative-grade bonds, also called “junk” or “high yield” refers to bonds rated lower than BBB. High yield bonds enables borrowers to increase leverage to levels that leveraged loans won’t support.
The high yield credit market represents a much smaller percentage of the total corporate debt issuances in the US because of the risk profile, i.e. junior tiers of capital structure.
High Yield Credit Market Growth (Source: Fidelity – ICE Data Services and LCD)
Below are typical features of a high yield bond:
High Yield Bonds are usually unsecured and can be either senior or subordinated to other bonds in the capital structure.
Being senior or subordinated to another bond has nothing to do with being secured, but instead depends on whether there is an inter-creditor agreement in place between the two (or more) bond tranches.
Being senior or subordinated to another bond technically has nothing to do with being secured, but instead depends on whether there is an inter-creditor agreement in place between the two (or more) bond tranches.
This makes the senior bond senior only to the subordinated bond. The senior bond is still junior to any secured debt and is on equal footing with any other unsecured claim against the business that it does not have a specific inter-creditor agreement with.
Practically speaking, however, senior bonds usually recover more in a bankruptcy because they receive whatever recovery would have otherwise also gone to the subordinated debt. As a result, senior bonds are cheaper for borrowers.
US High-Yield Bond Issuance (Source: Pitchbook – LCD)
With leveraged loans, the borrower can usually prepay principal with no penalties. In debt-lingo, that’s called having no call protection. In other words, the lender is not protected from the possibility of the borrowing paying off the loan and the lender no longer getting interest payments. With bonds, however, call protection is common.
A typical example of a bond with call protection would be 2 or 3 years of call protection (noted as NC-2 or NC-3), where the borrower is not allowed to prepay. After the end of the call protection period, the bonds do become callable, but the borrower would have to pay a call premium, usually as a % of par value. For example, an 8 year 10% might follow the following schedule:
This means that if the borrower wanted to prepay in year 4, it would need to repay 105% of the principal owed.
This is why, when building an LBO model or the debt schedule of a company with multiple tranches of debt, the model often uses excess cash flows to prepay bank debt (cash sweep) but does not touch the bonds due to the prepayment penalty.
Instead of paying interest with cash, the PIK toggle gave the borrower the option to pay cash interest or to let the interest accrue and grow the principal balance.
In 2006, when borrowing to finance LBOs was reaching frenzied levels, an “innovation” emerged to enable private equity firms to bring in additional debt to finance an LBO or to do a dividend recapitalization without having to pay cash interest immediately: The PIK-toggle. Instead of paying interest with cash, the PIK toggle gave the borrower the option to pay cash interest or to let the interest accrue and grow the principal balance. As an alternative to this binary option, notes were also sometimes structured with a predefined combination of cash and PIK interest. While PIK notes disappeared for a while following the financial crisis, they’ve had a modest resurgence, albeit with stricter investor protections and still amounting to a very small portion of overall high yield bond issuances volume.
Here is an example of a $500 PIK-Toggle note issued by J. Crew in 2013 to fund a dividend recapitalization. Per S&P LCD:
“J.Crew is driving by with a $500 million offering of six-year (non-call one) senior PIK-toggle notes via bookrunners Goldman Sachs, Bank of America, Morgan Stanley, and Wells Fargo, and price talk is for a 7.75-8% coupon at 99.5, according to sources. The guidance works out to an approximate yield-to-worst range of roughly 7.875-8.125%.
Investors are guided toward issue ratings of CCC+/Caa1, while the borrower is rated B/B2. Proceeds will be used to fund a dividend. Take note that the first call premium is 102, followed by 101, then at par annually thereafter.”
Mezzanine debt broadly describes financing between senior secured debt and equity, which would place 2 nd lien debt, senior and subordinated bonds into the category.
Unfortunately, in practice, that’s NOT what most people mean when they say mezzanine debt.
Mezzanine debt refers to financing with debt and equity like features, sitting below the traditional loans and bonds but right above common equity.
Mezzanine debt more commonly refers to securities that have both debt and equity like features, sitting below the traditional loans and bonds but right above common equity. This financing includes:
Because mezzanine debt is structured specifically for transactions, the characteristics can vary. However, the following generalities usually apply:
Oaktree Capital, one of the largest mezzanine funds, describes approaching Mezzanine debt investments in one of two ways:
As a result, cash interest is not the only source of return and includes:
Mezzanine Financing Structure (Source: Prudential Financial)
Mezzanine investors often like to juice an extra 100-200 basis points in returns by adding an “equity kicker” – the option to participate in the equity upside of the business being funded. There are three ways in which this is done:
Here’s what a mezzanine note issued to fund a leveraged buyout might look like:
Putting it all together, below is a table outlining the typical features of debt used in leveraged finance:
| Leveraged loans | Bonds | ||||
|---|---|---|---|---|---|
| Debt Type | Revolver | Term Loan A (Bank Debt); Term Loan B/C/D (Institutional) | Senior secured | Senior unsecured | Subordinated |
| Lender | Institutional investors & banks | Institutional investors | |||
| Coupon | Floating, i.e. LIBOR + 300 bps | Fixed, i.e. 8.00% coupon paid semi-annual | |||
| Cash/PIK interest | Cash interest | Cash or PIK | |||
| Interest rate | Lowest < >Highest | ||||
| Principal repayment schedule | None | Some principal amortization | Bullet at end of term | ||
| Secured/ unsecured | Secured (1st and 2nd liens) | Unsecured | |||
| Priority in bankruptcy | Highest< >Lowest | ||||
| Term | 3-5 years | 5-7 years | 5-10 years | ||
| Covenants | Mostly incurrence (“covenant lite”); Some maintenance (strictest) | Incurrence | |||
| Call protection | No | Yes | |||
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