Leveraged finance investment banking uses high debt levels to finance strategic business actions like share repurchases, acquisitions, Capex, recapitalizations, etc. It differs from normal investment banking in that it involves an excessively large amount of debt as a fraction of things like reserves and equity. Investment banks have dedicated leveraged finance teams that act as intermediaries and support companies in raising funds using the above mentioned strategies. They are also responsible for providing structuring, advisory, and execution of the deals.
Let us look at the role of leveraged finance in the investment banking industry.
How Does Leveraged Financing Work?
Gearing means using debt or borrowing money to finance a venture or project. Its ultimate goal is to multiply the project’s possible profits. Leveraged finance simultaneously increases the risk if the investment does not work out. When an investment, asset, or business is categorized as highly leveraged, it attaches more debt than equity.
Both businesses and investors employ leveraged finance as a tool to boost investment profits. They utilize various products, like futures, margin accounts, and options, to leverage the assets. Moreover, businesses may use leveraged finance investment banking to fund their purchases. They use that finance to invest in their business operations and improve shareholder value instead of raising money by issuing shares. It is a nice way for businesses to utilize leveraged finance without adding to their expenditure.
Types of Leveraged Finance Products
Different kinds of leveraged finance products are as follows:
Institutional Term and Leveraged Loans
Institutional investors provide term loans to businesses, and the borrowers agree to repay within the repayment schedule. The borrower must pay a small amount each year and the remaining amount on maturity. Corporations and individuals with low credit ratings can also obtain leveraged finance as debt. Several lending institutions collaborate with investment banks to offer syndicated and commercial loans.
High Yield Bonds
These are junk bonds below investment grade with poor credit ratings. The companies issuing these bonds cannot tap into the bond market. Therefore, they raise capital through this financing mode. Since these bonds have high default risk, they come with a higher coupon rate. Some of them may even have negative covenants. There is no option for additional borrowing until full repayment of previous bonds.
Mezzanine finance is a hybrid method to raise funds for a company. Working as a bridge to fill the gap between short-term and long-term financing, it is a cost-efficient funding method for small and medium-sized enterprises. The finance provider transforms debt into equity in this method.
Advantages of Leveraged Finance in Investment Banking
Leveraged finance investment banking is a high-return but high-risk debt that benefits borrowers and investors. Given below are a few major advantages one must know:
Companies in the speculative grade can easily obtain high-capital loans through leveraged finance. Without that facility, firms or firm owners with poor credit ratings will struggle to receive funds.
The returns for investors and bankers are higher for leveraged finance investments compared to normal loans. It is most probably because of the higher default risk.
Leveraged finance provides ample funds for high-value projects like leveraged buyouts, acquisitions, mergers, recapitalizations, debt refinancing, etc.
However, leveraged finance has some limitations as well, including the following:
It involves considerable monetary risk.
Speculative-grade borrowers have poor credit ratings.
Leveraged finance reduces the company’s liquidity.
It questions the firm’s solvency in the long term.
Macroeconomic factors like depression or recession seriously impact leveraged firms, thereby increasing the default chance.
It increases the debt-to-equity ratio, which means higher financial obligations.
The borrower must fulfill obligations regardless of profits to avoid insolvency.
Financial strategies that involve funding for purchases with higher expected returns refer to leveraged finance investment banking. Successful leverage boosts the small capital amount required to make substantial profits. Leveraged finance might also treat the asset purchased as collateral to secure the loan. Leverage amplifies the gains and losses when the asset returns outweigh the financing expenses. The asset amount in equity-like securities and stock is a funding requirement that companies use strategically for their short-term financing needs for buyouts or acquisitions.