Leveraged finance, also known as LF or LevFin, is the strategy of borrowing money with the aim of increasing ROI. If the returns from a security investment are higher than the interest paid on the borrowed amount, the investor makes a significant profit. The invested amount is the combination of the investor’s own amount and borrowed funds. Although leveraged finance investment banking does not alter the return percentage, it efficiently increases the total value of equity returns. Read on to know how it works.
An Overview of Leveraged Finance
Literally, the word ‘leverage’ means ‘debt’. In the financial context, ‘levering up’ refers to using outside funding to generate returns and maximize benefits from potential investments. Companies often use leverage finance in their projects, as it is easier and cheaper to achieve than stock issuance through a secondary offering or IPO. Leveraged finance is a specific area in a bank’s IBD (Investment Banking Division) that provides loans and advice to corporations and private equity firms. Their primary business areas include leveraged payouts, mergers & acquisitions, old debt refinancing, and recapitalizations.
If a company does not have sufficient capital to invest in a security or purchase an acquisition, they typically raise leverage to boost returns on their potential investments. Its focus on below-investment-grade debts is the main point that distinguishes leveraged finance from other loan types. Firms in this category often have a higher risk, inconsistent operations, more considerable leverage use, and a bigger default rate. For counterbalancing, the issuance of these debts often brings higher equity returns.
Is Leverage Good or Bad for an Investor?
Leverage, if appropriately managed, is an excellent strategic tool for investors who lack the capital or buying power of more prominent PE firms. Leveraged finance investment banking can generate substantial returns, which is beneficial for their investment portfolio. However, if mismanaged, leverage quickly burdens the investor with excessive debt, increasing their risk of holding the company’s equity.
For instance, if an investor undertakes a risky project using leverage, it can make them vulnerable if the investment does not go according to the plans. Therefore, excessive debt can reduce a company’s valuation due to the higher risk involved. That is why getting help from professional LevFin teams is essential to manage it properly and gain maximum returns.
What Does a LevFin Team Do?
LevFin teams work as middlemen between investors and companies looking to raise capital. They often work to structure the deal, advise the members, and eventually execute it. Private equity firms often contact them to communicate with clients, analyze and examine a client’s credit or risk profile, structure debt, and analyze the debt’s potential returns.
Leverage finance deals often involve a considerable sum of debt, with debt typically making up to 50-60% of the deal capital. These deals often increase the benefit of boosting a project’s IRR (Internal Rate of Return). Due to the transaction’s riskier nature, the ROI is much bigger than secured debts. The deals often require custom solutions from LF team members.
Advantages of Leverage Finance
In terms of capital structure, a secured loan is superior to an unsecured one, which is more prominent in leveraged finance investment banking. Both these debt types have a superior capital structure to preferred, common, or mezzanine equity. Here’s a look at the advantages of leverage finance to boost equity returns:
- Strong Capital Access: Leverage finance multiplies the value of each dollar put to work. It can help accomplish a more significant benefit if managed properly than investments without leverage.
- Ideal for Buyouts and Acquisitions: Because of its high cost and higher risk, leverage finance is the most suitable for short periods with particular growth objectives, like management buyout, one-time dividend, share buyback, or acquisition.
- Magnified Profits: If shareholder equity solely finances a company, its profitability will be directly proportional to the change in returns. For instance, if the profit increases by 5%, the shareholders’ share value or dividends will also increase by 5%. For a leveraged firm, the increased profitability will not change the payments required to repay the debt. Thus, the shareholder can keep all the excess profit.
When an equity investor borrows leverage finance, they must repay the debt to the investment bank. However, they must repay the amount in small EMIs over an extended period, freeing the funds for immediate use. Therefore, leveraged finance investment banking provides the required capital and boosts equity returns over time without any financial burden on the borrower.