Introduction to Leveraged Loans

Introduction

A leveraged loan is a commercial loan provided by a group of lenders. It is first structured, arranged, and administered by 1 or several commercial/investment banks, known as arrangers. It is then sold (or syndicated) to other banks or institutional investors. Leveraged loans can also be called senior secured credit.

What is considered ‘leveraged’?

Although there is not an official number at which a loan is considered leveraged, there are multiple ways that people look to ‘rate’ a loan.

One technique is called a ‘spread cut-off’. For example, if a loan is priced at LIBOR+150 bps then that may be considered leveraged. Another common measurement is to use credit ratings, for example any loan that is rated BB+ or lower would be considered leveraged.

LCD has a more complex definition of a leveraged loan. They classify a leveraged loan as:

- Anything rated BB+ or lower

- It is either not rated or is rated BBB- or higher BUT

1. Has a spread of LIBOR+125 bps or higher

2. Is secured by a first or second lien

E.g., if a loan had a rating of BB+ and a spread of LIBOR+75 then it would qualify as leveraged. However, if a loan had a rating of BBB- and a spread of LIBOR+75 then it would not be considered leveraged.

It is very difficult to put a ‘one size fits all’ definition on what is classified as leveraged, therefore, as seen above, it is usually a mixture of benchmarks that are used to classify a leveraged loan.

How big is the Leveraged Loan market?

The leveraged loan market has produced consistent growth for decades and has now become a complete asset class as well as a key component of corporate finance, M&A, and LBO’s.

The S&P/LSTA Loan Index (used as a tool to measure market size in the US) totalled ~$1.2 trillion in 2019.

The European leveraged loan market has also experienced consistent growth totalling ~€181 billion (an increase of €42 billion from the previous year). Although the European market doesn’t have the same loan fund investor segment that drives the US leveraged loan market, CLO issuance has been the key driver in driving the European market.

What's the purpose of Leveraged Loans?

There are 4 primary reasons that borrowers undertake leveraged loans:

1. Help fund an M&A transaction

2. To back a recapitalization of a company’s balance sheet

3. To fund project finance or other corporate purposes

4. Debt refinancing

M&A:

There are 3 main types of M&A loans:

1. Leveraged Buy Outs (LBOs)

The vast majority of LBOs are backed by private equity firms that usually fund 50%-75% of the acquisition via debt in the form of leveraged loans; mezzanine finance; and high-yield (junk) bonds. The exact amount of leverage varies on each transaction, e.g., if a company has high + stable cash flows and operates in a defensive/less-cyclical sector then they can support a higher amount of leverage than issuers in a more cyclical industry/uncertain sector. In addition to the nature of the issuers company/sector, the reputation of the private equity backer plays a role, as does market liquidity. In times of strong markets, investors are more willing to allow higher leverage, however in weak markets investors tend to manage leverage much more strictly.

There are 3 main LBO deals that take place:

- Public-to-private (P2P) – whereby the private equity firm buys a publicly traded company by tender offer. The structure of these deals can vary, e.g., a ‘stub’ of the targets stock may continue to be traded on an exchange whereas in other transactions the company is bought outright.

- Sponsor-to-sponsor (S2S) – one private equity firm (sponsor) will sell a portfolio company to another private equity firm.

- Non-core acquisitions – a corporate issuer will sell a division of the overall company to a private equity firm.

2. Platform acquisitions

An acquisition where a private-equity-backed issuer buys a business that they believe will be accretive through strategies such as cost-synergies or expansion synergies.

3. Strategic acquisitions

A strategic acquisition follows the same rationale as a platform acquisition however the issuers will not be owned or backed by a private equity firm.

Recapitalizations:

A leveraged loan that backs a recapitalization will change the capital structure of an entity by either (1) issuing debt in order to fund stock buybacks or pay dividends, or (2) issuing new equity, sometimes in order to repay debt.

Some common examples of leveraged loans for recapitalizations include:

Dividend financing. A company will take on extra debt in order to pay a dividend to its shareholders. During bull markets dividend deals are more common as issuers use excess liquidity to pay their equity holders, whereas during bear markets these deals are extremely uncommon as lenders avoid deals that will weaken an issuers balance sheet.

Stock repurchases. Companies can also use debt to complete share buybacks which results in the balance sheet shifting more towards debt.

IPO. When a company decides to list, they may decide to deleverage and revamp its loans/bonds at more favourable terms.

Refinancing/Build-outs/General Corporate Debt:

Refinancing – A refinancing means that a company has a new loan/bond issuance in order to refinance its existing debt.

Build-outs – A build-out financing supports a particular project rather than general operations. For example, the construction of a new utility plant, a casino, or production facility.

General Corporate Purposes – These deals simply support a company’s working capital and ‘day-to-day’ activities.

Pricing a loan:

Pricing a loan for the institutional market is fairly straightforward as it is based on simple risk/return considerations and market technicals. However, pricing a loan for banks is more complex as they invest in loans for more than just spread income – they value overall profitability of the relationship which may go beyond the initial loan repayment.

Bank Investors

The majority of large banks use portfolio-management techniques that measure the returns of loan/credit products relative to risk. Banks have realised that, on a stand-alone basis, loans are not often compelling investments. Therefore, the incentive for banks to allocate capital to issuers can be measured by different metrics such as return on capital or return on economic capital etc. When a bank puts a loan on its balance sheet it takes a look at other potential sources of revenue in addition to the loans yield, such as cash management, pension management, M&A advisory or capital markets activities such as bonds or equities.

Institutional Investors

In contrast to the complex strategic rationale for banks, institutional investors are only focused on their return from the loan therefore making the investment decision much more straightforward. When pricing loans for institutional investors, the key components are:

- Spread of the loan

- Risk

- Liquidity

- Market technicals

For large banks, their investment decision is much more complex than institutional investors due to the potential future revenues they can get from fostering a relationship with the issuer. Whereas institutional investors base their investment decision purely on loan-specific revenue, banks have additional potential incentives beyond the loan that they must consider.

Pricing terms/rates:

The majority of loans are floating-rate instruments that reset to a spread over a base rate (usually LIBOR) on a periodic basis. Typically, borrowers can lock in a rate for a one month to one-year period.

There are a few common ways to syndicate a loan, such as:

- Prime. Borrowed funds will be priced at a spread over the banks Prime lending rate. The rate is reset daily, and money can be repaid at any time without incurring a penalty. This is typically a ‘last resort’ because the Prime option is more expensive than LIBOR or CDs.

- LIBOR. With this option the interest rate is fixed for a set period between one month and one-year. The corresponding LIBOR rate is used to set the price, and money cannot be prepaid without incurring penalties.

- CDs. The CD option is very similar to LIBOR with the underlying benchmark being certificate of deposits.

Spreads (margin)

The borrower will repay a ‘spread’ which is usually calculated by basis points over a specified underlying base rate, e.g., LIBOR. On a lot of loans, spreads are tied to ‘performance grids’ that means the spread will adjust based on set financial criteria for the borrower to meet. Common criteria for borrowers are – the rating of investment-grade loans; financial rations of leveraged loans; debt-to-cash-flow ratio for TMT loans.

Libor floors

The point of a ‘LIBOR floor’ is to put a limit on the base rate for loans. For example, if a loan has a 3% LIBOR floor and LIBOR falls below this level, then the base rate automatically defaults to 3%.

Covenants

There are restrictions in loan agreements that dictate how borrowers are able to operate, as well as some financial criteria they need to meet e.g., borrower is not allowed to take on new debt. Covenants can also stipulate some performance targets that, if not maintained, give the lenders an option to terminate the agreement or push the borrower into default. The amount/severity of covenants really dependent on the risk of the loan. For example, an investment-grade loan would have relatively few covenants in comparison to a high-risk, leveraged borrower.

Affirmative covenants

Affirmative covenants state the actions that issuers need to complete in order to be in compliance with the loan agreement. These covenants require the borrower to repay the bank interest + fees, and also make sure the borrower provides audited financial statements, and pays taxes etc.

Negative covenants

These covenants limit the activities of borrowers such as new debt issuance; undertaking acquisitions/investments; liens; asset sales; and guarantees. They are extremely structured and customised to the borrower’s current financial situation. If the issuer is meeting certain criteria, then the covenants may allow acquisitions/debt issuance as long as the issuer maintains a healthy financial situation.

Financial covenants

Financial covenants ensure that borrowers maintain a strong financial performance, e.g., the company must have more assets than liabilities. In general, there are 2 types of financial covenants: maintenance and incurrence.

Maintenance covenants make sure that issuers agree to financial tests such as minimum cash flow and maximum leverage levels. If the issuer fails to follow these covenants, the lender has the right to accelerate the loan, however usually lenders will instead choose to add a spread increase or something of that nature.

An incurrence covenant is only for when an issuer proactively takes an action such as issuing debt.

Collateral

Almost all leveraged loans are backed by tangible/intangible assets and in some cases specific assets.

In the asset-backed market, that typically takes the form of inventories and receivables, the maximum amount of the loan that the issuer can draw down is capped by a formula based of these assets. The common rule is that an issuer can borrow against 50% of inventory and 80% of receivables. There are also certain loans that are backed by real estate, equipment and other property.

In the leveraged market the loans are backed by capital stock from operating units. In this structure, assets of the issuer are at the operating-company level, but the holding company pledges the stock of the operating company to the lenders. This means that lenders have control of these subsidiaries and their assets if the company defaults on their loan.

There is still a risk for the lenders if a bankruptcy court collapses the holding company with the operating company and renders its stock worthless. If this happens, loan holders become unsecured lenders of the company and are on the same ‘tranche’ as other senior unsecured creditors.

Conclusion

The leveraged loan market has grown significantly in the past decade and is now an asset class of its own. In simple terms, leveraged loans provide capital to individuals/companies that already carry a high amount of debt. Due to the risky nature of leveraged loans/potential for default, interest rates are higher than those of standard loans.