Demystifying Investment Banking: Leveraged Finance
Introduction
You might occasionally hear a student mention Leveraged Finance as one of the product teams that sit within a Bulge Bracket investment bank. All too often, Leveraged Finance (or LevFin) gets misunderstood, lost between the giants of Debt Capital Markets and plain old Corporate Banking.
This is a shame, because LevFin is endlessly interesting and can prepare analysts for a wide variety of roles inside and outside of banking.
Last week we focused on Debt Capital Markets, a product team whose bread and butter is investment-grade bond issuance. Leveraged Finance deals with all syndicated debt issuance that falls below investment grade.
So, LevFin helps companies structure and issue a wide variety of sub-investment grade debt instruments. This could include bank debt, which may or may not be held by the arranging bank, but could also include high yield bonds, senior and subordinated debt and hybrid debt instruments. LevFin is big business for banks.
It’s a mixture of a flow (leveraged loans need refinancing) and a transaction product, which means that analysts will always be busy, likely on multiple deals, many with significant complexities.
You might occasionally hear a student mention Leveraged Finance as one of the product teams that sit within a Bulge Bracket investment bank. All too often, Leveraged Finance (or LevFin) gets misunderstood, lost between the giants of Debt Capital Markets and plain old Corporate Banking.
This is a shame, because LevFin is endlessly interesting and can prepare analysts for a wide variety of roles inside and outside of banking.
Last week we focused on Debt Capital Markets, a product team whose bread and butter is investment-grade bond issuance. Leveraged Finance deals with all syndicated debt issuance that falls below investment grade.
So, LevFin helps companies structure and issue a wide variety of sub-investment grade debt instruments. This could include bank debt, which may or may not be held by the arranging bank, but could also include high yield bonds, senior and subordinated debt and hybrid debt instruments. LevFin is big business for banks.
It’s a mixture of a flow (leveraged loans need refinancing) and a transaction product, which means that analysts will always be busy, likely on multiple deals, many with significant complexities.
What kind of deals?
Analysts might also spend time working with restructuring colleagues, working on a debt structure that is suitable for a company who has defaulted on its debt, or has run into significant operational difficulties. Analysts will spend time arranging non-investment grade, high yield bonds for companies and countries.
On the completion of all these different types of deals, it is expected that the issuing company will have significant debt. Investment Grade companies tend to stick below a maximum Debt:EBITDA ratio of 3.5x whereas LevFin transaction can see debt go up as high as 10x EBITDA on issuance.
This is why LevFin is so interesting. Analysts need to think deeply about the structure of the financing, providing debt investors with appropriate upside (coupon) to make the increased risk of default worth it, whilst also providing really strong lender protections in the debt agreement.
Analysts might also spend time working with restructuring colleagues, working on a debt structure that is suitable for a company who has defaulted on its debt, or has run into significant operational difficulties. Analysts will spend time arranging non-investment grade, high yield bonds for companies and countries.
On the completion of all these different types of deals, it is expected that the issuing company will have significant debt. Investment Grade companies tend to stick below a maximum Debt:EBITDA ratio of 3.5x whereas LevFin transaction can see debt go up as high as 10x EBITDA on issuance.
This is why LevFin is so interesting. Analysts need to think deeply about the structure of the financing, providing debt investors with appropriate upside (coupon) to make the increased risk of default worth it, whilst also providing really strong lender protections in the debt agreement.
A menu of debt financing options
To better understand the range of debt financing options
available to a highly leveraged company, it’s important for analysts to get
their heads around capital structure.
Businesses are financed with debt and equity. Debt received
a fixed income (interest payments) and, if there is a bankruptcy, lenders will
be paid first, benefiting from the residual value in the business. Equity
investors get all the upside from growing businesses, however risk the very
real possibility that they will be left with nothing if the company fails.
The safest possible capital is senior secured bank debt – a
term loan secured against assets owned by the issuing business. This debt sits
at the ‘top’ of the capital structure. The riskiest possible form of capital is
ordinary equity – shares will no preferential treatment. This equity comes at
the ‘bottom’ of the capital structure.
In between the top and the bottom of a leveraged capital
structure comes a wide range of ‘mezzanine’ debt products, which take on some
debt-like elements, and some more equity-like characteristics.
These products exist to incentivise investors with a wider range of risk:reward profiles. One investor might only be interested in senior secured debt, happily sacrificing returns for a lower risk profile. Another investor might be happy to take on a little more risk, on the hunt for greater upside (a higher coupon).
The types of instruments you will hear about include Term
Loan B, High Yield Bonds, Subordinated Mezzanine Financing and Preferred
Equity. As we know, bankers can be extremely creative, introducing ever more
complex financing instruments to satisfy investor demand.
An example of this is the PIK toggle note. A toggle note allows a company of a payment-in-kind bond to defer interest payments, paying a higher coupon rate as compensation. This helps companies get through difficult trading periods, whilst compensating investors for their patience.
To better understand the range of debt financing options
available to a highly leveraged company, it’s important for analysts to get
their heads around capital structure.
Businesses are financed with debt and equity. Debt received
a fixed income (interest payments) and, if there is a bankruptcy, lenders will
be paid first, benefiting from the residual value in the business. Equity
investors get all the upside from growing businesses, however risk the very
real possibility that they will be left with nothing if the company fails.
The safest possible capital is senior secured bank debt – a
term loan secured against assets owned by the issuing business. This debt sits
at the ‘top’ of the capital structure. The riskiest possible form of capital is
ordinary equity – shares will no preferential treatment. This equity comes at
the ‘bottom’ of the capital structure.
In between the top and the bottom of a leveraged capital
structure comes a wide range of ‘mezzanine’ debt products, which take on some
debt-like elements, and some more equity-like characteristics.
These products exist to incentivise investors with a wider
range of risk:reward profiles. One investor might only be interested in senior
secured debt, happily sacrificing returns for a lower risk profile. Another
investor might be happy to take on a little more risk, on the hunt for greater
upside (a higher coupon).
The types of instruments you will hear about include Term
Loan B, High Yield Bonds, Subordinated Mezzanine Financing and Preferred
Equity. As we know, bankers can be extremely creative, introducing ever more
complex financing instruments to satisfy investor demand.
An example of this is the PIK toggle note. A toggle note allows a company of a payment-in-kind bond to defer interest payments, paying a higher coupon rate as compensation. This helps companies get through difficult trading periods, whilst compensating investors for their patience.
What’s going on with Private Credit?
After 2010, Banks had to ensure that they held a minimum amount of equity, relative to their risk-weighted assets. Leveraged loans are about as risky as banks got, and therefore came with stringent equity requirements. However, there were just as many private equity firms, requiring ever more leveraged loans.
The growth of private credit investors neatly filled the hole left by the increasingly risk-averse banks. Private credit, which is now a major asset class in its own right, involves investment funds, like KKR or Apollo, issuing debt to finance leveraged deals.
The advantage for issuers is that the debt deal is bilateral (between issuer and lender) and is not syndicated and traded on the secondary market, meaning that they need to deal with, and report to, a smaller number of lenders.
Private credit has become an increasingly important source of funding for leveraged deals and, since it’s the Private Equity firms that have launched this industry, it is likely to become the most important source of funding for highly leveraged deals.
This doesn’t mean that LevFin analysts no longer have a job. Analysts will still need to support on structuring, arranging and issuing the loans. Its just that the profile of the lender is changing.
After 2010, Banks had to ensure that they held a minimum amount of equity, relative to their risk-weighted assets. Leveraged loans are about as risky as banks got, and therefore came with stringent equity requirements. However, there were just as many private equity firms, requiring ever more leveraged loans.
The growth of private credit investors neatly filled the hole left by the increasingly risk-averse banks. Private credit, which is now a major asset class in its own right, involves investment funds, like KKR or Apollo, issuing debt to finance leveraged deals.
The advantage for issuers is that the debt deal is bilateral (between issuer and lender) and is not syndicated and traded on the secondary market, meaning that they need to deal with, and report to, a smaller number of lenders.
Private credit has become an increasingly important source of funding for leveraged deals and, since it’s the Private Equity firms that have launched this industry, it is likely to become the most important source of funding for highly leveraged deals.
This doesn’t mean that LevFin analysts no longer have a job. Analysts will still need to support on structuring, arranging and issuing the loans. Its just that the profile of the lender is changing.
Not as much as you might think. Remember, DCM is all about
credit risk. Happily, the major credit ratings agencies (Moody’s, S&P,
Fitch) will spend hundreds of hours arriving at a credit rating for an issuer,
which is relied upon by the industry.
This means that analysts can simply look at the pricing of
comparable issuers with a similar credit rating to determine pricing.
Modelling does become useful when the issuer is considering
a significant new issuance, which might could result in a change in credit
rating, due to higher leverage (Debt/EBITDA) ratios.
Also, it might be worth
modelling upside, base and downside scenarios to better understand an issuers
forward-looking credit rating and ability to repay in the future.
What do LevFin Analysts do all day?
Unlike Debt Capital Markets, LevFin is modelling intensive.
You will need to be able to build a Leveraged Buyout Model and will spend days
modelling different scenarios (base, upside, downside) to ensure that the blend
of leveraged loan products are appropriate for the issuer.
Like Debt Capital Markets, you will be involved in deal
pricing. However unlike DCM, pricing becomes more of an art, than science, as
there may not be the wide range of comparable bond issuances to anchor pricing
against.
You will need to be intimately familiar with credit ratings,
modelling how changes in leverage and capital structure affect the issuer’s
credit rating.
You will also be heavily involved in legal documentation, ensuring that lenders are appropriately protected through a robust set of financial and non-financial covenants.
Unlike Debt Capital Markets, LevFin is modelling intensive.
You will need to be able to build a Leveraged Buyout Model and will spend days
modelling different scenarios (base, upside, downside) to ensure that the blend
of leveraged loan products are appropriate for the issuer.
Like Debt Capital Markets, you will be involved in deal
pricing. However unlike DCM, pricing becomes more of an art, than science, as
there may not be the wide range of comparable bond issuances to anchor pricing
against.
You will need to be intimately familiar with credit ratings,
modelling how changes in leverage and capital structure affect the issuer’s
credit rating.
You will also be heavily involved in legal documentation, ensuring that lenders are appropriately protected through a robust set of financial and non-financial covenants.
The verdict
Starting your career in a LevFin team is not for the faint hearted.
The modelling is extensive, the technical training is intensive, and the hours are very long (sometimes longer than M&A). However, it’s a brilliant place to learn.
The modelling is extensive, the technical training is intensive, and the hours are very long (sometimes longer than M&A). However, it’s a brilliant place to learn.
As an analyst, you will become a financial modelling expert, learn to think like a banker (i.e. have a very good understanding of credit and risk), and also better understand alternative asset management.
In fact, working in LevFin might set you up for a role in Private Equity or Private Credit, as well as moving across to M&A and into other lending functions in the bank.
Ready to put theory into practice?
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