What is leveraged finance
Leveraged finance is a part of finance in the area of investment banking that deals with provision of loans to private equity companies and corporations for leveraged buyouts. They also provide advises to the companies and corporations on leveraged buyouts. LF can be used to represent leveraged finance. The department of LF primarily works on assets purchase, leveraged buyouts and recapitalisation. Companies looking for ways to do any of the above work prefers using debt rather than using equity.
LF department work mostly in structuring of the deal with the actual company collecting the debt from the debt capital market department. Leveraged finance is also involves a debt financing which a company finances with more debt than the usual and normal funding for the company which means the funding of the more risky than normal borrowing and consequently makes it to be costly. The leverage of any transaction within a company refers to the ratio to the cost of debt financing to the cost of equity financing.
Debt financing can be bank loans but usually bonds while the equity financing involves buying of shares. The ratio is uncommonly high in leveraged financing and consequently, the debt being financed by the company gets higher and absorbs all or most of the part of the income of the company and this causes the risk of the company financing the debt to be very high which makes the lender’s position to be at risk than the risk in conventional acquisition. The coupon rate which is also the interest rate at this stage gets higher.
The main purpose of leveraged finance is to increase the investments returns that is the investment profit from the investment the company had if the investment should increase value. Most company that are into leverage buyout try as much as possible to get much leverage in other to enhance the performance of the investment in getting returns which are internal rate of return. Leverage finance causes the risk and fear in lenders that lend money to a leverage buyout companies.
It also increases the volatility of the company cash flow and earnings. The leverage buyout firms increase their investment returns by engaging in three methods which are No leverage (this company finances it with 100% equity financing), moderate leverage (this involves the company using 30% debt and 70% equity) and high leverage (this makes use of lower equity financing than the debt financing in which the equity financing can be 35% and the debt financing to be 65%).
The leverage finance has very few careers under it which are the capital market research, assets management and deal originating. There are actually few established firms that uses leveraged finance but has a lot of opportunities to join with an equity financing company.
The risk involve in leveraged finance
- Leverage finance put the company on the risk of liquidity as the inability to refinance itself when there is tight credit conditions in the company.
- It creates structural risk as there are legal documentation and balancing of risk which were created by the provision of finance.
- It causes credit risk rather than financial risks. Credit risk is usually within the business while financial risk stays within the economy. Some financial risks are the interest rate, tax rates and foreign exchange rate.
Works of LF department.
Assets purchase. LF department helps in raising debt capital for the company that does not have their cash flow to purchase assets as the assets are limited. The cash flow or physical assets makes the basis assets that have high leveraged none or limited funding.
Recapitalisation. this is a system or strategy in which a company takes more additional debt for the sake of leaving the remaining shareholders to an interest that continues in a financially leveraged company by either repurchasing more shares or pay for dividends that are way higher. This is usually done in other to cash in on a company performance that are on the rout of leveraged buyouts.
Leveraged buyouts. This is done by providing loans from bank and the issuing of bonds that yield high amount of money for the purpose of funding a part of company or the whole companies by the internal management team.