Leveraged Lending

Overview

Leveraged lending is a type of corporate finance used for mergers and acquisitions, business recapitalization and refinancing, equity buyouts, and business or product line build-outs and expansions. It is used to increase shareholder returns and to monetize perceived “enterprise value” or other intangibles. In this type of transaction, debt is commonly used as an alternative to equity when financing business expansions and acquisitions. It can serve to support business growth and increase returns to investors by financing business operations that generate incremental profits against a fixed equity investment. While it is more prevalent in certain industries and with larger companies, banks provide leveraged financing to a variety of borrowers for a variety of reasons.

Institutions participate in leveraged lending activities on a number of levels. In addition to providing senior financing, they extend or arrange credit on a subordinated basis (mezzanine financing), and can provide short-term, or “bridge,” financing to expedite the syndication process. Institutions and their affiliates also may take equity positions in leveraged companies with direct investments through affiliated securities firms, small business investment companies (SBICs), and venture capital companies; or they may take equity interests through warrants and other equity “kickers” received as part of a financing package. Institutions also may invest in leveraged loan funds managed by investment banking companies or other third parties.

Although leveraged financing is more prevalent in large banks, it can be found in banks of all sizes. Large banks increasingly follow an “originate-to distribute” model with respect to large loans. This model, whereby a bank or group of banks arrange, underwrite, and then market all or some portion of the loan facilities to third-party investors, allows the banks to earn fees while limiting their overall exposure to the borrower. This can be especially important in certain leveraged lending transactions, such as those financing corporate buyouts, when the amount of the total credit facility can be quite large. Smaller banks participate in the leveraged loan market by either purchasing participations in these large corporate loans or by making direct extensions to smaller companies.

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