What is a leveraged loan?
A leveraged loan is a type of loan that is given to businesses or individuals who already have large debts and / or poor credit history. Lenders consider leveraged loans to have a higher risk of default and therefore a leveraged loan is more costly for the borrower. Default occurs when a borrower cannot make any payments for an extended period. Leveraged loans for indebted businesses or individuals tend to have higher interest rates than conventional loans. These rates reflect the higher level of risk associated with issuing loans.
There are no defined rules or criteria for defining a leveraged loan. Some market players base it on a spread. For example, many of the loans pay a variable rate, usually based on the London Interbank Rate (LIBOR) plus a declared interest margin. LIBOR is considered a reference rate and is an average of the rates that the world’s banks lend to each other.
If the interest margin is above a certain level, it is considered a leveraged loan. Others base it on rating, with loans rated below the investment category, which are classified as Ba3, BB- or lower by the rating agencies Moody’s and S&P.
Key points to remember
- A leveraged loan is a type of loan made to businesses or individuals who already have large debts and / or poor credit history.
- Lenders consider leveraged loans to have a higher risk of default and, therefore, are more costly for borrowers.
- Leveraged loans have higher interest rates than conventional loans, which reflects the increased risk associated with issuing the loans.
How a leveraged loan works
A leveraged loan is structured, arranged and administered by at least one commercial or investment bank. These institutions are called arrangers and can then sell the loan, through a process known as syndication, to other banks or investors to reduce the risk to lending institutions.
Typically, banks are allowed to change the terms when syndicating the loan, which is called flex pricing. The interest margin can be increased if the loan demand is insufficient at the initial interest level in the so-called upward flex. Conversely, the spread on the LIBOR can be reduced, which is called reverse flex, if the loan demand is high.
How do businesses use a leveraged loan?
Businesses generally use a leveraged loan to finance mergers and acquisitions (M&A), recapitalize the balance sheet, refinance debt or for general corporate purposes. Mergers and acquisitions could take the form of a leveraged buyout (LBO). An LBO occurs when a business or private equity firm buys a public entity and makes it private. Generally, debt is used to finance part of the purchase price. A recapitalization of the balance sheet occurs when a company uses the capital markets to change the composition of its capital structure. A typical transaction issues debt to buy back shares or pay a dividend, which are cash rewards paid to shareholders.
Leveraged loans allow businesses or individuals who already have high debt or poor credit history to borrow money, but at higher interest rates than usual.
Example of a leveraged loan
The S&P Leveraged Commentary & Data (LCD), which provides information and analysis on leveraged loans, places a loan in its universe of leveraged loans if the loan is rated BB- or lower. Alternatively, an unrated or BBB- or higher loan is often classified as a leveraged loan if the spread is LIBOR plus 125 basis points or more and is secured by a first or second lien.