Business owners often find themselves facing special situations, such as an acquisition opportunity, where they need more capital. For temporary, short-term funding needs, leveraged financing can be an investment strategy that supports business growth and increases returns.
What is Leveraged Financing?
Leveraged financing is when you utilize debt, more than what is considered normal for a particular business or industry, to acquire additional assets. In this type of financing, the ratio of debt measurements such as debt-to-equity, debt-to-asset and cash flow-to-total debt is frequently higher than 50 percent.
Why Choose Leveraged Financing?
The best reason to leverage your company is to utilize debt instead of equity. Debt holders will receive a set return – the interest. Equity holders will share in your profits.
How Does It Work?
In leverage financing you’re borrowing someone else’s asset (capital) to invest in something else (acquiring a new business.) This loan, called a leverage loan, works just like other types of loans; the term leverage refers to the fact that the loan is being made to a company that is heavily leveraged, or indebted.
There is no set definition of a leveraged loan, but typically it is determined by a floating interest rate based on the LIBOR (London Interbank Offered Rate) plus a fixed margin, the loan’s rating or a combination of both. A rating below investment grade (Ba3, BB- or lower) qualifies a loan as leveraged.
When Is It Used?
Because a leveraged loan costs more than regular borrowing due to its higher risk, this kind of financing is usually only used to accomplish a short-term objective. These short-term goals take several forms:
- Financing mergers and acquisitions
- Funding a dividend or repurchasing shares (recapitalization)
- Refinancing debt
- General corporate purposes
- Leveraged buyouts
What Are The Risks of Leveraged Financing?
Financial leverage magnifies the power of every dollar and increases the profitability of a venture. Increased debt also multiplies the company’s exposure to risk:
- Liquidity. A high level of debt absorbs a large part of the cash flow produced by the business.
- Refinance. Overestimating your capability to service the debt can lead to the inability to refinance under tight credit conditions.
- Losses. With leverage financing, there is a risk that borrowing costs will be higher than the income the asset generates or that the asset’s value will fall.
- Interest rates. Under leveraged lending, banks are allowed to change the terms when selling a leverage loan; if there is insufficient demand for the loan at its original level, the bank can raise the interest margin.
The Bank’s Perspective
Commercial or investment banks are the primary resources for leveraged lending. From the bank’s viewpoint, there is a high risk of the company not being able to repay the leveraged loan, which leaves the lender in a riskier position compared to a conventional loan. Because of this increased exposure, the interest rate on the loan will be high.
Leveraged financing can be complicated and has its risks, but when correctly structured, it can provide quick access to capital. When you partner with the seasoned professionals at Links Financial, we can help you calculate how to raise the needed financing to help you achieve your business objectives.