What Is a Leveraged Loan?
A leveraged loan is a type of loan that is extended to companies or individuals that already have considerable amounts of debt and/or a poor credit history. Lenders consider leveraged loans to carry a higher risk of default, and as a result a leveraged loan is more costly to the borrower. Leveraged loans for companies or individuals with debt tend to have higher interest rates than typical loans. These rates reflect the higher level of risk involved in issuing the loan.
There is no exact criteria for defining a leveraged loan. Some market participants base it on a spread. For instance, many of the loans pay a floating rate, typically based on LIBOR plus a stated interest margin. If the interest margin is above a certain level, it is considered a leveraged loan. Others base it on the rating, with loans rated below investment grade, which is categorized as Ba3, BB- or lower from the rating agencies Moody’s and S&P.
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 subsequently may sell the loan, in a process known as syndication, to other banks or investors to lower the risk to lending institutions.
Typically, banks are allowed to change the terms when syndicating the loan, which is called price flex. The interest margin can be raised if demand for the loan is insufficient at the original interest level in what is referred to as upward flex. Conversely, the spread over LIBOR can be lowered, which is called reverse flex, if demand for the loan is high.
Leveraged loans allow companies or individuals that already have high debt and/or bad credit history to borrow cash, though at higher interest rates than usual.
How Do Businesses Use a Leveraged Loan?
Companies typically use a leveraged loan to finance mergers and acquisitions (M&A), recapitalize the balance sheet, refinance debt or for general corporate purposes. M&A could take the form of a leveraged buyout (LBO). An LBO occurs when a company or private equity company purchases a public entity and takes it private. Typically, debt is used to finance a portion 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 stock or pay a dividend.
Example of a Leveraged Loan
S&P’s Leveraged Commentary & Data (LCD), which is a provider of leveraged loan news and analytics, places a loan in its leveraged loan universe if the loan is rated BB- or lower. Alternatively, a loan that is nonrated or BBB- or higher is often classified as a leveraged loan if the spread is LIBOR plus 125 basis points or higher and is secured by a first or second lien.