Advantages and Disadvantages of Leveraged Finance Investment Banking

Leveraged Finance as a mode of financing has been on the rise since its inception in the 1980s. Despite hitting its nadir in 2008, it has reached new highs in recent years. The end of 2018 witnessed the leveraged finance outstanding balance in the US touch an astounding US$ 1.15 trillion. Leveraged Finance Investment Banking involves a consortium of financial institutions providing lending to a risky company that is arranged by one or more investment banks. The rise of large acquisitions and incomprehensible valuations has also seen a growth in leveraged lending. Leveraged Finance Investment Banking finds its own set of suitors and detractors depending on where we are in the economic cycle.

The major advantages and disadvantages associated with the same are the following:

Advantages

Allows for more access to capital

One of the reasons for the usage of leveraged finance is access to a higher amount of capital than is available to entrepreneurs or companies. Financial leverage if used properly can provide high and multiply the returns of an entity from a transaction. Financial leverage can also allow for certain transactions to be executed in a situation wherein the required level of capital is not available with either the acquirer or the acquiring firm.

Ideal for Leveraged Buyouts

The lack of capital hampers transactions such as Management buyouts wherein the senior management of a company may be looking to acquire the assets and the business of the company from its owners. Since the managers generally do not have the required capital for the acquisition, such managers often rely on leverage from financial institutions to complete such acquisitions. The management then relies upon the cash flow of the business to repay such loans. Leveraged Finance enables the completion of such transactions and without the help of investment banks as arrangers, leveraged finance investment banking would be difficult to execute.

Disadvantages

Risk involved

A potent argument against leveraged finance is that it is a risky form of finance both from the lender’s as well as the borrower’s point of view. Leveraged lending is generally considered by firms or companies that already possess a high level of debt or are in a distressing situation. The taking upon of additional debt in the circumstances can lead to a quicker route for bankruptcy. 

In a similar situation, financial institutions usually employ a syndicate policy to provide the loans but face a higher chance of default.

Complex structure

Leveraged Finance Investment banking often employs at least three parties in the transaction. The first party is the borrower, the second party is the group of lenders, and finally, the investment bank is an arranger between them. Apart from the multiplicity of groups involved in the transaction, often the structure is complex due to various underwriting provisions as well as the use of derivatives or securitization concepts by lenders to reduce their risk. The transactions often become cumbersome to manage for the parties involved and result in high administrative costs.

Since the financial position of the borrower is distressed, the lender may also have to employ additional measures to monitor the financial condition of the lender on a regular basis.

Leveraged Finance is costly

Leveraged finance is costly from the point of view of the borrower as the credit spreads are quite large compared to normal loan or financing transactions that could have been undertaken. Execution of costly transactions often places pressure on the company to earn profits as well as repay the loans on a timely basis to alleviate the pressure of the high debt on the company.

Leveraged finance may also turn out to be a costly affair for the lender as they may have to incur additional administrative costs as well as monitoring costs towards the performance and financial condition of the borrower. While the lender earns a higher rate of interest, the lender must calculate whether such a higher rate of interest offsets the higher risk that is being undertaken in the situation.

Conclusion

As mentioned earlier, leveraged finance investment banking has been rising after an initial stagnation after the 2008 financial crisis. Whereas the ongoing pandemic has placed leveraged finance on the pedestal again, leveraged finance is expected to continue finding its supporters amongst a large group of corporate borrowers. Leveraged finance investment banking not only allows the borrowers to avail financial assistance in the face of economic hardship but could also benefit both the lenders as well as investment bankers. 

In recent times, firms such as Acuity Knowledge partners often assist investment banks and lenders in underwriting leveraged finance transactions as well as offering advanced analytics to monitor the financials of the company. Such AI technology can provide an advanced monitoring and alert system to financial institutions regarding the financial health of the underlying company.