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What is a Leveraged Loan?

Last updated 03/15/2024 by

Jamela Adam

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Summary:
A leveraged loan is typically used by companies to finance their acquisition or expansion projects. These loans are often structured in a way that allows the borrowing company to gain access to more funds than they could through traditional lending sources. For this reason, leveraged loans can be an attractive financing option for businesses looking to grow. However, as with any other major financial decision, it’s important to understand the risks and benefits associated with these products before taking the next step.
For companies that are growing quickly, a leveraged loan can be an essential tool for financing their expansion. But, one downside of leveraged loans is that they often have higher interest rates than traditional loans. If the company isn’t able to make the payments, it could default on the loan and get into serious financial trouble.
If you’re unfamiliar with the leveraged loan market but would like to learn more, read on as we dive deep into what a leveraged loan is and how it works.

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What is a leveraged loan and how does it work?

In a nutshell, a leveraged loan is a type of syndicated loan that is typically extended to below investment grade companies that have high levels of debt. While financial institutions used to primarily keep track of their loans through a ledger, some institutions now form syndicates to jointly loan funds to a borrower. In addition to this lending, syndicates also sell loans to investors, including mutual funds, exchange-traded funds, insurance companies, and pension funds.
Though there isn’t a strict or universal definition for what constitutes a leveraged loan, in terms of default rate, lenders usually consider leveraged loans to have an above-average risk. In general, leveraged loans are secured by collateral, such as the borrower’s real estate property, or even intellectual property like trademarks and other confidential information. Moreover, they’re typically structured as floating-rate loans, which means that the interest rate on the loan will fluctuate based on changes in market rates.
IMPORTANT! According to S&P’s Leveraged Commentary & Data (LCD), a loan is considered to be leveraged if it’s rated BB+ or lower. However, the loan can also be considered leveraged if it’s not rated or rated BBB- or higher, but
  1. is secured by a first or second lien; or
  2. has a spread of LIBOR +125 or higher.

How are leveraged loans used?

Leveraged loans are often used to finance mergers and acquisitions, or to provide working capital for businesses or institutional investors with high levels of debt. In some cases, they may also be used to refinance debt.
Because a leveraged loan is often riskier for lenders, these loans have a higher interest rate than other types of loans. Despite the high borrowing cost, they can be a crucial source of financing for companies that are unable to obtain traditional financing.

Pros and cons of leveraged loans

Every type of financing comes with its pros and cons. Here are some advantages and drawbacks of using leveraged loans for your business.
WEIGH THE RISKS AND BENEFITS
Here is a list of the benefits and the drawbacks to consider.
Pros
  • Access to capital. Without sufficient capital, it can be quite difficult for businesses to grow and scale past a certain point. One of the main benefits of leveraged loans is that it provides the capital that a company needs to accomplish business goals. The extra leverage provided by the loan can help expand its operations by allocating funds for other investments. This way, the company can efficiently generate longer-lasting and greater returns.
  • Ideal for acquisitions and buyouts. Though leveraged loans can be used to finance companies’ operations, they’re especially powerful when it comes to acquisitions and buyouts. This is because they allow companies to make large transactions without committing a significant amount of their own capital. However, due to the high cost of borrowing, and the risk of becoming overextended, this kind of credit is best for short-term use.
Cons
  • Can become overextended if not careful. The excessive use of financial leverage can become a problem for borrowers that aren’t careful. When a company takes on too much debt and the business slows down, it could quickly fall into trouble. To avoid this situation, borrowers need to be careful about how much debt they take on and only borrow what they can realistically afford to repay.
  • A costly borrowing method. Because of the high probability of default, leveraged loan lenders typically charge high-interest rates to compensate for the increased credit risk. So, if you’re taking out a significant amount of money to finance your business, the cost of borrowing can quickly add up.
  • Less protection compared to traditional loans. Sometimes, leveraged loans can have fewer restrictions and offer less protection to the lender than traditional loan types. One of the best examples is a covenant-lite loan. These types of leveraged loans do not require borrowers to comply with any financial covenants. This makes them more borrower-friendly, yet at the same time riskier for lenders.

Examples of leveraged finance products

  • Collateralized loan obligations. A collateralized loan obligation (CLO) is a type of structured finance product that collateralizes a pool of loans and repackages them into different tranches that are sold to investors. CLOs are typically managed by an asset manager who is responsible for selecting the loans that go into the pool, as well as managing the pool on an ongoing basis.
  • Covenant-lite loans. Covenant-lite loans are a type of corporate loan that have fewer restrictions (or covenants) than traditional loans. Because covenant-lite loans offer more flexibility to borrowers, they have become increasingly popular in recent years. However, they also tend to be more expensive and riskier than traditional loans.
  • Mezzanine finance. Mezzanine financing is a type of junior debt that is typically used by businesses to finance the purchase of capital assets or to fund other significant expenditures. The debt sits above equity and is subordinate to senior debt, which means that it ranks below senior debts in terms of priority if the borrower defaults on its obligations.
  • High-yield bonds. High-yield bonds are corporate bonds that offer a higher yield than investment-grade bonds. They are also known as junk bonds. These bonds are usually issued by companies with lower credit ratings and are considered to be riskier than investment-grade bonds. While they can be a great way to earn a higher return on investment for investors, these bonds also have a greater chance of default.
If you’re looking for a more straightforward form of financing for your business, you may want to consider the below lenders for a business loan. You can filter your lender search by your credit score as well, so even if you have bad credit, you can find a loan for your financial situation.

SuperMoney may receive compensation from some or all of the companies featured, and the order of results are influenced by advertising bids, with exception for mortgage and home lending related products. Learn more

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FAQs

What is the difference between high-yield and leveraged loans?

High-yield bonds are also known as junk bonds. They are debt instruments that are considered to be high risk because they’re issued to companies with weak credit ratings. As a result, these bonds typically offer higher interest rates than other types of debt instruments.
Leveraged loans are another type of high-risk debt. These loans are made to companies or individuals that already have a significant amount of debt. The interest rate on a leveraged loan is usually floating, meaning that it can change over time. In contrast, the interest rate on a high-yield bond is fixed, meaning that it will remain the same for the life of the bond.
Another major difference between high-yield bonds and leveraged loans is that high-yield bonds are typically unsecured, whereas leveraged loans are secured. Leveraged loans are generally secured with first liens on the collateral. This means that in the event of a default, creditors have a better chance of recouping their investment through the sale of collateral.

Why are leveraged loans attractive?

Though interest rates on leveraged loans can often be quite high, there are a number of selling points that make leveraged loans attractive to borrowers.
For one, leveraged loans can be used to finance a wide variety of activities, including acquisitions, expansions, and refinancing. Also, leveraged loans can be structured as revolving lines of credit, which gives borrowers flexibility in how they use the funds.

Should I get a leveraged loan?

Leveraged loans are typically used by companies such as private equity firms to finance business activities. With that in mind, it’s probably not the best personal finance option. So, if you’re just hoping to get some cash for your home renovation, a leverage loan might not be the best fit for you.

Key Takeaways

  • Leveraged loans are usually extended to borrowers with a high level of existing debt, as well as a low credit rating.
  • Due to the greater risk of default, the interest rate on a leveraged loan is generally higher than the rate borrowers can get on other financing products.
  • Typically, leveraged loans are used by corporations and businesses for activities such as acquisitions, mergers, or leveraged buyouts.
  • Leveraged loans generally have floating interest rates that fluctuate throughout the life of the loan.

Get the right financing for your business

When you’re ready to take your business to the next level, it’s important to explore all of your financing options. A leveraged loan can be a viable choice for businesses that are expanding quickly but have a high level of debt and credit ratings. However, it also comes with relatively expensive borrowing costs. And if you’re not careful, your company could be in deep water.
Before taking the plunge to take out a loan, research your options, and consider the different types of business loans or even business lines of credit you could qualify for. This way, you can find the perfect financing option for your business needs.

SuperMoney may receive compensation from some or all of the companies featured, and the order of results are influenced by advertising bids, with exception for mortgage and home lending related products. Learn more

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