Legal Lingo - What is leveraged finance?

Being an aspiring commercial lawyer often means being confronted by complex, often abstract, concepts leading to an often impenetrable wall of jargon for students and trainees. Next up in our Legal Lingo series, which we've introduced to help break down this jargon, is an explanation of what leveraged finance is.

A leveraged finance transaction involves borrowing money from a lender (such as a bank or a credit fund).  From a borrower’s perspective, a leveraged finance transaction will often be used for a specified purpose including, but not limited to, the acquisition of a public or private company through a leveraged buyout ("LBO") to pay the purchase price for the acquisition under the LBO, refinance any existing debt on the balance sheet, and any fees, costs and expenses that were incurred by the buyer in relation to the acquisition. 

A private equity firm (a “financial sponsor”) will typically back the purchaser and use debt to finance a significant proportion of the acquisition purchase price and will then take ownership of the target company. The target company’s assets will commonly be used as collateral for the debt used in the LBO transaction. An LBO is structured as to carry a high amount of debt and risk with a likely ratio of 90% debt to 10% equity. 

On the lender-side, a leveraged finance transaction is assumed to carry a higher-than-average risk (i.e., the risk of default) and will carry a higher margin (e.g., the interest to the lender above the cost of the funds) to the borrower. 

In leveraged transactions, the lenders may require certain financial covenants to be included in the loan documentation together with other general covenants which regulate the behaviour of the borrower and its subsidiaries.  

Over the past ten years, the market for leveraged transactions has been particularly busy and, accordingly, the terms that borrowers can benefit from under their transactions have, in the case of strong financial sponsor-backed borrowers, become more flexible. 

An example of this flexibility is through the so-called “cov-lite” loans. These cov-lite loans have features similar to high-yield bonds and, as a key feature, have no financial maintenance covenants.  They are also coupled with the “incurrence style” general covenants which are written in a “US style” as opposed to the more traditional “English style” under the LMA. 

Traditional “LMA style” leveraged loans have greater protections for lenders, including restrictions on the incurrence of debt, mandatory prepayments by the borrowers from asset sales, excess cash flow and other occurrences, and a wider pool of guarantees and security (e.g., charges over shares and mortgages over real assets) from the loan parties together with a more restrictive covenant package.

Want to find out more about leveraged finance? If so, here are links to three excellent articles on the subject: 

• Financial Times: The increasing complexity of modern leverage raises risks 
• Fidelity International: Chart Room: After a record-breaking year, where next for leveraged finance
• S&P Global: Navigating the Evolving Landscape of Leveraged Finance 

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