What is Leveraged Finance? Definition, Structure and Key Players

Leveraged finance focuses on providing funding for companies with high levels of debt, in exchange for higher potential returns. While it offers tax benefits and the possibility of multiplying gains, it also comes with significant financial risks that require precise management to ensure long-term sustainability.

Leveraged finance is a strategy used to fund transactions such as acquisitions, recapitalizations or leveraged buyouts. This model is characterized by a high debt-to-equity ratio, which entails greater financial risk but also a higher potential return for investors.

Common borrowers include medium- and large-sized companies with leveraged capital structures, companies backed by private equity funds, and small businesses in sectors with high volatility but cash flow generation potential. 

The structure of leveraged finance

The design of financial leverage is usually complex and organized into different levels of debt, depending on their level of risk and payment priority: 

• Senior secured loans are the safest term of debt and, therefore, with the lowest cost. They are backed by company assets, which reduces risk for lenders. They tend to have shorter repayment periods and more restrictive covenants. 
• Senior unsecured loans occupy a lower seniority level, as they are not backed by specific assets. They entail a higher risk and, therefore, a higher cost for the borrower. 
• Subordinated debt, which is below senior debt in the capital structure. It has both debt and equity characteristics, as it can include stock conversion options. It offers a higher return to investors in exchange for higher risk. 
• High-Yield Bonds, also known as "junk bonds", are debt issues with a low credit rating due to the high risk of default. These offer a high return to compensate investors for the risk taken. Where appropriate, preferreds are also used. This is a hybrid instrument that combines debt and equity characteristics. Investors in preferreds receive fixed dividend payments before common shareholders, but after debt holders. 

The key players in the leveraged finance market 

The leveraged finance market involves a wide variety of participants. Private equity funds are usually the main drivers of this type of transactions, using debt to acquire companies. However, one of the key players are investment banks. As Jean Francois Guicheteau, Managing Director of Mid Market LBOS at BBVA, explains, "at BBVA CIB we play two crucial roles: Advising companies that seek financing (whether for acquisitions, recapitalizations, etc.), and underwriting and syndication of debt, i.e. we structure the financing, guarantee it and distribute it among a group of investors." 

Other prominent players are credit funds, which invest in different debt instruments, including senior loans, subordinated debt and high-yield bonds, or hedge funds, in view of finding investment opportunities with higher returns and assuming greater risks. Finally, credit rating agencies also play an important role: They assess the creditworthiness of the borrower and assign a rating to the debt issued, which influences the cost of financing. 

Higher profits, higher risk 

Financial leverage allows for multiplied gains for capital investors, as the return is calculated on a lower capital base. It also imposes financial discipline, since the obligation to meet debt payments requires greater financial discipline from the company. 

In addition, it offers tax benefits, as the interest paid on the debt is tax deductible, reducing the tax burden on the company. However, it is also important to take account of the financial risk involved. BBVA CIB offers the necessary support by structuring the debt optimally for the risk profile of each company, by negotiating less restrictive covenants and by optimizing financing costs through access to a wide range of investors. Additionally, the bank carries out an exhaustive due diligence process to identify risks and advise on post-acquisition financial management in order to obtain a perfect balance between leverage and financial sustainability. 

As the leveraged finance market is a very dynamic sector, it is affected by macroeconomic conditions, interest rates and regulation. In recent years, there has been an increase in regulation and a stronger focus on debt sustainability. Growing concerns about ESG are also influencing investment decisions in the market. Investors are increasingly interested in funding companies with strong ESG practices, which is driving demand for green loans and other forms of sustainable finance.