Over the years, investment banks have explored new ways of offering funding to companies. While equity finance is widely used, debt financing is also on the rise. Most organisations prefer to raise capital with a mix of debt and equity. Investment banks often work closely with private equity firms and investors to raise debt capital for companies in distress.
Debt financing can allow companies to acquire significant capital for operations, large-scale projects, or debt restructuring. The leveraged finance department of investment banks is responsible for helping companies with debt financing. Investment banks also overcome several challenges to provide the best debt financing services. Let us explore the opportunities and challenges in leveraged finance.
Understanding the Concept of Leveraged Finance
Not every company will have a high credit rating. Some are speculative-grade companies with lower credit ratings. These companies are often associated with junk bonds and stocks. Investors can buy their bonds or stocks at lower rates and hope for capital appreciation. There are also highly-leveraged companies having a higher magnitude of debt compared to their assets or equity. These companies in distress need funding to get back on their feet.
Since they have a poor credit rating, most banks or investors might not be interested in offering funding. It is where Leveraged Finance or LevFin comes into the picture. LevFin is concerned with providing funding for speculative-grade, highly-leveraged, and junk-rated companies.
Companies in distress usually contact investment banks for LevFin. There is a higher magnitude of debt involved in LevFin. Companies can use the funding for multiple reasons, from expansion to debt consolidation. Most investment banks have a separate department for LevFin processes. Banks might also work with private equity firms to collect funds for LevFin.
Also, debt financing involves a large amount of capital compared to equity financing. Since the amount of capital is large, risks are also involved with LevFin. LevFin can take multiple forms, depending upon the need of companies or investors, such as:
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Investment banks help companies in distress secure leveraged loans. Since companies in distress have a higher credit risk, these loans come with high-interest rates.
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Companies with low credit ratings might issue junk or high-yield bonds. These are debt securities that offer high-interest rates to investors.
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Mezzanine financing is another form of LevFin containing a mix of debt and equity. Investors have the option of converting debt securities into equity in the future.
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LBOs or Leveraged Buyouts help companies acquire other companies by taking a debt.
Unitranche financing, second lien loans, and senior secured bonds are some other forms of LevFin.
Opportunities in Leveraged Finance
Now that we know what leveraged finance means let’s look at the opportunities in this field.
Opportunity for Turnaround
Companies in distress do not have to stop operations and quit. They can make a turnaround by securing capital via debt financing. Most companies run out of business because they cannot secure funding from traditional means. However, they can always try partnering with investment banks for debt financing.
Higher Returns
LevFin offers opportunities to investors as they can secure high returns. For example, investors can earn high-interest rates by offering leveraged loans or purchasing high-yield bonds. Similarly, there are opportunities for investment banks to help their clients secure high returns. Investment banks might also get commissions by helping companies with debt financing.
ESG Debt Financing Opportunities
Investment banks can indulge in ESG debt financing for better results. With ESG debt financing, lenders offer funds to companies based on some ESG conditions. When the ESG conditions are met, the company or borrower will pay a fewer interest rate. Investors also get to include ESG-centric assets in their portfolios, which is the new trend in today’s era.
Critical Challenges in LevFin
Let’s dig into some critical challenges in the leveraged finance space.
Analysing the Risk of Default
Investors trust banks to explore debt financing opportunities. However, the risk of default is higher in offering funds to companies in distress. Investors count on banks to determine companies that are free from the risk of default. It is where investment banks face challenges in analysing the creditworthiness of speculative-grade companies.
Complex Deals
Leveraged finance often involves complex paperwork and documentation. As a result, investment banks require experts for deal structuring. However, many investment banks have started partnering with third parties to reduce the manual burden on employees for deal structuring.
Regulatory Compliance
There are several regulations for LevFin in different jurisdictions. Both investors and investment banks are concerned with the changing regulations. To remove the regulatory compliance challenge, investment banks partner with third parties. A third party can focus on regulatory compliance, and the investment bank can focus on core competencies.
In a Nutshell
Leverage finance has become a priority for many speculative-grade companies. Companies with poor credit rating hope for a turnaround with the help of debt financing. Investment banks play a major role in helping companies secure debt financing. Investment banks offering LevFin services must be aware of the recent trends and challenges. Learn more about LevFin now!