What it's all about
Leveraged finance involves using borrowed money, in an amount greater than would be typical for a normal corporate loan in a particular sector, as part of a strategy to increase the returns on an investment made.
On our deals we're usually lending money to private equity firms who buy companies (known as targets), aiming to grow their value, typically over a two to five year ownership period, and then sell them for a profit.
Leveraged finance enables private equity firms to significantly increase their returns on such investments. To give a simple example, if a private equity firm were to buy a company for ï¿½100 million using only their own money and later sell it for ï¿½200 million, they'd make ï¿½100 million profit on a ï¿½100 million investment - a 100 per cent return. But if they were to put in ï¿½50 million of their own money and borrow the other ï¿½50 million from us, after repaying us they'd still have ï¿½100 million from an investment of only ï¿½50 million - a 200 per cent return.
How it brings in revenue
As an investment bank, fees are our principal source of profit. On leveraged finance deals we're taking on greater risk - we lend more money in relation to the size of the company whose cashflows are going to repay us (the target) than we would on a standard loan - so we need to do a lot of research and analysis before we make that loan. Therefore we can charge a higher percentage of the borrowed amount as a fee.
As well as the fee we make for lending directly we also get fee revenue when we sell on portions of the debt to other parties once the loan has been made - a process called "syndication."ï¿½ New lenders get a proportion of the fees the borrower originally paid us but, because we've done all the initial work, they accept a lower percentage than the one we took, and we retain the remainder.
We also make money from the interest we charge on the loans that we make. As with fees, we can charge higher interest rates for leveraged finance loans than for normal corporate loans because of the greater amount of work and risk involved.
How it works
When we hear that a business is going to be sold, we speak to our private equity clients and ask them if they're interested. If any of them say yes, we'll investigate the transaction with them. We read the information memorandum distributed to prospective bidders (a 50-70 page document on the target's history, market position, products, operations, finances, legal framework, and structure), do additional research, and prepare transaction models.
At the end of this process, we decide if we're prepared to lend and, if so, how much. We mainly base our decision on what we think about the target. We're looking for businesses that are going to grow quickly, but in a sustainable way - for example, a hi-tech business might be doing well in a particular niche at the moment, but may suffer if someone brings out a better gizmo. We also look for businesses that won't need to spend all of the cash that they generate, because we want our loans to be paid back quickly and easily. We're also interested in the particular skills of the private equity buyer, for example, whether or not they've got a strong track record in working with businesses in the industry involved, and what proportion of the purchase price they're prepared to contribute themselves.
Non-binding bids are normally due from our client and other interested parties about three weeks after receipt of the information memorandum. The seller then whittles these down to a shortlist of three to five. Next come meetings with the target's management, and access to more information about the target. We go through the additional information with our client, usually for a further four to six weeks. At the end of that period, we go to our credit committee for approval of a formal offer of financing to our client. The client, with this offer, then makes a binding bid for the target. Finally, a winning bidder is selected, and the financing is legally documented and finalised, often in a very short period of time.
The process takes place in a very competitive landscape. There's always a number of bidders circling the target, and a number of banks circling each bidder. We talk to as many bidders as we can initially. Sometimes we choose just one to work with because we think they're best placed to get the deal. Or we may assist two or three bidders, and will then set up clearly segregated teams to work with each one.
We start syndicating the deal soon after we've committed to the transaction to free up funds to make other loans and to ensure we're not excessively exposed to any risks involved. We usually agree a list of potential new lenders with our client, who could include banks who don't want to play a role in the initial stages, investment funds, and those creating structured financial products from combinations of loans. This process normally takes about a month.
Issues that can come up include problematic new information surfacing, such as product problems, or previously hidden company liabilities. Market movements can adversely affect the prospects of the company and the chances of syndicating the debt. Legal and tax hurdles can also arise.
One of our recent larger transactions involved a target company that provides office vending services - for example, for chocolate bars or coffees. The business is very well suited to leveraged finance because its future cash flows are predictable and robust. Vending sales are always going to remain solid as we expect there will continue to be a demand for products from the company's machines. In addition, the company enters into contracts with their customers for three to five years, so has guaranteed revenues once these contracts are in place.
The transaction was particularly interesting because the owner of the business had agreed to sell the business privately. So we didn't go through the normal process and instead worked with the buyer and a small number of other banks to get the transaction financed on a completely confidential basis. It was great to be trusted so significantly, and then announce the deal to a surprised market!
There is a significant pool of existing deals that were done in 2006 and 2007 under which repayment is due between 2012 and 2015. Not all of the loans are likely to be repaid by resales of the targets involved, particularly in the current challenging economic environment, so a significant number of them are going to need to be refinanced. Many of the funds that are presently lenders in these transactions are, however, unable to extend their commitments so new sources of debt will need to be found to enable such refinancings. The high yield bond market is one potential source; this market has been very active in 2012 and is expected to continue to be strong, although it is susceptible to periods of closure driven by macroeconomic factors. Whether or not the high yield market is the answer, one thing can however be relied on: the leveraged finance market is a very positive, dynamic and creative environment that has the ability to confront and manage challenges.