What is Leveraged Finance?

//What is Leveraged Finance?
What is Leveraged Finance? 2017-10-05T06:08:27+00:00

Definition: Leveraged finance, also referred to as LevFin, indicates a special division of investment banking, which seeks to provide advisory and loan services to private equity firms that engage in leveraged buyouts (LBOs).

What Does Leveraged Finance Mean?

What is the definition of leveraged finance? A key element of leveraged finance is the mezzanine debt. Like in the case of collateralized debt obligations (CDOs), which consist of various tranches of debt (senior, mezzanine and junior), leveraged finance is dealing with leveraged buyouts, in which mezzanine debt is extremely important.

Although mezzanine debt is riskier than senior debt in a structured product, investors and private equity firms prefer to take a higher risk and be rewarded with a higher, almost equity-like return, than investing in low yield bonds. In addition, small and medium companies that cannot capitalize on the opportunities of the bond market, use mezzanine debt, especially in the cases of mergers, acquisitions and/or leveraged buyouts.

Let’s look at an example.

Example

Lorenzo owns a small Italian restaurant in one of the oldest neighborhoods of Boston. He is very proud of his business as he has managed to survive the competition of larger restaurants and fine-dining in the area due to the high quality of service and the delicious foods he and his wife are cooking.

Recently, he was offered a deal from another Italian immigrant, Fabio, who offered him $500,000 to buy the business. Lorenzo’s restaurant realizes an operating income of $250,000 a year and he asks for, at least $800,000 before start considering the deal.

Fabio does not have $800,000, so he considers mezzanine debt to cover the $300,000. Eventually, he finds a lender who is willing to give him the $300,000 for the following capital structure:

  • The senior lender will lend Fabio $300,000 of mezzanine debt at an annual interest rate of 6.5%.
  • Fabio will contribute the equity portion of $500,000.

Once the deal is closed, Fabio calculates his return on investment. The business has an annual operating income of $250,000. The interest paid to the senior lender is $300,000 x 6.5% = $19,500. Hence, Fabio will earn $250,000 – $19,500 = $230,500. Assuming a tax rate of 35%, the net income is $230,500 x (1 – 65%) = $149,500.

Summary Definition

Define Leveraged Finance: Leveraged finance means using debt to fund operations or expansions.