Leveraged finance investment banking refers to using above-normal debt amount, rather than cash or equity, to purchase an investment asset. Its primary goal is to increase potential returns from an investment as its value increases. Private equity firms employ the maximum leverage possible to boost their investment asset’s IRR (Internal Rate of Return). They typically borrow maximum leverage from different lenders and fund the remaining amount using their own equity. Let’s find out how leveraged finance is the perfect channel to private equity.
Reasons Why Private Equity Firms Use Leveraged Finance
The use of leveraged finance increases the expected returns for the private equity firm. By not investing their own money into the asset, PE firms aim at achieving a more substantial ROE (Return on Equity) and IRR (Internal Rate of Return). Since the firms receive compensation based on their returns, using leveraged finance is critical to boosting their targeted IRRs.
Which Asset is the Best Candidate for Leveraged Finance?
Generally speaking, assets that are stable, mature, predictable, and non-cyclical are the best candidates for leveraged finance investment banking. Given the substantial amount the PE firm will invest into the asset, it’s crucial to ensure that the cash flow is predictable with low expenditures and high margins. A steady cash flow enables a PE firm to repay its debt easily. In an ideal situation, the cash flow should go towards repaying the debt, and the balance should gradually decrease.
Effects of Leverage
Debt holders always receive the payment before the equity holders. Hence, a lower risk is involved, and the debt’s effective cost is lower than the equity. However, leverage increases the company’s cash flow and earnings volatility, enhancing the risk of owning the said asset. The significant risk factors include changes in an asset’s liquidity, industrial stability, economic shifts, and interest rates.
A PE firm must assess an asset’s return and risk characteristics and understand its use of leverage. Understanding the effects of leverage also helps forecast the cash flows, helping a PE firm select an appropriate discount according to the firm’s current value. As the firm adds more leverage, the equity investor’s IRR also increases.
Few Words of Caution
While leveraged finance enhances equity returns, it also increases the risk involved. By using multiple debt sources on an asset, the PE firm significantly increases the risk associated with the transaction. That is why PE firms typically choose stable companies for investment. During tight cash flow and a downturn in the company’s economy, servicing the debt may become challenging for the PE firm. At such times, they may restructure the debt ad wipe out all the returns to the sponsor.
Leverage finance investment banking is highly attractive to PE firms with ambitions and interests in private equity. Expert Leveraged finance analysts analyze risk and credit, structure debt, and communicate with clients to help PE investors make data-based decisions. They examine their clients’ credit profiles and analyze potential returns to determine an optimal PE structure based on the firm’s financial projections. Hiring these experts helps make sound decisions with maximum chances of returns.