The growing need for capital and finance in the world of business has provided tailwinds to leveraged lending. Leveraged lending includes providing lending to corporates or companies that already have a high level of debt.
The urge to stay ahead of the competition can fuel higher expenses, such as increased spending in research and development, marketing, and sales. To ensure that these activities don’t slow down, several companies resort to a high leverage level to fund their business. However, this cannot be met through regular financing. The higher level of debt means that banks and financial institutions are often reluctant to issue additional debt to these companies.
Leveraged lending or loans are below investment grade investments for investors, but they provide higher yield, are secured against the companies’ assets, and carry a floating interest rate. Leveraged loans allow investors to gain a higher interest rate in a low-interest-rate environment in the market.
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What parties constitute the leveraged lending market?
The leveraged lending market typically consists of three parties. The first party is the company that needs a loan. Many companies, including those involved in infrastructure development, high levels of R&D, or projects with a long gestation period, procure these loans. These companies might provide a stable cash flow once their project starts but initially might be cash strapped. Companies would prefer leveraged lending as it provides them with significant flexibility and allows them to borrow a higher amount compared to normal business loans. Even though the yields may be higher, a stable future cash flow or the company’s assets enable them to secure these loans.
The second party or important force in the lending market is the investor willing to invest in leveraged loans. These investors are willing to take a higher amount of risk to secure a higher yield. Leveraged loans are more prevalent in the European and American markets, wherein the traditional yields are meager, and investors are attracted to a riskier but secure mode of gaining higher yields.
The third and final party of this deal is the financial institution or the consortium of financial institutions that offer loans to companies seeking to borrow. They help in originating and executing the deal between the lender, the investor, and the company.
It could involve bringing together different lenders underwriting credit risks and monitoring these deals either on behalf of investors or the lending financial institutions. Leveraged lending has been a preferred mode of raising finance for many companies where financials might be deteriorating, but they possess good projects to execute.
Leveraged Lending and COVID-19
The leveraged loan or leveraged lending market has been estimated to be somewhere between USD 3.2 trillion to USD 5 trillion. North America, including the United States of America, leads all other regions in terms of the outstanding in terms of leveraged loans. However, the leveraged loans market has been hit high by the onset of COVID-19. As per S&P global, 25% of the total leveraged loan market has been termed a weak link as of July 2020. Although these figures are expected to improve once businesses resume and normalcy is restored, the leveraged loan market might undergo a structural change for a short period as investors mull about the risk associated.
However, many investors and lending institutions were supportive and reluctant to consider COVID-19 as a trigger event to declare such loans as default. It would provide many businesses ample time to restructure such loans or stabilize their business and regularly make payments to the investors.
The leveraged lending market is one that is of high risk and high returns for the investors. Black swan events such as the pandemic may lead to high losses for investors, whereas, in normal circumstances, they can generate higher than expected returns than the standard interest scenario in the market. The Leveraged Lending market requires various parties and forces to get together to execute a transaction. With the increasing use of debt in M&A transactions and a growing impetus to leveraged buyouts, leveraged lending may well make a comeback once the pandemic situation normalizes.