Using debt to increase equity returns
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What is Leveraged Finance?
Leveraged financeis the use of an above-normal amount of debt, as opposed to equity or cash, to finance the purchase of investment assets. Leveraged finance is done with the goal of increasing an investment’s potential returns, assuming the investment increases in value.
Private equity firms and leveraged buyout firms will employ as much leverage as possible to enhancetheir investment’s internal rate of return or IRR.
The Effects of Leverage
The effectivecost of debt is lower than equity (since debt holders are always paid out before equity holders; hence, it’s lower risk).
Leverage, however, will increase the volatility of a company’s earnings and cash flow, as well as the risk of lending to or owning said company. These risks will include factors such as (but not limited to) changes in the company’s liquidity, the stability of its industry, and shifts in the economy, such as interest rates.
Analysts need to understand a company’s use of leverage to assess its risk and return characteristics. Understanding leverage can also help in forecasting cash flows, allowing the selection of an appropriate discount rate for finding a firm’s present value.
Example of How Leveraged Finance Increases Returns
Here is a simple example of exactly how leveraged finance increases equity returns.
In the illustration below we show three examples:
- No Leverage – 100% equity-financed
- Moderate Leverage – 70% equity-financed (30% debt)
- High Leverage – 40% equity-financed (60% debt)
Notice how the internal rate of return to equity investors goes up over time as more leverage is added. We made the assumption that all debt is amortized into equal payments over 5 years.
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What is Leveraged Finance at a Financial Institution?
Within an investment bank, a division in charge of leveraged finance is responsible for services related to a client’s leveraged buyouts. These services typically include structuring, managing, and advising on debt financing for acquisitions.
For example, if a private equity firm is exploring various financing options in its efforts to acquire another company, the leveraged finance division would present different types of debt the client firm might raise (bank debt, high-yield debt, syndicated loans, etc.). It would subsequently help the client firm determine the best option based on their capital structure and operations.
Once the firm has raised the debt, the leveraged finance department markets the offering(s) to debt investors, helping the firm raise the capital needed for their acquisition.
To learn more, explore CFI’sInteractive Career Map.
What Leveraged Finance Analysts Do
The job of a leveraged finance analyst is largely divided between analyzing credit and risk, structuring debt, and communicating with clients. Analysts are responsible for examining the credit profile of their clients and debt investors, analyzing the potential returns to their sponsors, as well as utilizing Excel models to determine the optimal capital structure, based on their client’s financial projections.
Career Outlook
There are many areas of expertise employed within leveraged finance divisions, namely deal originating, capital market research, asset/portfolio management, and the sales and trading of debt instruments. As leveraged finance divisions typically deal with less-established firms, this offers a variety of opportunities to connect and collaborate with private equity firms, which can be attractive to people who have interests and ambitions in private equity.
Additional Resources
We hope this is been a helpful guide to leveraged finance and how leverage increases equity returns (and increases the corresponding risk). To keep learning, explore these relevant CFI resources below:
FAQs
“Why Leveraged Finance?” Interview Question
You want a window into many different industries, how they run, and how their debt and assets balance. You love to learn. LevFin gives you high exposure to some of the most complex corporate finance topics.
Does leveraged finance pay well? ›
Leveraged Finance Analyst Salary. $70,000 is the 25th percentile. Salaries below this are outliers. $116,500 is the 90th percentile.
Is leveraged finance risky? ›
Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment.
Is financial leverage good or bad? ›
Key Takeaways. The use of debt, also known as leverage, can be a positive indicator of a company's health when future benefits are expected to compensate for the current debt. The problem is when debt becomes excessive and harms the funds needed to properly run a business.
What is the best answer to why finance in an interview? ›
Here's an example of how to highlight your educational background in your answer:"I chose to study finance because I realized I was passionate about investing and excellent at investment strategies. I took capital markets, financial accounting, corporate finance, financial modelling, and portfolio management courses.
How to crack a finance interview? ›
Six expert tips for your next finance interview
- Get to the point. ...
- Know your finances. ...
- Make yourself the added value. ...
- Talk confidently about the industry. ...
- Engage with the interviewer. ...
- Keep learning.
Complex. The financial instruments involved, such as subordinated mezzanine debt, are more complex. This complexity calls for additional management time and involves various risks.
What skills do you need for leveraged finance? ›
Having a solid understanding of corporate finance, mergers and acquisitions (M&A), debt capital markets, and industry-specific knowledge can be advantageous for a leveraged finance specialist. Continuous learning and staying updated on market trends and regulatory changes are also important in this dynamic field.
What is the difference between FSG and LevFin? ›
There is some overlap with the Financial Sponsors Group (FSG) because both teams work with private equity firms. Financial Sponsors may focus on maintaining relationships with private equity firms, while Leveraged Finance might do more of the credit/LBO analysis for deals.
What are the benefits of leveraged finance? ›
By leveraging their capital, investors are able to increase their potential returns and magnify their potential profits. This may happen exactly at a time when there is little market liquidity, i.e. a paucity of buyers, and sales by others are depressing prices.
However, leverage can also pose some risks and other financial disadvantages, including: Increased financial risk resulting from the cash flow that will be required to service the debt. This additional pressure on cash flow can lead to an increased risk of insolvency and bankruptcy during a downturn.
How do the rich use debt to get richer? ›
The practice, known as debt recycling, involves paying down the non-tax-deductible home loan debt on your principal place of residence, either in full or substantially, and then borrowing against it at home loan interest rates to buy investment assets, such as a property or shares, thereby turning non-tax-deductible ...
Do you need leverage to get rich? ›
Nobody gets rich without leverage. If you aren't employing leverage in your business and wealth plans, it means you're compromising the speed, time, and work effort necessary to reach each level of success.
What are the pros and cons of leverage? ›
While leverage can enhance gains when the market moves in favour, it also escalates losses if the market moves against the position. It's important to note that leveraging magnifies risk and isn't suitable for all investors. Sudden market fluctuations can lead to significant losses.
How much financial leverage is enough? ›
A financial leverage ratio of less than 1 is usually considered good by industry standards. A leverage ratio higher than 1 can cause a company to be considered a risky investment by lenders and potential investors, while a financial leverage ratio higher than 2 is cause for concern.
Why did you want to work in finance? ›
I'm drawn to finance because it provides a comprehensive understanding of an organization's financial health, risk management, and investment decisions. By pursuing a career in finance, I can strengthen my ability to analyze financial data, provide strategic insights, and guide organizations towards sustainable growth.
Why should we hire you finance answers? ›
I pursued an MBA in finance which has equipped me with technical knowledge and a strong foundation to qualify for this job. I understand the industry trends, and I believe I have the right acumen for this job. I'm keen to use my knowledge and gain some more.
Why did you choose investment banking? ›
Specifically, investment banking interests me because it offers the opportunity to develop substantive analytical skills, while developing a close network of colleagues. While working long hours is scary to some, to me, it is in a strange way exciting.
Why do you want to work in banking? ›
Sample Answer:
The banking industry is lucrative and plays an important role in our economy. It offers challenging roles and opportunities to develop skills and knowledge. The dynamic nature of the industry and its relevance in the economic scenario is why I want to pursue a career in the banking sector.
