Leveraged Finance (LevFin) refers to the process of financing speculative-grade and somewhat riskier companies and investments, yielding higher potential returns. Worth more than $2 trillion in the US, the LevFin market has grown by 80% since the early 2010s, although the COVID-19 pandemic has brought significant instability to the markets.  This article explores the world of LevFin and the virus’ impact on investors, financial intermediaries and advisors.
LevFin enables companies, such as private equity firms, to raise large amounts of debt capital to finance large strategic corporate actions, such as Leveraged Buyouts (LBOs), debt refinancing1 and recapitalisations2. An LBO is where a private equity firm uses a combination of cash and debt to purchase a company. They then look to make the business more efficient and valuable to get the desired IRR3 above the hurdle rate4, before selling for a profit. Within an investment bank, the LevFin division works with corporations and private equity firms to provide advisory services and capital-raising to fund these acquisitions using speculative-grade debt (debt owned by a company that is deemed to be more likely to be unable to pay creditors). This is done through leveraged loans (loans with high interest rates backed with collateral5), high-yield or ‘junk’ bonds6. These transactions are often riskier and carry higher levels of credit and default risk, which in turn can be profitable for banks offering this service due to the high interest on the debt.
A Brief History
The history of LevFin is turbulent. Huge growth during the 1980s resulted from the emergence of the high-yield bond market as a way to finance riskier companies. However, during the 1990s, tighter regulation and a bond-market bubble collapse in 1989 meant a declining interest in this method of financing. Come the turn of the millennium, there was a rise in prominence of asset-backed securities and a greater availability of leveraged loans, causing LevFin to grow again. More recently, the COVID-19 outbreak in January 2020 has wreaked havoc in a world where debtors and creditors are at the mercy of prevailing market uncertainty.
The vast global downturn resulting from the COVID-19 pandemic has had a huge impact, with both debtors and creditors being majorly affected. The record expansion in the US economy since 2014 has been blown out of the water by a 4.8% contraction in the first quarter of 2020.  This, combined with April’s 12.6% fall in consumer spending, has meant revenues are at levels that were much lower than forecasts from the start of the year.  Consequently, without a sufficient level of cash flow to pay for the loan, companies that were perhaps looking at LevFin as a way to finance future operations have shied away from doing so.
Not only this, but the downturn in economic conditions has caused a dramatic wave of credit rating downgrades for many firms. In the past 3 months, downgrades have outnumbered upgrades 43 to 1, with more than one third of US leveraged loans now rated at a B-minus or lower. The implication is that now over a third of US companies with leveraged loans are at a greater risk of default than they were prior to the pandemic. The large influx of downgrades can be seen on Figure 1. This hampers the future prospects of securing loans, creating problems for many businesses who rely on the loan market for funding. 
However, it is not just the loanees of LevFin that have felt the brunt of the pandemic. Creditors have also suffered due to a lack of demand for their products. In an LBO transaction, the investment bank involved will usually agree to hold the debt for a period of time before selling it to investors in the form of junk bonds or leveraged loans. Though this happens in normal market conditions, the deterioration of the global economy and a lack of demand has meant banks have found themselves in a scenario where the only way they can sell this debt is at a large discount. In turn, this means the debt being sold by the banks has lost its profitability. There are numerous examples of this phenomenon. In early June, Bank of America, RBC and Barclays sold off $1 billion of loans at a reduced rate of 90.5cents to the dollar – a deep discount – whilst similar stories are coming to the surface including the likes of JP Morgan and Credit Suisse. 
Though LevFin is experiencing one of its hardest periods in recent history, it is not all doom and gloom. There does seem to be some light at the end of the tunnel.
First of all, in April, the European Central Bank (ECB) decided to accept ‘fallen angel’7 bonds in a bid to maintain market access to liquidity during the pandemic. This change in rules should hopefully advert a complete collapse in the debt markets and, being in place until September 2021, will last long enough to ensure the chances of collapse are as low as possible. 
Other positive news includes the LBO of Spanish telecom operator MasMovil in a deal worth €5billion.  This could signal a change in sentiment in the market where banks are beginning to look at LevFin as an attainable source of income. Consequently, the use of these services could be expected to rise.
Finally, the decline in European COVID-19 cases has improved customer confidence, with looser lockdown measures enabling greater retail spending.  This consumer spending should hopefully boost the revenues of firms, enabling repayments of debt, whilst also bringing some much-needed confidence to financial institutions in the industry.
The LevFin sector has been greatly impacted by the unforeseeable economic downturn that the COVID-19 pandemic has created. Huge falls in consumer and business confidence have left struggling loanees and cautious banks. Though this is true, it is crucial to realise that the LevFin industry (and the global economy as a whole) is slowly on the mend as the lost confidence gradually trickles back. In theory, this will enable financial institutions to feel secure enough to finance these deals again, but whether this happens is still uncertain. In the coming months, it will be interesting to see how the industry adapts to the changing market conditions.
1Debt refinancing refers to the replacement of an existing debt obligation with another agreement with new terms.
2Recapitalisations involve altering the financial structure of an organisation (Debt-Equity ratio) in order to gain greater financial stability. 
3IRR (internal rate of return) is a metric used to assess a project or investment’s profitability. It is calculated as a discount rate that makes the net present value of all future cash flows equal 0. 
4A hurdle rate is the minimum rate of return required by a manager for them to undertake the investment. This is pre-determined. 
5Collateral refers to an asset that the lender accepts as security for a loan. This can be seized if the debtor fails to repay the loan. 
6‘Junk’ bonds are high-yielding securities with a greater risk of default. They are typically issued by companies that need capital quickly and/or are struggling financially. 
7‘Fallen angel’ bonds are bonds that have lost their investment-grade status and so potentially look less attractive to investors. 
Undergraduate at the University of Leeds studying Banking and Finance