Author: Gus Wilkinson

About Gus Wilkinson

Undergraduate at the University of Leeds studying Banking and Finance

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Leveraged Finance and the Pandemic

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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. [1] This article explores the world of LevFin and the virus’ impact on investors, financial intermediaries and advisors.

The Basics 

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.

COVID-19’s Impact

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. [2] 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. [3] 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. [4]

Figure 1: Reuters.com [5]

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. [6]

The Revival

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. [7]

Other positive news includes the LBO of Spanish telecom operator MasMovil in a deal worth €5billion. [8] 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. [9] 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.

Conclusion 

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.

Glossary

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. [9]

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. [10]

4A hurdle rate is the minimum rate of return required by a manager for them to undertake the investment. This is pre-determined. [11]

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. [12]

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. [13]

7‘Fallen angel’ bonds are bonds that have lost their investment-grade status and so potentially look less attractive to investors. [14]

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A phase-by-phase analysis of an M&A deal

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Listen to the article here below, narrated by Yunus Skeete:

Mergers and Acquisitions (M&A) is a general term used to describe the process of combining two companies into one. News in the financial world is often littered with rumours of one firm’s hostile attempts to acquire another, or huge conglomerates looking to expand their market share through merging with other firms. In this way, M&A is fundamental to the financial world and the workings of the economy. But why would a company want to merge with or acquire another? And how does it take place? This article explores the timeline of an M&A deal whilst contextualising case studies along the way, pointing out reasons for potential success and failure.  

Phase 1: Acquisition Strategy and Criteria

An investment bank is usually brought in by a company who wishes to investigate the possibility of merging with or acquiring another firm. M&A deals start with a set goal or target in mind. This can vary but ultimately it comes down to what the acquirer desires from the deal. There is a huge array of reasons as to why a firm may want a transaction to take place, and these can be generalised into two categories: financial or strategic. Financial reasons encompass reasons related to the return that can be achieved as a result of the deal (i.e. the money that can be made or the financial health improvements that can be made), while strategic reasons place more of an emphasis on benefits from dual-company synergies. 
Once a strategy is established, it is then time to detail the criteria that the acquirer is looking for. The criteria are a description of what the acquirer wants from the deal. The list could be endless, but common examples include companies looking to access a certain consumer base, reach a certain profit level, achieve market penetration or acquire a certain product line to name but a few. 

In 2019, the proposed merger of UK supermarkets Sainsbury’s and Asda was founded on the basis that the deal would lower costs for both firms. This is an example of a financial reason as through achieving lower costs, the firms are able to reach higher profit levels and more economic success. This benefit was estimated to amount to around £500m worth of capital improvements, brought about through synergies from the deal [1].

Phase 2: Planning

Once a strategy and criteria are found, the acquirer will screen for targets that could roughly meet the standards desired. It is integral here that the acquirer thoroughly assesses potential strengths and weaknesses in prospective targets.

It is also important here to consider any regulatory consequences of the transaction and how this could impact the deal in terms of length and cost. Arguably this was not sufficiently considered in the case of Sainsbury’s and Asda, whereby the Competition and Markets Authority (CMA) blocked the deal on the proposed grounds that it would form a monopoly in the UK supermarkets market and thus could potentially put customers at risk of higher prices and reductions in quality [2].
At this point, if the targets found are deemed a potential acquisition, contact will be made with these firms to see their openness to a deal as well as to obtain more information about them (e.g. financial data). If one target is then chosen for the acquisition, a letter of intent (LOI) will be sent to the target, notifying them of the proposed merger/acquisition.
   

Phase 3: Valuation

With the information gathered from the ‘Planning’ phase, various financial models and valuation techniques are used to estimate a figure for the deal. 

One such valuation technique is Comparable Analysis, which involves comparing the current value and financial data of the proposed acquisition company to other similar firms. This can be done using various metrics. For example, analysts may look at data points such as enterprise value (a calculated statistic encompassing a range of financial data including debt, interest, share price and cash) or earnings per share (a calculation of profit divided by the number of outstanding shares) to compare the target acquisition to.
Precedent Transaction Analysis (PTA) is another technique that may also be used. This involves looking at similar deals that have occurred previously to create an estimate of what this acquisition could cost. 

Another popular valuation technique is use of the Discounted Cash Flow (DCF) model. Analysts use financial modelling techniques to discount future estimated cash flows and values, which is then used to calculate a present enterprise value, thus giving an estimate of the company’s worth. This technique is often favoured as it is more open to scenario analysis (taking into account economic conditions) and is more accurate than valuing M&A cases using adaptive expectations (which is determining current and future values based on historical data).

The outcome of all this analysis, which can take between six months and a year, will be a figure with which the acquirer can approach the target with. The accuracy of this outcome is greatly important; fine margins can be the difference between a good deal, a bad deal and failed negotiations.

Phase 4: Negotiations and Due Diligence

Now that the valuation analysis is complete and an estimate has been made, the acquirer approaches the target company and begins negotiations following the LOI sent in Phase 2. This is where the finer details of the deal are considered, and the months of analysis and model-building are utilised to their full extent to agree on a final valuation figure.
Once this figure is agreed on, due diligence takes place. Due diligence is the process of authentication and investigation of the potential deal in order to confirm financial information and verify the accuracy of everything found in the valuation stage. This includes getting sales figures, an entire financial background of the company as well as the target company’s intellectual property level within the firm (copyrights, patents, etc.).  Deals that undergo a high level of due diligence often have a higher level of success as decisions of higher quality can be made. Additionally, there are instances where the due diligence process enables the acquirer to re-open negotiations with the target company as they may have a more precise valuation figure.

Phase 5: Execution of the Deal

Finally, when negotiations are sorted and issues from the due diligence report have been corrected, the deal itself can begin to take place. The two companies discuss how the company is going to be acquired. The acquirer has the option of either a stock purchase (buying the target’s shares) or an asset purchase (purchasing the target’s assets – this is usually favoured and includes physical capital, intellectual property, etc.). Upon this decision being made, the two parties discuss the financing of the deal and begin communicating about the integration plan. As can be imagined, integration issues such as a lack of technological consistency between the two firms’ systems or differences in working culture may arise from the merging of two companies, so these must be considered and dealt with by the acquirer. Once the negotiations are closed and final meetings are held, the deal is done. 

M&A enables businesses to grow quickly and achieve great economic success, but it is imperative that firms to focus upon thoroughness and accuracy throughout a deal, as ultimately, this is at the heart of determining overall success.