Leveraged Finance Explained: Strategies & Applications

Leveraged finance is 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 buyoutLeveraged Buyout (LBO)A leveraged buyout (LBO) is a transaction where a business is acquired using debt as the main source of consideration. firms will employ as much leverage as possible to enhance their investment’s internal rate of return or IRRInternal Rate of Return (IRR)The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment..

The Effects of Leverage

The effective cost of debtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis. 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 flowCash FlowCash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period. There are many types of CF, 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:

1. No Leverage – 100% equity-financed
2. Moderate Leverage – 70% equity-financed (30% debt)
3. 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.

To learn more, and how to build a model like this, check out our financial modeling courses!

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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’s Interactive 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:

• Leverage RatiosLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. Excel template
• Leveraged Buyout (LBO)LBO Buy-SideThis article is specifically about LBOs on the buy-side of corporate finance. In a leveraged buyout (LBO), a private equity firm uses as much leverage as possible to acquire a business and maximize the internal rate of return (IRR) to equity investors. LBO buy-side entities include private equity firms, life insurance companies, hedge funds, pension funds and unit trusts.
• LBO modelLBO ModelAn LBO model is built in Excel to evaluate a leveraged buyout (LBO) transaction, the acquisition of a company funded using a significant amount of debt.
• Private Equity CareersPrivate Equity Career ProfilePrivate equity analysts & associates perform similar work as in investment banking. The job includes financial modeling, valuation, long hours & high pay. Private equity (PE) is a common career progression for investment bankers (IB).  Analysts in IB often dream of “graduating” to the buy side,