Demystifying Investment Banking: What is Leverage Finance? (Part 1)

Welcome back to The Deal Room, and we have a two-part mini-series on leveraged finance. And this is going to form part of our continuous kind of education around different areas and different roles in investment banking divisions, or IBD specifically. So it's going to be a two-part series. In this episode, we are going to explain, or I should rephrase that, Stephen is going to explain what is leveraged finance. We'll have a look at a primer on the credit rating agencies, and we'll talk about the state of the market and why a lot of people are talking about this specific area as of right now. And then, as always, what we try to do is tie this to an actual piece of news that's in play at the moment to bring it all to life. And then don't forget to subscribe to the channel if you have not already done so. Hit the bell icon if you can see it, and that means you'll get notified when the second episode the following week drops. And there we will look at the kind of things a leveraged finance analyst would do day to day, a primer on capital structures, a look at how it's slightly different from other areas like you might have heard of, like dealmaking or debt capital markets. And then of course, we will look at career advice to break into this area. So Stephen, as ever, thanks very much for your time. And yeah, let's kick it off and know a little bit more about leveraged finance.

Yeah, thank you very much, Ant. Leveraged finance, it's a really interesting area of the investment bank and one that we touch upon with some of the stories over the last few months, whether it's Elon Musk and the acquisition of Twitter and how he's trying, how the banks are trying to offload all of that debt, or whether it's that boom in private credit that we spoke about last week. So I thought it would be useful just to spend two short episodes on this product group that is less well known maybe than debt capital markets or equity capital markets, or indeed M&A. So what is leveraged finance? So leveraged finance is providing financing to non-investment-grade companies, non-investment grade as determined by the credit ratings given or issued by the three big credit ratings, S&P, Moody's, and Fitch. So these are companies that have got maybe a lot of debt on their balance sheets. Maybe they're relatively risky. Maybe they're not yet profitable. And one of the key metrics that we consider when we look at how highly levered a company is, and therefore whether it fits into leverage finance as a product team, is the debt-to-profit or debt-to-EBITDA, earnings before interest, tax, depreciation, and amortization ratio. And effectively, if you've got no debt on your balance sheet, well, you're debt to EBITDA is infinite, right? It's, well, it's nothing. Sorry. If your debt is 100 and your profit is 1, your debt to EBITDA is 100 times, and that's extremely highly levered. So we look at that threshold between about 3 and 3.5 times debt to EBITDA to determine whether something is highly levered. And therefore non-investment grade, and therefore the subject of these next two episodes, or whether it's more investment grade, more blue chip, the kind of thing that debt capital market, the kind of company that capital markets teams will deal with on a day-to-day basis. So this is a division really focused on those riskier, more indebted companies. So what are the types of companies that the leveraged finance team will deal with, where it's these risky companies and what do they want to do? Well, maybe they want to borrow money for a significant acquisition that will make them heavily indebted. Maybe they want to do a highly leveraged debt refinancing. So they've already got a lot of debt on their balance sheets and they just need to roll that over and refinance it. Maybe they want to do some major investments, some CAPEX. Maybe they are involved in a restructuring process. All of these are instances where companies are going to go to the leveraged finance team. There's also the private equity firms that go to leveraged finance teams and say, look, we're thinking of buying a company. What kind of debt can you give us? Can you provide us? Can you originate for us in order to make that deal look a little bit more appropriate from a debt and an equity perspective? So leverage finance team, it's a product team. You focus on these more risky companies and you basically originate two different types of debt instruments. The first is a leveraged loan, more of your traditional, what you would call a term loan, which again can be issued by banks, can be underwritten by banks, can actually be, uh, can actually be sold to investors. And then the second is high yield bond issuance, exactly the same as investment grade bond issuance that we see in the debt capital markets teams, but obviously it is some sub-investment grade. So it comes with a lot, a lot higher coupon and more highly levered high yield bond terms. So that's a little bit of an overview of what is Rich Finance.

Cool. I was just writing down a few questions. If I may, as you were explaining that. So first things first, like we did on the episode about FIG, and what I'll do is I'll put some notations in the episode show notes of some of the things like you mentioned, high yield, investment grade. I'll drop all of those so that people can just go immediately to it and see all of these words if they're unfamiliar with them. My questions are, so this type of area, would it be all banks are doing this? Is it only just big, the biggest financial institutions that are offering this, these products? So who would be typical names we're talking about?

Yeah, so this, this is the big banks that are doing, that are doing specifically leverage finance. And when I see big banks, I mean all of the bulge brackets and probably the second-tier banks as well. Now, specific dedicated leverage finance teams, Their goal, unlike syndicated debt teams, and I know it gets a little bit complicated, the goal of a leverage finance team is to help originate these loans, but then pass them on to investors, right? They don't want to hold this debt on the bank's balance sheet. So it's more of a capital markets type activity, and therefore it's more suitable for the bulge bracket investment banks. The smaller banks actually might want to buy a tranche of this debt that gets resold by the leverage finance team, but it's mainly the big two, and it's mainly the likes of Morgan Stanley and JP Morgan that you'll see on these big leverage finance originations.

And just a bit of context, because something that I really enjoyed when you were explaining, um, I think it was debt capital markets, was just how massive it is in terms of the transactions, but also the revenue it brings for a bank. Where would this fit within, like, how do the fees work and how much income does this kind of bring in for those bulge bracket banks?

Yeah, this is really interesting. So it sits somewhere in terms of fees per percentage fees, it sits somewhere in between get capital markets and M&A/ECM. The deals are harder to do. They're more interesting because you're often dealing with slightly idiosyncratic, complex companies that maybe have been performing badly for a while. So the fees are commensurate with the difficulty of getting a high-yield bond away in the secondary market. Getting a leveraged finance issuance out. And we'll talk next week about all of the different types of debt that you can provide, all of the different tranches and the complexity around capital structure. So yes, the fees are higher relative to debt capital markets, but the volume of issuance is lower. So overall, the overall fee take is probably higher in a debt capital markets team. Because there are more investment-grade companies and governments issuing more bonds. So that kind of flow fee is higher in debt capital markets and it's more event fee when it comes to leverage finance. But then again, leverage finance, my gosh, high-yield companies or leveraged companies need to refinance. So it's not like M&A where you can do M&A or you don't need to do M&A. You need to refinance your debt. And you've got the whole sponsor or private equity community that's got the best part of a trillion dollars of dry powder waiting to be invested in the form of a buyout, which often comes with a nice bit of leveraged finance attached to it. So, you know, this is, this is a growing sector and one that it's pretty interesting to be part of, or at least be adjacent to. When it comes to a career in finance.

So one thing you mentioned earlier was investment grade. So let's talk about credit rating agencies then. So if someone was new to them, they've probably heard of some of them, but how did that actually work? How do those ratings impact what we're talking about?

Yeah. So credit rating agencies, they're these weird, weird companies that have an an overweight power in the industry, but they're not necessarily, well, they're kind of not government entities, so they're independent companies. And if anyone's watched The Big Short, there is the ability potentially to pull the wool over the eyes of some of these credit ratings agencies for the benefit of making a lot of money.

So just to explain The movie, and what happened there was that the fact is, is that credit rating agencies need to rate these things in order to, for them to generate revenue. So they need business, they need business coming to them, they need banks working with them to get rated. And obviously, if you rated something very badly that tanks a deal, you're probably going to lose business to your other, what, your other competitors within the rating agency community.

Exactly. And there's only 3 ratings agencies, so there's a little bit of a kind of oligopoly there. They all look at each other's investment rate or credit rating methodologies, and they all end up coming out with roughly the same kind of tier of credit ratings. They all— the business model does feel a little bit, as you say, a little bit like a perverse incentive. I only get paid when I provide a credit rating, and wow, I'm going to get paid more if people like my credit ratings. It's a little bit more complicated and a little bit more regulated than that. Let's be honest. So 3 credit rating agencies, and this is so important for debt capital markets and it's so important for leveraged finance. So S&P, Standard Poor's, Moody's, and Fitch are the 3 main credit rating agencies. Think about that word, by the way, credit. Credit. We're talking about debt. They're not rating the equity. You know, you don't look at the rating agencies when you're thinking about buying the equity of a company because credit is all about lending and are you going to get your money back? Equity is all about upside, and we acknowledge that there is risk of losing all of your money there. So we're really specifically dialing in on debt. So credit ratings, investment-grade credit ratings. For S&P, anything above BBB. So you have, you go from AAA, which is the highest possible rating. I'll do a little quiz later to see if you know who might be AAA rated, all the way down to BBB within that investment grade, which means that they can get investment-grade bonds away in the market, which is great because loads of investors think pension funds, mutual funds, et cetera, only invest in investment-grade debt. Moody's, the highest is AAA, but with a capital A at the beginning, just to be nice and confusing. They go down to BAA. Underneath this kind of this line, this line that is very, very hard to traverse, is speculative grade. So anything below a BBB, i.e., a BB+ and below, all the way down to a D for S&P, and anything below a BA, BA+, all the way down to a D for Moody's, that is speculative, non-investment grade, high yield junk. That's again, like with a lot of things in finance, We have a lot of different words for the same thing, but it's all— this is the domain in which leverage finance teams play. So if you come to me with an Apple bond issuance, well, put it into the investment grade, put it into debt capital markets. You come to me with a speculative high yield, triple C rated company that's trying to get a bond away or a leveraged loan issuance. That really is the domain that we're talking about today. And actually, I'll tell you what, I'm going to give you a quiz. I'm going to give you a credit rating quiz. I'm going to, I'm going to make it relatively easy to start off with. I'm just going to say, I'm going to say name of a company, round one, going to say the name of a company and you're going to tell me whether you think it's investment grade or whether you think it's junk or high yield. Okay. Yeah, we'll start off with an easy one. Alphabet, investment grade or junk?

Investment grade.

Definitely investment grade. Do you know what it is on a, from an S&P perspective? Would you remember AAA is the highest?

AAA. AA.

So pretty, pretty good. The second highest. And again, you can have AA+, AA-, so there's a variation, but it's a, it's a solid AA.

Apple's AAA, isn't it?

So I think, I think it's down to AA+ now.

Okay.

And the reason why it might have gone from AAA to AA+ is when looking at these, when looking at a particular issuer, for example, Apple, the ratings agencies will look at 3 different areas. It will look at the country risk. It will look at the industry risk and it will look at the company risk. And the company risk is going to be split into qualitative things. Like for example, with Apple impending regulation and lawsuits across Asia and across Europe and quantitative metrics. For example, its leverage ratios, its debt to EBITDA, its profit margins, its debt to equity, its cash flow to debt, all of these different things it will look at and it will put it all into a big, into a big file and it will come out with a number.

Yeah, that's a really nice way to remember actually. So country, industry, and company in terms of the three key criteria.

Absolutely. Absolutely. So next one, Ford, Ford Motors.

I mean, you'd like to say, well, it's American. You know, historic household name. I think it's a trick question. So like you would lean into investment grade, which means it probably isn't.

Non-investment grade. It's a BB+ from an S&P perspective, really close to investment grade.

So how much, like when you are one threshold away from being junk to investment grade, how much of an impact would that make to Ford?

Massive. It would make a huge impact. It would affect the, it would affect demand for their issuances. It would affect the coupon. You're suddenly paying a much bigger premium. There are slightly different terms in the way that high yield leveraged loan goes out relative to an investment grade loan. So yeah, it's weird that it's only one different It's probably the biggest chasm to jump, easier to jump between A and AA than it would be between non-investment grade and investment grade.

So strategically, do you think that Ford would have a team with their task is to get it up and try to work with the credit rating agency to get back into that?

Definitely. Definitely. They will be working really, really hard. And it's a wonderful moment for a finance team within a company where they go from non-investment grade to investment grade. And that happens with, as you know, these tech companies grow from being very speculative to being a little bit more consistent, to being a little bit more blue chip. To that extent, next question, Netflix, investment grade or junk?

I'm going to go junk.

So if I had asked you that, I think 2 years ago you would be right, but it is now gone into the investment grade space. It's now a BBB+. from an S&P perspective. So that means again, Netflix is playing with the big boys. It's an investment-grade company. It gets access to these better terms and larger liquidity pools or pools of money. What about Tesla?

Junk.

Again, I, I, Was it May 20th or March 2023 that it got upgraded from, from non-investment grade to investment grade and everyone, everyone went a little bit crazy. Yeah.

There was going to be lots of portfolio inflow, wasn't it? Where people were going to be buying into. Yeah. Now you say it. I remember that.

Yeah. Yeah. So it's, it's, it's now BBB, but interesting enough. And just as a kind of nuance, uh, that's important to understand these credit rating agencies rate the issuer. So they'll rate Tesla as a company, but they'll also rate the instrument. So you can issue a debt instrument, so a leveraged finance debt instrument, a high yield bond or whatever it might be, that will receive a lower credit rating, maybe because the terms of that instrument are a little bit more risky. It's subordinated to another piece of debt within that company's profile. So actually a lot of Tesla's debt issuance is sub-investment grade. I'm not going to go too far into the details there, but it gets a little bit complicated. And this is a massive industry with a degree of complexity that you'll get your heads around if you work in this industry. What about countries? Let's, you know, countries issue debt, they have credit ratings. So let's start with the UK, an easy one.

Yeah. UK's got to be not AAA. Just not that good anymore. Probably were, yeah, in a bygone era. But so yeah, probably AA.

Yep.

AA.

So again, would be AAA if its debt to GDP was a lot lower, if its economic growth was higher, if its productivity was higher, et cetera. What about Brazil? Investment grade, non-investment grade?

Yeah. I guess this is between developed and emerging markets. So anything that falls out of developed world economies has got to be junk.

Double B into the junk zone. So you're absolutely right. Again, massive economy, but heavily indebted, a great deal of risk associated, political risk, et cetera. What about India?

Probably the same junk because you just said there, They probably need debt to grow. And also the political risk is, I'd say it's pretty significant.

Triple B minus, i.e., it's just investment grade, which surprised me a little bit. So again, fast growing economy, more political stability, I would say erring on the side of authoritarian and some really interesting economic growth stories there. So it's just eats its way into investment grade. Last question. Do you know any countries that are AAA?

Yeah, I was just thinking, I knew this was coming. I seem to think like Australia or somewhere like that was AAA.

Aussies are AAA. Absolutely. You're, you're absolutely right. AAA. A lot of the Scandi countries are AAA. Luxembourg, I think.

Surely Australia's at risk from China. They're so dependent on exportation of like gas to Korea and China for coal and things like that.

Yeah, there's debt. They'll definitely have that factored in, but I just don't think it's got a lot of debt. Yeah. And it has really, really solid pension provision. It's got a big export sector with regards to its natural resources. So it's pretty solid. Poor old UK. The EU is only AA as well. So we're in good European company.

Okay. So I know we had some other areas we wanted to touch on. So the next one being the general state of the market, because I know we, we nearly always do this when we talk about these topics. So what's the leveraged finance situation?

Yeah. So I started thinking about this little mini series when I read the article, countries can't issue debt fast enough with 88 deals in 72 hours. That was the one that really got me interested. And of those 88 bond deals, by the way, debt deals. There were 13 high-yield issuers pricing $11 billion worth of debt in, in 72 hours. And lots of different types of companies from lots of different places around the world. There's a tech company, Cloud Software Systems. There's a municipal bond. So the state of Illinois sold $1.8 billion worth of high-yield bonds. It's The market is booming. So the reason why risk premiums and debt worldwide remain tight, and there's a lot of, there's a lot of, there's a lot of good news coming out. There's a lot of conditions that would make the high yield bond market relatively attractive. So state of the market, reason why 2024 is going to be good. There's a wave of refinancing. Coming on, coming online in 2024. M&A activity is going to return with a vengeance. We've covered that quite a lot over the last few months. With M&A activity comes the need for leveraged debt, whether it's in the form of a private equity transaction or whether it's in the form of just a company taking on a lot of debt to buy another company. We're in a post-interest rate hiking era. We think, and actually the likes of Sweden have been the first movers as you well know, and have decreased their headline interest rates. So there's a lot of stability and a little bit more certainty and very tight spreads there. Economic growth outweighs recession. So a little bit more confidence and buoyancy in the market. And so there's a lot of things that are suggesting that leveraged finance is going to grow. Now we will talk about this maybe in the next episode, but it's come alongside what's called direct lending or private credit. So private credit, it's slightly different from leveraged finance in the sense that private credit is just the origination of debt between an investor, a KKR private credit team, and a company. So it's not syndicated. It doesn't have to go through a bank's leverage finance team. So there's a huge increase in this rival form of highly leveraged or leveraged finance. So remember leverage finance team offer high yield bonds and leveraged debt. And then there's this private credit thing that's really increasing the size of market and increasing competition, driving down coupons and things like that. So this is, this is why the market's interesting. This is why from a career perspective, it's really, really good to get a handle on this because this is where a lot of the innovation is as well. Okay.

And then to finish off, a recent deal and what can we learn from that deal?

Yeah, I had to pick from a lot of different options. I picked Air Baltic. I don't think many podcasts are going to be speaking about Air Baltic, but you never know, it might do. So this is a Latvian carrier airline, and it sold earlier on last week, it sold Europe's highest yielding bond this year. So it was a €340 million junk bond, a single B credit. So remember, double B+ is the highest junk bond rating or, or, or a speculative grade rating. B is relatively low. So this was a €340 million junk bond at a 14.5% coupon. That's pretty punchy right now. Obviously interest rates are relatively high at the moment, but anything with a, anything double digits is going to get people interested. And actually the order book when originating this issuance, this primary issuance, the order book was up at about €840 €1 million, suggesting there's real pent-up demand from the investor community for this type of coupon, for this 14.5% that you just haven't seen for quite some time. It's a speculative grade company. I was looking at its net debt to EBITDA. It's up at 7.5 times. It means it's debt 7 times as much as its profit, which really puts it in that single B category. But it got the deal away and it just reminds us of this relationship between risk and return. It's a risky company, but at 14.5% with appropriate checks and credit checks and covenants and things like that, it's probably worth it for that coupon.

Cool. All right. So again, just to recap, that's a good way to finish. That's what is leveraged finance and a little bit more details around how it all works. The next episode, just to remind you, we'll talk about what type of things does a leveraged finance analyst do all day? Because I know a lot of you would be thinking, okay, now I've got a bit of a handle on it. What does a normal typical day look like? Because that's definitely a good input into making your future career decision. And we'll also talk about some tips, some hacks, and all the good stuff about how to break into lev fin. So Stephen, thanks as always, and yeah, look forward to that conversation.

Thank you, Anthony Cheung.