Today’s leveraged loan market is an indispensable asset class and a vital part of global finance. As a strategic lending partner to companies in transition, Colbeck Capital Management is at the forefront of the phenomenon, devising creative solutions and bespoke credit structuring.
Despite its critical and ever-increasing role in the industry, the leveraged loan market is not always well understood.
History Of The LBOs
To better understand the emergence of the leveraged loan market, it makes sense to start with the leveraged buyout (LBO). In this type of deal, an investor—generally a private equity firm —purchases a company with a mix of equity and borrowed funds (not all that different from the way a homebuyer gets a 30-year mortgage with the bank providing the majority of upfront capital).
Previously known as a “bootstrap” acquisition (the company acquired is supposed to provide a stream of revenue, thus pulling itself up by the bootstraps), LBOs have been around at least since the 1940s, though they were rarely employed until the 1980s. Financier Michael Milken is largely credited with inventing the high-yield “junk bond,” which served as essential financing during the period. However, poorly constructed borrower terms, bad press, and risky ventures led to the crash of the high-yield bond market. The LBO market in the 90s was more evenly distributed, with the balance of equity to debt often coming close to 50/50, increasing from 30/70 —or more— of just a few years earlier.
It wasn’t until the age of the mega-buyout in the early aughts that the next LBO boom began in earnest. In a deviation from the past, private equity deals now saw large institutional investors, such as giant global banks, taking on the role of lenders. Powered by lower taxes and reduced regulation, things were roaring…until the global financial crisis of 2008.
For many outside the industry, the crash was their first introduction to the leveraged credit market, and it wasn’t a great optic, as huge, unsinkable institutions went under. The United States government approved a record $700 billion rescue package to shore up and streamline the nation’s financial system. It worked: with interest rates kept low, liquidity increased.
The U.S., still tender from the crash (and with pressure from Main Street), saw regulations reverse course from the liberalization seen in the past twenty years. In 2010, the Dodd-Frank bill set up rules forbidding banks from using their own money to speculate and requiring that CLO (Collateralized Loan Obligation) managers retain at least 5% of their funds. The market once again shifted. Investors began trading pieces of the loans themselves, with this market eventually evolving into its own mature asset class, providing even greater liquidity.
In the decade since 2008, the leveraged loan market has more than doubled. Before the COVID-19 pandemic upended nearly every facet of everything, the U.S. (the largest leveraged loan market) topped $1.2 trillion in 2019—the highest it’s ever been.
Generally, leveraged loans are loans where lenders consider the borrower at greater risk to default than investment-grade loans. In the majority of cases, the borrower has a large amount of debt on the books and a less-than-investment-grade credit rating (think lower than BBB- on the S&P rating scale).
The terms of these leveraged loans often come with higher interest rates and more restrictive covenants than investment-grade credits. These terms provide a bit of a cushion for the lender. And with more risk comes more potential reward, making the profit margin all the more enticing for the lenders.
There’s not a hard and fast set of rules for the loan. Some are based on a spread. Many involve a floating rate, often based on the London Interbank Offered Rate (LIBOR), and a spread over LIBOR (LIBOR is set to be phased out by year-end).
Arrangers—generally one or more commercial or investment banks (more investors mean the risk is spread around to the loaning institutions, should the borrower default)—round up investor cash for issuers who need capital. The issuer pays the arranger for, well, arranging the loans, and the fees can be anywhere from 1% to 5% of the total commitment.
After being arranged and structured, the loans are syndicated, and arrangers can sell their leveraged loans to all manner of players, including other banks, institutional investors, mutual and hedge funds. If interest in a loan is less than expected, arrangers may end up with more hold than they had in mind. In the past 25 years, arrangers have increasingly used “market-flex” language, where they can alter the pricing of the loan in coordination with the investor demand.
At any given time, these flexes serve as a good indication as to the state of the leveraged loan market. An abundance of issuer-friendly flexes suggests the market demand outpaces supply.