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What is a Leveraged Loan?

what is a leveraged loan

A leveraged loan is a commercial loan provided by a group of lenders. It is first structured, arranged, and administered by one or several commercial or investment banks, known as arrangers. It is then sold (or syndicated ) to other banks or institutional investors. Leveraged loans can also be referred to as senior secured credits.

LCD’s Primer/Almanac details the main leveraged loan market mechanics and historical trends, and is aimed at those new to or interested in the leveraged loan asset class. We invite you to take a look.

A good place to start? This terrific video, featuring Paddy Hirsch .

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Defining "leveraged"

Just what qualifies as a leveraged loan is a discussion of long standing.

Some participants use a spread cut-off. For example, any loan with a spread of at least LIBOR+125, or maybe LIBOR+150, would qualify as “leveraged.”

Others use rating criteria: any loan rated BB+ or lower would qualify.

But what of loans that are not rated?

At LCD we have developed a more complex definition. We include a loan in the leveraged universe if:

it is rated BB+ or lower or

it is not rated or rated ‘BBB-‘ or higher but has

(1) a spread of LIBOR +125 or higher and

(2) is secured by a first or second lien

Under this definition, a loan rated BB+ that has a spread of LIBOR+75 would qualify as leveraged, but a nonrated loan with the same spread would not.

It is hardly a perfect definition, but one that LCD thinks best captures the spirit of loan market participants when they talk about “leveraged loans.”

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Market background

In the second quarter of 2015 the window for opportunistic executions reopened amid a more buoyant market tone. With repricings again in play and dividend financing more accessible, leveraged loan volume climbed to $135.1 billion, including $86.3 billion of institutional tranches, from $93.9 billion total/$56.2 billion institutional during the first three months of the year. That was still down 15% total/23% institutional, however, from the liquidity-soaked second quarter of 2014, when $159.5 billion/$112.8 billion of new loans cleared the market.

Starting with the large leveraged buyout (LBO) loans of the mid-1980s, the leveraged/syndicated loan market has become the dominant way for corporate borrowers (issuers) to tap banks and other institutional capital providers for loans. The reason is simple: Syndicated loans are less expensive and more efficient to administer than traditional bilateral – one company, one lender – credit lines.

Arrangers serve the time-honored investment-banking role of raising investor dollars for an issuer in need of capital. The issuer pays the arranger a fee for this service and, naturally, this fee increases with the complexity and riskiness of the loan.

As a result, the most profitable loans are those to leveraged borrowers – those whose credit ratings are speculative grade (traditionally double-B plus and lower), and who are paying spreads (premiums above LIBOR or another base rate) sufficient to attract the interest of nonbank term loan investors, (that spread typically will be LIBOR+200 or higher, though this threshold rises and falls, depending on market conditions).

By contrast, large, high-quality, investment-grade companies – those rated triple-B minus and higher – usually forego leveraged loans and pay little or no fee for a plain-vanilla loan, typically an unsecured revolving credit instrument that is used to provide support for short-term commercial paper borrowings or for working capital (as opposed to a fully drawn loan used to fund an acquisition of another company).

In many cases, moreover, these highly rated borrowers will effectively syndicate a loan themselves, using the arranger simply to craft documents and administer the process.

For a leveraged loan, the story is very different for the arranger. And by different we mean more lucrative.

A new leveraged loan can carry an arranger fee of 1% to 5% of the total loan commitment, depending on

  1. The complexity of the transaction
  2. How strong market conditions are at the time
  3. Whether the loan is underwritten

Merger and acquisition (M&A) and recapitalization loans will likely carry high fees, as will bankruptcy exit financings and restructuring deals. Seasoned leveraged issuers, in contrast, pay lower fees for re-financings and add-on transactions.

Because investment-grade loans are infrequently drawn down and, therefore, offer drastically lower yields, the ancillary business that banks hope to see is as important as the credit product in arranging such deals, especially because many acquisition-related financings for investment-grade companies are large, in relation to the pool of potential investors, which would consist solely of banks.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

How are Loans Syndicated?

Once the loan issuer (borrower) picks an arranging bank or banks and settles on a structure of the deal, the syndications process moves to the next phase. The “retail” market for a syndicated loan consists of banks and, in the case of leveraged transactions, finance companies and institutional investors such as mutual funds, structured finance vehicles and hedge funds (more on that in section 5).

Before formally offering a loan to these retail accounts, arrangers will often read the market by informally polling select investors to gauge appetite for the credit.

Based on these discussions, the arranger will launch the credit at a spread and fee it believes will “clear” the market.

Until 1998, this would have been all there is to it. Once the pricing was set, it was set, except in the most extreme cases. If the loan were undersubscribed – if investor interest in the loan was less than the amount arrangers were looking to syndicate – the arrangers could very well be left above their desired hold level.

As of 1998, however, the leveraged issuers, arrangers and investors adopted a “market flex” model, which figures heavily in how the sector operates today. Market Flex is detailed in the following section.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Market Flex

After the Russian debt crisis roiled the market in 1998, arrangers adopted “market-flex” language. Market flex allows arrangers to change the pricing of the loan based on investor demand—in some cases within a predetermined range—as well as shift amounts between various tranches of a loan, as a standard feature of loan commitment letters.

Market-flex language, in a single stroke, pushed the loan syndication process, at least in the leveraged arena, across the Rubicon to a full-fledged capital markets exercise.

Initially, arrangers invoked flex language to make loans more attractive to investors by hiking the spread or lowering the price. This was logical after the volatility introduced by the Russian debt debacle. Over time, however, market-flex became a tool either to increase or decrease pricing of a loan, based on investor demand.

Supply of new-issue loans was no match for investor demand in 2015′s second quarter, keeping issuers firmly in the drivers seat, as illustrated by the share of deals that had pricing or other terms cut while in syndication during the quarter.

For example, an account may put in for $25 million at LIBOR+275 or $15 million at LIBOR+250. At the end of the process, the arranger will tally the commitments, then make a call as to where to price, or “print,” the paper.

Following the example above, if the loan is oversubscribed at LIBOR+250, the arranger may slice the spread further. Conversely, if it is undersubscribed, even at LIBOR+275, then the arranger may be forced to raise the spread to bring more money to the table.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Leveraged Loan Purposes

For the most part, issuers undertake leveraged loans for four reasons:

  • To support an M&A-related transaction
  • To back a recapitalzation of a company’s balance sheet
  • To refinance debt
  • To fund general corporate purposes or project finance

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.


M&A is the lifeblood of leveraged finance. There are the three primary types of acquisition loans:

1) Leveraged buyouts (LBOs)

Most LBOs are backed by a private equity firm, which funds the transaction with a significant amount of debt in the form of leveraged loans, mezzanine finance, high-yield bonds and/or seller notes. Debt as a share of total sources of funding for the LBO can range from 50% to upwards of 75%. The nature of the transaction will determine how highly it is leveraged. Issuers with large, stable cash flows usually are able to support higher leverage. Similarly, issuers in defensive, less-cyclical sectors are given more latitude than those in cyclical industry segments. Finally, the reputation of the private equity backer (sponsor) also plays a role, as does market liquidity (the amount of institutional investor cash available). Stronger markets usually allow for higher leverage; in weaker markets lenders want to keep leverage in check.

In a blowout year for M&A volume, private equity firms looking for LBO candidates were left wanting in 2015′s first half, largely because sky-high stock prices made many deals costly (regulatory pressure re highly leveraged loans helped none, as well). Indeed, greenfield LBO loan volume – which excludes tuck-in acquisitions by seasoned portfolio companies – plummeted in the second quarter, putting the first-half 2015 LBO loan pace behind that seen a year earlier.

There are three main types of LBO deals:

  • Public-to-private (P2P) – also called go-private deals – in which the private equity firm purchases a publicly traded company via a tender offer. In some P2P deals a stub portion of the equity continues to trade on an exchange. In others the company is bought outright
  • Sponsor-to-sponsor (S2S) deals, where one private equity firm sells a portfolio property to another
  • Non-core acquisitions, in which a corporate issuer sells a division to a private equity firm.

2) Platform acquisitions

Transactions in which private-equity-backed issuers buys a business that they judge will be accretive by either creating cost savings and/or generating expansion synergies.

3) Strategic acquisitions

These are similar to a platform acquisitions but are executed by an issuer that is not owned by a private equity firm.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.



Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Types of Syndications

There are three main types of leveraged loan syndications:

  • An underwritten deal
  • A best-efforts syndication
  • A club deal

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Underwritten Deal

In an underwritten deal the arrangers guarantee the entire amount committed, then syndicate the loan.

If the arrangers cannot get investors to fully subscribe the loan, they are forced to absorb the difference, which they may later try to sell sell. This is achievable, in most cases, if market conditions – or the credit’s fundamentals – improve. If not, the arranger may be forced to sell at a discount and, potentially, even take a loss on the paper (known as “selling through fees”). Or the arranger may just be left above its desired hold level of the credit.

So, why do arrangers underwrite loans? Two main reasons:

Offering an underwritten loan can be a competitive tool to win mandates.

Underwritten loans usually require more lucrative fees because the agent is on the hook if potential lenders balk.

Of course, with flex-language now common, underwriting a deal does not carry the same risk it once did, when the pricing was set in stone prior to syndication.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.


In a “best-efforts” syndication the arranger group commits to underwrite less than the entire amount of the loan, leaving the credit to the vicissitudes of the market. If the loan is undersubscribed, the credit may not close, or may need major surgery – such as an increase in pricing or additional equity from a private equity sponsor – to clear the market.

Traditionally, best-efforts syndications were used for riskier borrowers or for complex transactions.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Club Deal

A “club deal” is a smaller loan (usually $25 million to $100 million, but as high as $150 million) that is pre-marketed to a group of relationship lenders.

The arranger is generally a first among equals, and each lender gets a full cut, or nearly a full cut, of the fees.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

The Bank Book (IM)

Before awarding a mandate, an issuer might solicit bids from arrangers. The banks will outline their syndication strategy and qualifications, as well as their view on the way the loan will price in market.

Once the mandate is awarded, the syndication process starts.

The arranger will prepare an information memo (IM) describing the terms of the transactions. The IM typically will include an executive summary, investment considerations, a list of terms and conditions, an industry overview, and a financial model. Because loans are not securities, this will be a confidential offering made only to qualified banks and accredited investors.

If the issuer is speculative grade and seeking capital from non-bank investors, the arranger will often prepare a “public” version of the IM. This version will be stripped of all confidential material, such as financial projections from management, so that it can be viewed by accounts that operate on the public side of the wall, or that want to preserve their ability to buy bonds, stock or other public securities of the particular issuer (see the Public Versus Private section below).

Naturally, investors that view materially nonpublic information of a company are disqualified from buying the company’s public securities for some period of time.

As the IM is being prepared the syndicate desk will solicit informal feedback from potential investors regarding potential appetite for the deal, and at what price they are willing to invest. Once this intelligence has been gathered the agent will formally market the deal to potential investors.

Arrangers will distribute most IMs—along with other information related to the loan, pre- and post-closing – to investors through digital platforms. Leading vendors in this space are Intralinks, Syntrak and Debt Domain.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Bank book - Components

The IM typically contain the following sections:

  • Executive summary: A description of the issuer, an overview of the transaction and rationale, sources and uses, and key statistics on the financials
  • Investment considerations: Basically, management’s sales “pitch” for the deal
  • Terms and conditions: A preliminary term sheet describing the pricing, structure, collateral, covenants, and other terms of the credit (covenants are usually negotiated in detail after the arranger receives investor feedback)
  • Industry overview: A description of the company’s industry and competitive position relative to its industry peers
  • Financial model: A detailed model of the issuer’s historical, pro forma, and projected financials, including management’s high, low, and base case for the issuer

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

The bank meeting

Most new acquisition-related loans kick off at a bank meeting, wherepotential lenders hear management and the private equity/sponsor group (if there is one) describe what the terms of the loan are and what transaction it backs. Understandably, bank meetings are more often than not conducted via a Webex or conference call, although some issuers still prefer old-fashioned, in-person gatherings.

Whatever the format, management uses the bank meeting to provide its vision for the transaction and, most important, tell why and how the lenders will be repaid on or ahead of schedule. In addition, investors will be briefed regarding the multiple exit strategies, including second ways out via asset sales. (If it is a small deal or a refinancing instead of a formal meeting, there may be a series of calls. or one-on-one meetings with potential investors.)

Once the loan is closed, the final terms are then documented in detailed credit and security agreements. Subsequently, liens are perfected and collateral is attached.

Loans, by their nature, are flexible documents that can be revised and amended from time to time. These amendments require different levels of approval (see Voting Rights section). Amendments can range from something as simple as a covenant waiver to as complex as a change in the collateral package, or allowing the issuer to stretch out its payments or make an acquisition.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Leveraged Loan Investor Market

There are three primary investor consistencies for leveraged loans:

  • Banks
  • Finance companies
  • Institutional investors

Institutional investors can comprise different, distinct, important investor segments, such as CLOs (collateralized loan obligations) and mutual funds.

Each segment is detailed below.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.


A bank investor can be a commercial bank, a savings and loan institution, or a securities firm that usually provides investment-grade loans. These are typically large revolving credits that back commercial paper or general corporate purposes. In some cases they support acquisitions.

For leveraged loans, banks typically provide unfunded revolving credits, letters of credit (LOCs) and – less and less, these days – amortizing term loans, under a syndicated loan agreement.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Finance companies

Finance companies have consistently represented less than 10% of the leveraged loan market, and tend to play in

smaller deals – $25 million to $200 million.

These investors often seek asset-based loans that carry wide spreads. These deals often require time-intensive collateral monitoring.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Institutional investors

Institutional investors in the loan market usually are structured vehicles known as collateralized loan obligations (CLOs) and loan participation mutual funds (known as “Prime funds” because they were originally pitched to investors as a money market-like fund that would approximate the Prime rate).

In addition, hedge funds, high-yield bond funds, pension funds, insurance companies, and other proprietary investors do participate opportunistically in loans focusing usually on wide-margin (or “high-octane”) paper.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.


CLOs are special-purpose vehicles set up to hold and manage pools of leveraged loans.

The special-purpose vehicle is financed with several tranches of debt (typically a ‘AAA’ rated tranche, a ‘AA’ tranche, a ‘BBB’ tranche, and a mezzanine tranche) that have rights to the collateral and payment stream, in descending order. In addition, there is an equity tranche, but the equity tranche usually is not rated.

CLOs are created as arbitrage vehicles that generate equity returns via leverage, by issuing debt 10 to 11 times their equity contribution.

In the second quarter of 2015 loan managers inked $28.6 billion of new CLO vehicles, which, though the lowest figure since the first quarter of 2014, was enough to overrun supply. The YTD total is off only slightly from the record-shattering pace set in 2014.

There are also market-value CLOs that are less leveraged – typically 3 to 5 times. These vehicles allow managers greater flexibility than more tightly structured arbitrage deals.

CLOs are usually rated by two of the three major ratings agencies and impose a series of covenant tests on collateral managers, including minimum rating, industry diversification, and maximum default basket.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Loan mutual funds

Loan mutual funds are how retail investors can access the loan market. They are mutual funds that invest in leveraged loans. These funds – originally known as Prime funds, because they offered investors the chance to earn the Prime interest rate that banks charge on commercial loans – were first introduced in the late 1980s.

After eking out two months of growth, loan mutual funds’ assets under management declined $2.9 billion in June – the biggest drop since January – to a two-year low of $135.6 billion, from $138.5 billion a month earlier, according to data from Lipper FMI and fund filings. The reason? institutional investors in June adopted a low-wattage risk-off posture across risk assets, amid growing tensions surrounding the Greek debt situation.

Today there are three main categories of funds:

    Daily-access funds: These are traditional open-end mutual fund products into which investors can buy or redeem shares each day at the fund’s net asset value.
  • Continuously offered closed-end funds: These were the first loan mutual fund products. Investors can buy into these funds each day at the fund’s net asset value (NAV). Redemptions, however, are made via monthly or quarterly tenders, rather than each day, as with the open-end funds described above. To make sure they can meet redemptions, many of these funds, as well as daily access funds, set up lines of credit to cover withdrawals above and beyond cash reserves.
  • Exchange-traded closed-end funds (ETF): These funds, which have skyrocketed in popularity over the past few years, trade on a stock exchange. Typically the funds are capitalized by an initial public offering. Thereafter, investors can buy and sell shares, but may not redeem them. The manager can also expand the fund via rights offerings. Usually they are able to do so only when the fund is trading at a premium to NAV, however – a provision that is typical of closed-end funds regardless of the asset class.

In March 2011, Invesco introduced the first index-based exchange traded fund, PowerShares Senior Loan Portfolio (BKLN), which is based on the S&P/LSTA Loan 100 Index. By the second quarter of 2013 BKLN had topped $4.53 billion in assets under management.

Some ETFs related to the loan market:

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Public vs. Private Markets

In the old days, a bright red line separated public and private information in the loan market. Leveraged loans were strictly on the private side of the line, and any information transmitted between the issuer and the lender group remained confidential.

In the late 1980s that line began to blur as a result of two market innovations.

The first was a more active secondary trading market, which sprung up to support (1) the entry of non-bank investors into the market (investors such as insurance companies and loan mutual funds) and (2) to help banks sell rapidly expanding portfolios of distressed and highly leveraged loans that they no longer wanted to hold.

This meant that parties that were insiders on loans might now exchange confidential information with traders and potential investors who were not (or not yet) a party to the loan.

The second innovation that weakened the public/private divide was trade journalism focusing on the loan market.

Despite these two factors, the public versus private line was well understood, and rarely was controversial, for at least a decade.

This changed in the early 2000s as a result of:

  • The proliferation of loan ratings which, by their nature, provide public exposure for loan deals
  • The explosive growth of non-bank investors groups, which included a growing number of institutions that operated on the public side of the wall, including a growing number of mutual funds, hedge funds, and even CLO boutiques
  • The growth of the credit default swaps market, in which insiders like banks often sold or bought protection from institutions that were not privy to inside information
  • Again, a more aggressive effort by the press to report on the loan market

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Background - Public vs private

Some background is in order. The vast majority of loans are unambiguously private financing arrangements between issuers and lenders. Even for issuers with public equity or debt, and which file with the SEC, the credit agreement becomes public only when it is filed – months after closing, usually – as an exhibit to an annual report (10-K), a quarterly report (10-Q), a current report (8-K), or some other document (proxy statement, securities registration, etc.).

Beyond the credit agreement there is a raft of ongoing correspondence between issuers and lenders that is made under confidentiality agreements, including quarterly or monthly financial disclosures, covenant compliance information, amendment and waiver requests, and financial projections, as well as plans for acquisitions or dispositions. Much of this information may be material to the financial health of the issuer, and may be out of the public domain until the issuer formally issues a press release, or files an 8-K or some other document with the SEC.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Today's changing market

In recent years there was growing concern among issuers, lenders, and regulators that migration of once-private information into public hands might breach confidentiality agreements between lenders and issuers. More important, it could lead to illegal trading. How has the market contended with these issues?

  • Traders. To insulate themselves from violating regulations, some dealers and buyside firms have set up their trading desks on the public side of the wall. Consequently, traders, salespeople, and analysts do not receive private information even if somewhere else in the institution the private data are available. This is the same technique that investment banks have used from time immemorial to separate their private investment banking activities from their public trading and sales activities.
  • Underwriters. As mentioned above, in most primary syndications, arrangers will prepare a public version of information memoranda that is scrubbed of private information (such as projections). These IMs will be distributed to accounts that are on the public side of the wall. As well, underwriters will ask public accounts to attend a public version of the bank meeting, and will distribute to these accounts only scrubbed financial information.
  • Buyside accounts. On the buyside there are firms that operate on either side of the public-private divide.

Accounts that operate on the private side receive all confidential materials and agree not to trade in public securities of the issuers in question. These groups are often part of wider investment complexes that do have public funds and portfolios but, via Chinese walls, are sealed from these parts of the firms.

There are also accounts that are public. These firms take only public IMs and public materials and, therefore, retain the option to trade in the public securities markets even when an issuer for which they own a loan is involved. This can be tricky to pull off in practice because, in the case of an amendment, the lender could be called on to approve or decline in the absence of any real information. To contend with this issue the account could either designate one person who is on the private side of the wall to sign off on amendments or empower its trustee, or the loan arranger to do so. But it’s a complex proposition.

  • Vendors. Vendors of loan data, news, and prices also face many challenges in managing the flow of public and private information. In general, the vendors operate under the freedom of the press provision of the U.S. Constitution’s First Amendment and report on information in a way that anyone can simultaneously receive it (for a price, of course). Therefore, the information is essentially made public in a way that doesn’t deliberately disadvantage any party, whether it’s a news story discussing the progress of an amendment or an acquisition, or a price change reported by a mark-to-market service. This, of course, doesn’t deal with the underlying issue: That someone who is a party to confidential information is making it available via the press or pricing services, to a broader audience.

Another way in which participants deal with the public-versus-private issue is to ask counterparties to sign “big-boy” letters. These letters typically ask public-side institutions to acknowledge that there may be information they are not privy to, and they are agreeing to make the trade in any case. They are, effectively, big boys, and will accept the risks.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Credit Risk - Overview

Pricing a loan requires arrangers to evaluate the risk inherent in a loan and to gauge investor appetite for that risk.

The principal credit risk factors that banks and institutional investors contend with in buying loans

  • Default risk
  • Loss-given-default risk

Among the primary ways that accounts judge these risks are ratings, collateral coverage, seniority, credit statistics, industry sector trends, management strength, and sponsor. All of these, together, tell a story about the deal.

Descriptions of the major risk factors follow.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Default risk

Default risk is simply the likelihood of a borrower being unable to pay interest or principal on time.

It is based on the issuer’s financial condition, industry segment, and conditions in that industry, as well as economic variables and intangibles, such as company management.

Default risk will, in most cases, be most visibly expressed by a public rating from Standard & Poor’s Ratings Services or another ratings agency. These ratings range from ‘AAA’ for the most creditworthy loans to ‘CCC’ for the least.

The market is roughly divided into two segments:

  • Investment grade (loans to issuers rated ‘BBB-’ or higher)
  • Leveraged (borrowers rated ‘BB+’ or lower).

Default risk, of course, varies widely within each of these broad segments.

Since the mid-1990s, public loan ratings have become a de facto requirement for issuers that wish to do business with a wide group of institutional investors. Unlike banks, which typically have large credit departments and adhere to internal rating scales, fund managers rely on agency ratings to bracket risk, and to explain the overall risk of their portfolios to their own investors.

As of mid-2011, then, roughly 80% of leveraged loan volume carried a loan rating, up from 45% in 1998. Before 1995 virtually no leveraged loans were rated.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.


Where an instrument ranks in priority of payment is referred to as seniority. Based on this ranking, an issuer will direct payments with the senior most creditors paid first and the most junior equityholders last. In a typical structure, senior secured and unsecured creditors will be first in right of payment – though in bankruptcy, secured instruments typically move the front of the line – followed by subordinate bond holders, junior bondholders, preferred shareholders and common shareholders. Leveraged loans are typically senior, secured instruments and rank highest in the capital structure.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.


Loss-given-default risk measures how severe a loss the lender is likely to incur in the event of default.

Investors assess this risk based on the collateral (if any) backing the loan and the amount of other debt and equity subordinated to the loan. Lenders will also look to covenants to provide a way of coming back to the table early – that is, before other creditors – and renegotiating the terms of a loan if the issuer fails to meet financial targets.

Investment-grade loans are, in most cases, senior unsecured instruments with loosely drawn covenants that apply only at incurrence. That is, only if an issuer makes an acquisition or issues debt. As a result, loss-given-default may be no different from risk incurred by other senior unsecured creditors.

Leveraged loans, in contrast, are usually senior secured instruments that, except for covenant-lite loans, have maintenance covenants that are measured at the end of each quarter, regardless of the issuer is in compliance with pre-set financial tests.

Loan holders, therefore, almost always are first in line among pre-petition creditors and, in many cases, are able to renegotiate with the issuer before the loan becomes severely impaired. It is no surprise, then, that loan investors historically fare much better than other creditors on a loss-given-default basis.

Calculating loss given default is tricky business. Some practitioners express loss as a nominal percentage of principal or a percentage of principal plus accrued interest. Others use a present-value calculation, employing an estimated discount rate – typically the 15-25% demanded by distressed investors.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Credit statistics

Credit statistics are used by investors to help calibrate both default and loss-given-default risk. These statistics include a broad array of financial data, including credit ratios measuring leverage (debt to capitalization and debt to EBITDA) and coverage (EBITDA to interest, EBITDA to debt service, operating cash flow to fixed charges). Of course, the ratios investors use to judge credit risk vary by industry.

In addition to looking at trailing and pro forma ratios, investors look at management’s projections, and the assumptions behind these projections, to see if the issuer’s game plan will allow it to service debt.

There are ratios that are most geared to assessing default risk. These include leverage and coverage.

Then there are ratios that are suited for evaluating loss-given-default risk. These include collateral coverage, or the value of the collateral underlying the loan, relative to the size of the loan. They also include the ratio of senior secured loan to junior debt in the capital structure.

Logically, the likely severity of loss-given-default for a loan increases with the size of the loan, as a percentage of the overall debt structure. After all, if an issuer defaults on $100 million of debt, of which $10 million is in the form of senior secured loans, the loans are more likely to be fully covered in bankruptcy than if the loan totals $90 million.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Industry segment

Industry segment is a factor because sectors, naturally, go in and out of favor.

For that reason, having a loan in a desirable sector, like telecom in the late 1990s or healthcare in the early 2000s, can really help a syndication along.

Also, loans to issuers in defensive sectors (like consumer products) can be more appealing in a time of economic uncertainty, whereas cyclical borrowers (like chemicals or autos) can be more appealing during an economic upswing.

Copyright © 2013 by Standard & Poor’s Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc.

Private equity sponsor

Sponsorship is a factor too. Needless to say, many leveraged companies are owned by one or more private equity firms. These entities, such as Kohlberg Kravis & Roberts or Carlyle Group, invest in companies that have leveraged capital structures. To the extent that the sponsor group has a strong following among loan investors, a loan will be easier to syndicate and, therefore, can be priced lower. In contrast, if the sponsor group does not have a loyal set of relationship lenders, the deal may need to be priced higher to clear the market. Among banks, investment factors may include whether the bank is party to the sponsor’s equity fund. Among institutional investors, weight is given to an individual deal sponsor’s track record in fixing its own impaired deals by stepping up with additional equity or replacing a management team that is failing. For reference, here’s some of the largest sponsor-backed leveraged loans in 2015, along with the private equity firm associated with each deal. You can read about each loan by clicking on the issuer name below.

Category: Forex

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