Leveraged finance refers to debt financing, usually of a business, that is in excess of the norm. Businesses have two ways of financing their operations: debt and equity. Equity financing is accomplished for a small business by the owner using his personal funds to enable the business to function. A larger company will issue stock.
A business of any size may require additional funds for operation or expansion. Banks lend to businesses, usually in the form of a revolving line of credit. That means the company will draw money from the bank when it needs it, then pay it back as sales create profits. For instance, retail chains see most of their profits near Christmas, and are likely to use a line of credit in the fall to finance increasing inventory for the upcoming season. Corporate long term debt is financed by the issuance of bonds.
Debt beyond these sources is leveraged finance. One well-understood approach is called mezzanine debt. The corporation issues bonds with warrants attached. A warrant provides the lender with an “equity kicker,” the option to buy a specified amount of stock at a specified price for a specified time. Equity kicker financing appeals because the lender accepts a lower interest rate, making it easier for the corporation to succeed, but gets the opportunity for an above market return by exercising the option to buy stock. An option is usually exercised only if the price of the stock exceeds the price specified in the option.
Leveraged finance can take another form called collateralized debt obligations (CDOs). Any form of collateral may be used, including machinery, equipment, real estate, and gold. The reason to use a CDO rather than pure debt is to reduce the interest rate the company pays by decreasing the lender’s risk. At the beginning of the 21st century, many large banks used real estate to create CDOs called mortgage backed securities (MBSs).
MBSs were sold to hedge funds, other banks, and corporate investors in amounts estimated to be in excess of $10 trillion US Dollars (USD). The MBSs were divided up into groups or tranches based on perceived risks and expected returns. Individual tranches were rated by credit rating agencies, then sold to the buyer that wanted the characteristics offered by the MBSs in that tranch. As subsequent events showed, leveraged finance can be quite risky, and even world-sized banks can be destroyed by its use.