Using debt to increase equity returns
Published March 16, 2020
Updated December 13, 2022
What is Leveraged Finance?
Leveraged financeis 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 buyout firms will employ as much leverage as possible to enhancetheir investment’s internal rate of return or IRR.
The Effects of Leverage
The effectivecost of debt 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 flow, 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:
- No Leverage – 100% equity-financed
- Moderate Leverage – 70% equity-financed (30% debt)
- 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.
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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’sInteractive 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:
FAQs
Leveraged financing is generally considered riskier than traditional financing, as it involves taking on more debt and therefore carries a higher level of risk. However, it can also offer higher potential rewards for investors who are willing to take on that risk.
How much does leveraged finance pay? ›
As of Jul 22, 2023, the average annual pay for a Leveraged Finance in the United States is $86,569 a year.
What is considered highly leveraged? ›
A company with more debt than average for its industry is said to be highly leveraged. Leverage is not necessarily bad. When revenues are growing, payments are made with comfortable surpluses and additional debt is acquired to take advantage of market opportunities.
Why is too much leverage bad? ›
Key Takeaways. A company is said to be overleveraged when it has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses. Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more.
Is 3x leverage risky? ›
Since they maintain a fixed level of leverage, 3x ETFs eventually face complete collapse if the underlying index declines more than 33% on a single day. Even if none of these potential disasters occur, 3x ETFs have high fees that add up to significant losses in the long run.
Why leveraged funds are bad? ›
Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.
How much financial leverage is too much? ›
A financial leverage ratio of less than 1 is usually considered good by industry standards. A leverage ratio higher than 1 can cause a company to be considered a risky investment by lenders and potential investors, while a financial leverage ratio higher than 2 is cause for concern.
What are the salaries in LBO? ›
The average salary for Lbo Holding Inc employees is around $92,179 per year, or $44 per hour. The highest earners in the top 75th percentile are paid over $104,538.
Can you make money with leveraged ETFs? ›
Leveraged ETFs utilize forms of leverage, such as debt, futures, options, and other financial instruments in an effort to yield these higher returns. This makes leveraged ETFs both deeply lucrative and incredibly risky; potential gains are multiplied, but potential losses are, too.
Is Netflix highly leveraged? ›
Netflix's operated at median financial leverage of 3.5x from fiscal years ending December 2018 to 2022. Looking back at the last 5 years, Netflix's financial leverage peaked in December 2018 at 5.0x. Netflix's financial leverage hit its 5-year low in December 2022 of 2.3x.
In the foreign exchange markets, leverage is commonly as high as 100:1. This means that for every $1,000 in your account, you can trade up to $100,000 in value. Many traders believe the reason that forex market makers offer such high leverage is that leverage is a function of risk.
What does it mean to be 4X leveraged? ›
Leverage is the key feature that makes margin trading possible, as it represents the ratio of borrowed funds to the trader's own capital. With 4X leverage, you can trade with four times the amount of capital you have in your account.
Why do rich people use leverage? ›
The wealthy have learned the power of leverage—how to use their assets to obtain more assets. It's a calculated process, and in turn it allows them to build monthly cash flow over stagnant cash. To them, debt is a tool to building greater certainty in their own lives.
How high leverage is risky? ›
A firm that operates with both high operating and financial leverage can be a risky investment. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales.
What is a healthy leverage ratio? ›
A figure of 0.5 or less is ideal. In other words, no more than half of the company's assets should be financed by debt.
Is leverage trading more risky? ›
The bottom line: Leverage trading, whether with underlying assets or through CFDs, is a high-risk approach to investing and can potentially lead to high losses. It's important to do your own research and take the time to maintain your trading strategy.
What is the main disadvantages of financial leverage? ›
Disadvantages of using financial leverage
They may pay higher interest rates on loans because their risk is greater. Here are some other potential drawbacks of using this financial method: Assets may decline in value quickly, and the financial losses may increase with financial leverage.
What type of risk is financial leverage? ›
The most common risk of financial leverage is that it multiplies losses. A company may face bankruptcy due to financial leverage's effect on its solvency. If the company borrows too much money, it will have more chances of bankruptcy, while a less-levered company may avoid bankruptcy due to higher liquidity.
