A Pragmatist's Guide to Leveraged Finance

1. Leveraged Finance: A Unique Market with Hybrid Analysis

It is often said that the leveraged finance market has characteristics of both fixed income and equity.

Hybrid nature. The leveraged finance market, encompassing high-yield bonds and loans, uniquely blends features of traditional fixed income and equity markets. This hybrid nature necessitates a specialized analytical approach, drawing tools and techniques from both disciplines.

Event-driven volatility. Unlike the more stable investment-grade fixed income market, leveraged finance is characterized by event-driven volatility, similar to equities. Mergers, acquisitions, restructurings, and other corporate actions can significantly impact the credit quality and trading levels of leveraged debt.

Structural features. The market also has structural features within the securities and among the participants that are unique to the leveraged market. These include complex covenant packages, tiered capital structures, and the active involvement of private equity firms.

2. Financial Statement Analysis: Unveiling Key Liquidity and Solvency Metrics

The statement of cash flows shows a more realistic picture than the income statement of where and how cash is being used, giving you a better picture of liquidity.

Prioritizing cash flow. In leveraged finance, the statement of cash flows is paramount, offering a more realistic view of a company's liquidity than the income statement. Focus on cash from operations, capital expenditures, and changes in working capital.

EBITDA and free cash flow. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and free cash flow are key metrics for assessing a company's ability to service its debt. Adjusted EBITDA, which adds back non-cash items, provides a more refined measure of cash flow generation.

Balance sheet scrutiny. Key balance sheet items include cash, debt, and capitalized leases. Understanding debt maturities is crucial for identifying potential refinancing risks.

3. Credit Ratios: Quantifying Risk and Comparing Credits

Ratio analysis lets you compare a company over time, even if it has undergone major changes.

Standardized comparisons. Credit ratios provide a standardized way to compare companies of different sizes and across industries. They offer insights into a company's ability to service its debt and its overall financial health.

Key ratios. The most common ratios include:

• EBITDA/Interest: Measures a company's ability to cover its interest expense.
• Debt/EBITDA: Indicates the level of leverage and asset protection.
• FCF/Debt: Shows the percentage of debt that can be repaid with free cash flow annually.

Context is crucial. Ratios should not be viewed in isolation. It is important to consider industry-specific benchmarks, business trends, and qualitative factors.

4. Business Trend Analysis: Assessing Operational Health and Sustainability

If you are seeing meaningful changes in margins, you will want to examine the cost lines in greater detail.

Beyond financial metrics. Analyzing business trends and operational ratios provides a deeper understanding of a company's underlying performance. This includes examining revenue growth, EBITDA margins, and key operational metrics specific to the industry.

Margin analysis. Monitoring gross profit margins and operating expenses can reveal insights into a company's operating leverage and cost structure. Significant changes in margins warrant further investigation.

Capital expenditure trends. Analyzing capital expenditure trends, both in absolute terms and as a percentage of revenue, can indicate a company's investment in its future growth and its ability to maintain its existing assets.

5. Expectations, Modeling, and Scenarios: Projecting Future Performance

When building models, don’t just assume that the conditions of the recent past will continue.

Forward-looking analysis. Credit analysis should not be limited to historical data. Building financial models and running scenarios are essential for projecting future performance and assessing potential risks and opportunities.

Key modeling drivers. Revenue projections should be based on macroeconomic factors, industry trends, and company-specific initiatives. Expense projections should consider fixed and variable costs, as well as potential cost savings.

Scenario planning. Running multiple scenarios, including upside, downside, and base case scenarios, can help assess the sensitivity of a company's credit quality to various assumptions.

6. Structural Issues: Coupons, Calls, and Maturities

The interest rate or coupon is determined when the bond or bank loan is issued.

Coupon structures. Understanding the different types of coupon structures, including fixed-rate, floating-rate, zero-coupon, and pay-in-kind (PIK) coupons, is crucial for assessing the cash flow implications of a debt instrument.

Call features. Call features give the issuer the right to redeem the debt at a specified price on or after a specified date. Understanding the call schedule is essential for calculating yield-to-worst and assessing potential refinancing risk.

Maturity dates. The maturity date is the date on which the principal amount of the debt is due. Analyzing maturity schedules is crucial for identifying potential refinancing risks and liquidity pressures.

7. Structural Issues: Ranking of Debt

When a company files for bankruptcy, the debt obligations are considered claims.

Priority of claims. The ranking of debt determines the order in which creditors will be repaid in the event of a bankruptcy or liquidation. Senior secured debt has the highest priority, followed by senior unsecured debt, subordinated debt, and equity.

Structural subordination. Structural subordination occurs when debt is issued at a holding company level, rather than at the operating subsidiary level. This can effectively subordinate the holding company debt to the debt at the operating subsidiary.

Subsidiary guarantees. Subsidiary guarantees can enhance the credit quality of debt by providing a claim on the assets of the guaranteeing subsidiaries. However, the value of the guarantee depends on the financial health of the guarantor.

8. Key Covenants: Protecting Lenders' Interests

The covenants are the rules that help protect the loan and bondholders.

Covenant analysis. Covenants are contractual provisions that protect the interests of lenders by restricting the borrower's actions. Understanding the key covenants in a debt agreement is essential for assessing the credit quality of the debt.

Key covenants. The most important covenants include:

• Debt incurrence: Limits the amount of additional debt the borrower can incur.
• Restricted payments: Restricts the borrower's ability to pay dividends, repurchase stock, or make other distributions to equity holders.
• Change of control: Requires the borrower to offer to repurchase the debt in the event of a change in control of the company.
• Asset sales: Restricts the borrower's ability to sell assets and requires the proceeds to be used to repay debt.

Defined terms. Covenants often rely on defined terms, such as EBITDA, total debt, and change of control. Understanding these definitions is crucial for interpreting the covenants correctly.

9. Amendments, Waivers, and Consents: Navigating Covenant Changes

An amendment is a permanent change to the terms of an agreement. A waiver is usually a one-time or event-specific change to the covenants.

Covenant flexibility. Companies may seek amendments or waivers to covenants to address unforeseen circumstances or to pursue strategic initiatives. Understanding the process for obtaining amendments and waivers is important for assessing the potential impact on debt holders.

Amendment vs. waiver. An amendment is a permanent change to the terms of the debt agreement, while a waiver is a temporary suspension of a covenant.

Consent fees. Companies often pay consent fees to debt holders in exchange for their approval of amendments or waivers. The size of the consent fee depends on the nature of the change and the bargaining power of the debt holders.

10. Event-Driven Analysis: Capitalizing on Market-Moving News

Few companies in the high-yield market are stagnant or stable.

Proactive analysis. The leveraged finance market is highly event-driven. Analysts must be prepared to react quickly to breaking news and assess the potential impact on credit quality and trading levels.

Common events. Common events include:

• Mergers and acquisitions
• Initial public offerings (IPOs)
• Debt refinancings
• Asset sales

Scenario planning. Developing scenarios for potential events and assessing their impact on key credit metrics can help analysts make informed investment decisions.

11. Management and Ownership: Assessing Leadership and Incentives

Management and their advisors regularly look at ways to improve their cost of borrowing and increase liquidity.

Management quality. Assessing the quality and experience of management is crucial for evaluating a company's ability to execute its strategy and navigate challenges.

Ownership structure. Understanding the ownership structure, including the presence of private equity sponsors or controlling shareholders, can provide insights into a company's financial goals and risk tolerance.

Incentive alignment. It is important to assess whether management's incentives are aligned with the interests of debt holders. This includes examining compensation structures and ownership stakes.

12. Equity Matters: Using Equity to Inform Debt Analysis

The leveraged finance market is more highly correlated to equities (especially mid-cap and small-cap equities) than to fixed-income markets.

Equity as a valuation tool. Public equity valuations can provide a valuable benchmark for assessing the asset value of leveraged companies. Comparing enterprise value to debt levels can indicate the level of asset protection for debt holders.

Equity monitoring. Monitoring equity prices and trading volumes can provide early warning signals of potential credit problems or opportunities. Unusual trading activity may indicate that investors are anticipating a significant event.

Equity influence. The equity market can influence management decisions, particularly in publicly traded companies. Understanding the pressures and incentives facing management can help analysts anticipate potential strategic shifts.

Last updated: February 5, 2025