A calculated risk Featured

8:00pm EDT May 26, 2007

Since the 1980s, leveraged financing has become more widespread in the middle market. By increasing the amount of debt relative to equity, companies can enhance the return on equity. Of course, there are significant risks, and not every business is well suited for this type of financing.

“Leverage can increase returns to equity, but it can also cut the other way if things don’t work as planned. The art is determining how much is too much and how much is just right,” says Edmund Ozorio, senior vice president of Comerica Bank’s Western Market.

Smart Business spoke with Ozorio about financial leverage, the risks involved and current market terms and conditions.

What is leveraged financing?

The generic term ‘leverage’ refers to the amount of debt relative to either the value of a company’s assets or its cash flow. Today, the term ‘leveraged financing’ is generally understood as debt financing in excess of the value of a company’s assets. This means that debt is replacing part of what is traditionally funded with equity.

Because debt is cheaper than equity, the average cost of capital is lowered and the return on equity goes up. Since nothing is free, this increased return comes with increased risk. The trick is to use the ‘Goldilocks’ amount: just enough to get the increased return on equity, but not so much that a minor downturn causes payment problems.

How can a company determine if it is a good candidate for leveraged financing?

The best candidates are businesses with reliable cash flow over a fairly broad spectrum of scenarios. While nobody can predict the future, banks look at likely projection scenarios and past performance under various economic conditions.

The best candidates have a strong market position and barriers to entry, meaning their products will continue to sell even in a moderate downturn and are difficult to displace by competitors. Branded products are common examples of this type of business. Other good candidates include businesses with low fixed operating costs.

Less attractive are businesses that are highly cyclical with high fixed costs, or those that consume large amounts of capital due to growth.

When is leveraged financing used?

Common uses center around changes in equity structure. The most frequent example is an acquisition, when a new owner borrows against the cash flow of the company in order to buy out the former owner.

Leveraged financing is also used to fund distributions to owners and equity holders for other outside investments. Over the past several years, banks have seen many business owners increase the leverage on their operating businesses to provide the equity for commercial real estate investments or to finance unrelated businesses that might not qualify for financing on their own.

What are some common mistakes, and how can they be avoided?

The most common mistake is taking on too much leverage relative to the level of reliable cash flow. In today’s fast-paced and highly competitive marketplace, businesses can be affected much easier and faster than ever before. The debt structure has to leave some buffer for drops in revenue and cash flow. This means one of two things: either less leverage or debt structured in such a way that there is some flexibility in repayment terms.

One of the best ways of achieving a fairly high level of leverage is a combination of bank debt and mezzanine, or subordinated, debt. The bank debt generally amortizes early and the subordinated debt later.

What terms and structures are commonly used?

Commercial banks will usually want keep the company's bank debt at three times cash flow or less. Subordinated debt lenders might provide an additional one to two times cash flow. There are extraordinary circumstances that might increase or decrease these levels by as much as 50 percent. Banks may also require that the amount of financing in excess of asset values amortizes more quickly than other debt.

On rare occasions when the business has a very strong model and cash flow but extremely limited hard assets, the analysis is based on the value of the intangibles and amortization is set accordingly.

The terms are a function of the risk involved. While premiums for leveraged financing have come down over the past few years, it remains more expensive than traditional financing. The spread over comparable rates for debt fully covered by assets will generally range from 1 percent to 4 percent. Fees might increase by a quarter to one-half. Some lenders will also take warrants instead of part of their fees, lessening the cash drain on the business.

EDMUND OZORIO is senior vice president of Comerica Bank’s Western Market. Reach him at epozorio@comerica.com or (619) 338-1512.