Highly Leveraged Transaction (HLT)

What is a Highly Leveraged Transaction (HLT)?

A highly leveraged transaction is a bank loan that is issued to a company that is already in a large amount of debt. 

These transactions are often used as a method of financing buyouts, acquisitions, and recapitalizations. HLTs are also used by firms that need to generate substantial capital expenditures to grow their business by creating new products or entering new markets. 

HLTs were primarily popularized in the 1980s when there was an upsurge in M&A deals. Lenders assume that the additional revenues from an acquisition will allow firms to pay back their debt from an HLT. 

HLTs are similar to junk bonds in that both have a high default risk (a chance that the borrower will not be able to pay their debts). 

Junk bonds (also known as high-yield bonds) are risky investments that usually offer much higher returns but have higher default rates. Junk bonds are sometimes issued as a part of the deal structure of an HLT. 

Despite their high default risk, HLTs attract lenders because they carry very high-interest rates. This means the lender will make more money because of the high interest a company pays on an HLT. 

Understanding highly leveraged transaction

Lenders do not like to frequent loans to firms that already carry a lot of debt. Because of this, highly leveraged transactions usually require some debt restructuring. 

The company receiving the loan must first deal with its existing debt for the HLT to have any chance of success. This is how a company reduces its risk of default. 

An HLT typically results in a complicated debt structure with various kinds of subordinated debt (unsecured borrowings). The lenders backing the highly leveraged transaction usually acquire an equity stake in the newly restructured company. 

1. Debt structure

It concerns the length and timing of principal and interest payments. The characteristics of a debt structure include maturity dates, principal repayment terms, and plans for prepaying loans. 

The equity stake that the lenders receive is usually issued in the form of shares, stock warrants, or other stock options. 

2. Stock warrant

It is the derivative contract between an investor and a public firm. In a stock warrant, the holder has the right to buy or sell shares of the company's stock at a specific date and price. 

An example is a leveraged buyout (LBO). A leveraged buyout is an acquisition of a firm using large amounts of debt to cover the cost of the trade. 

Conditions for a Highly Leveraged Transaction

The U.S. Office of the Comptroller of Currency (OCC), the Federal Deposit Insurance Corporation, and the Federal Reserve Board all guide highly leveraged transactions. 

A combination of the following criteria is necessary for a loan to be considered an HLT:

1. The transaction's proceeds are used for acquisitions, buyouts, and recapitalization. 

2. The result of the transaction is a significant increase in the borrowing company's leverage ratio. Here are a few benchmarks that determine the significance of the rise:

• The borrowing company's operating leverage ratios (e.g., debt-to-EBITDA) are above established levels
• A balance sheet leverage ratio higher than 50%  
• An increase in the balance sheet leverage ratio of more than 75%

3. The borrowing company must be classified as a non-investment grade firm with a high debt-to-equity ratio. A non-investment grade company has low credit ratings because of high levels of debt, low earnings potential, and poor debt-paying records. 

A company's debt-to-equity (D/F) ratio is calculated by dividing the firm's total liabilities by its shareholders' equity. This metric assesses a firm's financial leverage and how much equity and debt a company uses to finance its assets. The higher the debt-to-equity ratio is, the more debt the company has. 

4. The loan is usually priced at a rate that fluctuates with market conditions.

Personal Highly Leveraged Transactions

Highly leveraged transactions can also occur in the field of personal loans. Personal HLTs are typically in the form of home equity loans or second mortgages. 

A home equity loan is a form of consumer debt issued to homeowners. The loan amount is the difference between the current market value of the property and the property owner's mortgage balance due. Typically, home equity loans are set at a fixed interest rate. 

Second mortgages are made while the initial mortgage is still in effect. Because second mortgages are to be paid off after the first mortgage, they typically have higher interest rates. 

The metric that is considered when issuing these loans is the homeowner's income-to-debt ratio or their assets-to-debt ratio.

When a homeowner's income-to-debt or assets-to-debt ratio is considerably higher than the norm, a lender may still issue a loan if they trust that the homeowner will be able to sell their property at a price that exceeds their outstanding debt. This will ensure that the borrower can pay back the loan.

Conclusion

A financial strategy known as Highly Leveraged Transactions (HLT) involves significant borrowing by firms that are already highly leveraged.

HLTs are a way to finance a range of operations, including capital expenditures, buyouts, and acquisitions, notwithstanding the risks involved. The possibility of large returns through interest payments draws lenders, but they also have to deal with intricate debt arrangements and legal requirements.

There are also personal HLTs that are subject to comparable risk assessment standards, including home equity loans.

In general, even while HLTs present chances for investment and growth, all stakeholders must carefully weigh the risks and ensure that they comply with regulations.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Asset Acquisition
• Joint Venture (JV)
• Memorandum of Understanding (MoU)
• Pitch
• Private Equity Transaction Timeline