Leveraged finance means essentially to borrow money to finance any kind of operation or investment. Whereas a certain amount of borrowed money is in most cases used to finance a company, it is to lesser extent true for investments. In general, the term leveraged finance implies that the proportion of borrowed money is comparatively high. Naturally, such behavior increases both the upside and downside potential of such an operation. Any venture that uses a large proportion of borrowed money becomes increasingly sensitive to changes in interest rates. In addition, the volatility of the underlying asset or business can be small and yet with a highly leveraged investment a huge amount of risk is taken.
Although highly leveraged undertakings were partly blamed for the current financial crisis, it is not necessarily a strategy that should be condemned. As said before it can increase the risk significantly. However, for a company an optimal degree of leverage can be calculated in order to optimize the return on equity. A similar approach can be taken for any individual investment to optimize the return on initial capital.
To give a simple example: you want to invest $10.000 into a venture with an expected return of 20%. You can borrow from a bank at a 5% rate. So you decide to borrow $90.000 from the bank and invest $100.000. You will get a return of $20.000 minus $4.500 in interest payment which equals $15.500. You made 155% on your initial investment if everything goes well. The example implies are very high degree of leverage and as a private individual you would have a hard time to convince your bank to lend you so much money without any collateral.
Degrees of leverage as in the example above, or even higher, are what private equity companies often tried to do. The management used as little own capital as possible in order to maximize their earnings. In case their investment strategy fails, they loose relatively little and the banks have to foot the bill. The upside is, of course, the prospect of huge gains even with relatively boring and stable businesses.
You may have heard the term deleveraging recently. It describes the process of reducing the proportion of borrowed funds in an investment. The reason why this term becomes a sort of buzzword for banks and the economies as whole, is that U.S. and European economies were highly over-leveraged and such a situation is not sustainable in the long run.