Getting the Leftovers: An Interactive Learning Guide
Second lien debt is secured financing that holds a junior position on the same collateral as first lien debt. Think of it as being second in line at the buffet – you get what's left after the first lien lenders have taken their share.
Both first and second lien lenders have claims on the same collateral (assets like equipment, inventory, receivables), but first lien gets paid first. Second lien only gets the "leftovers" – whatever remains after first lien is fully satisfied.
Provides extra debt capacity beyond what first lien lenders will provide
Unlike unsecured debt, second lien has a claim on collateral (even if subordinated)
Costs less than unsecured mezzanine debt due to secured status
Lenders earn higher interest (6-9% over base rate) for taking subordinated risk
Amount: $40M
Rate: SOFR + 4.5%
Priority: First claim on all collateral
Recovery: Gets paid first, typically 70-90% recovery in default
Amount: $15M
Rate: SOFR + 8.0%
Priority: Gets leftovers after first lien paid
Recovery: Only paid if collateral > first lien, typically 20-40% recovery
First lien provides $40M but company needs $55M total for acquisition
Second lien lender provides additional $15M secured by same collateral, but junior position
Contract between first and second lien defines who gets paid first, standstill periods, and rights
Second lien charges ~3-4% more than first lien to compensate for subordinated position
Imagine collateral as a buffet with limited food. Both first and second lien lenders are hungry, but first lien is at the front of the line.
Equipment • Inventory • Receivables • Real Estate
Total Value: $80M
$40M claim
First in line
$15M claim
Gets leftovers
Both lenders have liens on the exact same $80M of assets. The difference is in payment priority during liquidation or default. First lien must be paid in full ($40M) before second lien gets a single dollar.
All proceeds from collateral go to first lien until fully repaid, then to second lien
Second lien typically cannot enforce rights for 90-180 days after default, giving first lien control
Second lien cannot modify terms without first lien consent in most cases
First lien controls enforcement, foreclosure, and bankruptcy decisions
When a company defaults and assets are sold, proceeds flow in a strict order. Let's see what happens to second lien as collateral values change.
Adjust the collateral recovery value to see how proceeds are distributed:
With $60M in proceeds:
• First Lien receives full $40M (100% recovery)
• Second Lien receives $20M out of $15M owed (133% recovery - excess returned)
• Everyone is happy! Both lenders are made whole.
| Recovery Value | First Lien Recovery | Second Lien Recovery | Second Lien Recovery % |
|---|---|---|---|
| $80M (100%) | $40M (100%) | $15M (100%) | 100% |
| $60M (75%) | $40M (100%) | $15M (100%) | 100% |
| $50M (62.5%) | $40M (100%) | $10M (67%) | 67% |
| $40M (50%) | $40M (100%) | $0 (0%) | 0% |
| $30M (37.5%) | $30M (75%) | $0 (0%) | 0% |
Notice that second lien gets zero recovery until collateral value exceeds the first lien claim ($40M). This is why second lien recovery rates are typically 20-40% in defaults versus 70-90% for first lien. Second lien only gets meaningful recovery in "soft landings" where asset values hold up well.
Second lien sits in the middle of the capital structure, offering a balance between security and return.
| Feature | First Lien | Second Lien | Mezzanine |
|---|---|---|---|
| Security | Secured - Priority | Secured - Subordinated | Unsecured |
| Typical Pricing | SOFR + 4-5% | SOFR + 7-9% | SOFR + 10-13% |
| Recovery in Default | 70-90% | 20-40% | 10-30% |
| Amortization | Yes (1-2% per year) | None (bullet) | None (bullet) |
| Covenants | Strict maintenance | Lighter | Lightest |
| Maturity | 5-7 years | 7-8 years | 8-10 years |
| Control in Default | Full control | Limited (standstill) | Minimal |
Best for: Core financing needs, conservative leverage, companies needing flexibility with lower rates
Best for: Bridging the gap when first lien capacity is maxed but don't want mezzanine costs; moderate leverage increase
Best for: Maximum leverage with minimal restrictions; when secured debt markets are tight; accepting higher cost for flexibility
Best for: Simplifying the capital structure; single lender relationship; middle-market companies wanting execution speed
Let's see how second lien debt fits into typical capital structures.
The sponsor wanted to minimize equity ($30M vs $45M without second lien) to boost returns. First lien lenders capped their exposure at 55% of purchase price. Second lien filled the gap at moderate cost (cheaper than mezzanine), allowing the deal to get done with acceptable leverage (7x EBITDA total, 5.5x first lien).
Private equity firm finds attractive acquisition target, needs financing
Banks provide $55M first lien at 4.5x EBITDA leverage (their comfort limit)
Need $70M debt total but banks only willing to provide $55M senior secured
Second lien lender commits $15M secured by same collateral, junior to first lien
First and second lien agree on terms: 180-day standstill, payment waterfall, amendment rights
All documents signed, funds released, company acquired with optimal capital structure