Second Lien Debt

Introduction

What is Second Lien Debt?

• A form of secured financing that holds a subordinated lien position on borrower's assets
• Ranking junior to first lien debt but senior to unsecured obligations and equity

Introduction

What is Second Lien Debt?

• Emerged as a distinct asset class in the early 2000s
• Fills the gap between senior secured lending and mezzanine financing
• Offers borrowers additional leverage capacity while providing lenders with security and structural protections

Key Characteristics

Subordinated Security:

• Second lien lenders hold liens on the same collateral as first lien lenders
• But with junior priority in bankruptcy and enforcement scenarios
• Creating differentiated recovery expectations

Key Characteristics

Higher Pricing:

• Interest margins typically range from 600 to 900 basis points over benchmark rates
• Reflecting subordinated position, lower recovery prospects
• And additional risk compared to first lien debt

Key Characteristics

Intercreditor Agreements:

• Detailed agreements govern the relationship between first and second lien lenders
• Defining payment priorities, enforcement rights, standstill periods
• And amendment procedures

Key Characteristics

Bullet Maturity:

• Most second lien facilities feature no scheduled amortization
• With entire principal due at maturity
• Preserving borrower cash flow for senior debt service and operations

Key Characteristics

Extended Tenor:

• Maturities typically range from seven to eight years
• Generally six to twelve months longer than accompanying first lien facilities
• To ensure second lien doesn't mature first

Key Characteristics

Institutional Investors:

• Held primarily by CLOs, credit funds, hedge funds
• And other institutional investors
• Willing to accept subordinated risk for enhanced returns

Structure and Components

Facility Size:

• Second lien tranches typically range from $25 million to $500 million
• Though most middle-market facilities fall between $50 million and $200 million
• Size is limited by first lien lender tolerance for additional leverage

Structure and Components

Leverage Multiples:

• Second lien typically represents 0.5x to 2.0x EBITDA in the capital structure
• With total leverage (first plus second lien) often reaching 5.0x to 6.5x
• Depending on credit quality and industry

Structure and Components

Interest Rate Structure:

• Floating rate based on SOFR plus a fixed spread
• Many facilities include SOFR floors (typically 1.00% to 1.50%)
• Protecting lender returns in low-rate environments

Structure and Components

Payment-in-Kind (PIK) Options:

• Some structures include PIK toggle features
• Allowing borrowers to capitalize interest during periods of cash flow stress
• Though this has become less common in recent markets

Structure and Components

Covenants:

• Typically lighter than first lien facilities
• Often featuring incurrence-based covenants similar to high-yield bonds
• Rather than quarterly maintenance tests, though maintenance covenants appear in some transactions

Structure and Components

Security Package:

• Secured by second-priority liens on all assets pledged to first lien lenders
• Including accounts receivable, inventory, equipment
• Intellectual property and subsidiary equity interests

Intercreditor Agreements

Payment Subordination:

• Second lien lenders generally receive payments only after first lien obligations are current
• Though ongoing interest payments typically continue
• Absent first lien payment defaults

Intercreditor Agreements

Standstill Provisions:

• Second lien lenders agree not to exercise remedies for specified periods
• Typically 90 to 180 days after first lien default
• Allowing senior lenders to control initial enforcement actions

Intercreditor Agreements

Purchase Rights:

• First lien lenders often receive rights to purchase second lien debt at specified prices
• During enforcement
• Enabling them to eliminate junior claims

Intercreditor Agreements

Amendment Restrictions:

• Second lien lenders cannot amend their facility in ways that adversely affect first lien lenders
• Including shortening maturity, increasing interest rates that might stress cash flow
• Or modifying collateral

Intercreditor Agreements

Enforcement Control:

• First lien lenders generally control foreclosure processes, asset sales, and bankruptcy proceedings
• With second lien lenders having limited ability to object or intervene

Intercreditor Agreements

Proceeds Distribution:

• In asset sales or bankruptcy liquidations
• First lien lenders receive all proceeds until fully satisfied
• Before second lien lenders receive any recovery

Comparison with Other Debt Instruments

Second Lien vs. First Lien:

• Second lien carries subordinated collateral priority
• Higher pricing (typically 300-400 basis points higher)
• Lighter covenants, longer maturity

Comparison with Other Debt Instruments

Second Lien vs. First Lien (continued):

• Significantly lower recovery rates in default scenarios

Comparison with Other Debt Instruments

Second Lien vs. Mezzanine Debt:

• Second lien offers secured status versus unsecured mezzanine
• Lower pricing (typically 200-300 basis points lower)
• Simpler documentation
• Though mezzanine provides greater structural flexibility and covenant freedom

Comparison with Other Debt Instruments

Second Lien vs. Unitranche:

• Unitranche combines senior and junior debt in single facilities with blended pricing
• While second lien maintains separate documentation, lender groups
• And intercreditor dynamics with first lien facilities

Comparison with Other Debt Instruments

Second Lien vs. High-Yield Bonds:

• Second lien provides secured status, floating rates
• And typically shorter maturity compared to unsecured fixed-rate bonds
• Though bonds offer greater market depth and liquidity

Role in Capital Structure

Leveraged Buyouts:

• Second lien provides additional leverage beyond first lien capacity
• Reducing required equity contributions and enhancing sponsor returns
• While maintaining secured debt profile

Role in Capital Structure

Acquisition Financing:

• Companies use second lien to fund large acquisitions
• Where strategic value justifies additional leverage
• But first lien markets limit senior debt capacity

Role in Capital Structure

Recapitalizations:

• Dividend recapitalizations and ownership transitions utilize second lien
• To extract value or refinance existing obligations
• While maintaining operational liquidity

Role in Capital Structure

Bridge Financing:

• Temporary second lien facilities can bridge to permanent refinancing, IPOs, or asset sales
• When timing makes permanent financing premature or unavailable

Role in Capital Structure

Growth Capital:

• Companies requiring substantial capital for expansion beyond first lien availability
• But unwilling to accept mezzanine terms or dilutive equity
• May utilize second lien

Advantages for Borrowers

Additional Leverage:

• Provides incremental debt capacity beyond first lien limits
• Enabling higher overall leverage
• Without resorting to more expensive mezzanine or dilutive equity

Advantages for Borrowers

Lower Cost than Alternatives:

• Pricing falls between first lien and mezzanine/equity
• Offering more cost-effective leverage
• Than purely subordinated or equity alternatives

Advantages for Borrowers

Covenant Flexibility:

• Lighter covenant packages compared to first lien facilities
• Reduce compliance burden
• Provide greater operational flexibility during business cycles

Advantages for Borrowers

Cash Flow Preservation:

• Bullet maturities eliminate amortization requirements
• Preserving cash for business reinvestment, first lien debt service
• And strategic opportunities

Advantages for Borrowers

Market Access:

• Well-developed institutional investor base
• Provides reliable execution for appropriately structured credits
• Particularly in the middle market

Advantages for Lenders

Enhanced Returns:

• Higher spreads compensate for subordinated position
• All-in yields typically 300-500 basis points above first lien
• While maintaining secured status

Advantages for Lenders

Collateral Protection:

• Second lien status provides meaningful recovery prospects compared to unsecured alternatives
• Historical recoveries averaging 50-70% versus 30-40% for unsecured debt

Advantages for Lenders

Floating Rate Exposure:

• SOFR-based pricing protects against rising interest rates
• Unlike fixed-rate subordinated alternatives
• That suffer price declines when rates increase

Advantages for Lenders

Structural Protections:

• Intercreditor agreements, covenant packages
• And maturity extensions beyond first lien
• Create protective features limiting downside risk

Advantages for Lenders

Market Inefficiency:

• Less commoditized than first lien markets
• Second lien often offers relationship-focused investing
• With opportunities for negotiated structural enhancements

Common Terms and Conditions

Financial Covenants:

• When included, typically feature maximum total leverage (often 6.0x to 7.0x)
• And minimum interest coverage or EBITDA metrics
• Though many facilities now include only incurrence covenants

Common Terms and Conditions

Permitted Debt Baskets:

• Limitations on additional debt incurrence
• With ratios-based or fixed-dollar baskets
• Permitting specified amounts of incremental first lien or pari passu debt

Common Terms and Conditions

Restricted Payments:

• Constraints on dividends, distributions, and equity repurchases
• Often tied to leverage thresholds, pro forma compliance tests
• Or available cash flow baskets

Common Terms and Conditions

Asset Sale Proceeds:

• Requirements to offer proceeds to prepay debt
• Typically applying first to first lien obligations
• With second lien receiving proceeds only after senior debt satisfaction

Common Terms and Conditions

Change of Control:

• Events triggering prepayment offers or consent requirements
• Protecting lenders from fundamental ownership changes
• That might alter credit risk profiles

Common Terms and Conditions

Cross-Default Provisions:

• Defaults under first lien facilities typically trigger second lien defaults
• Though grace periods may apply
• To provide opportunity for cures before second lien acceleration

Pricing Mechanisms

Spread Determination:

• Margins reflect credit quality, total leverage, first lien structure
• Sponsor reputation, industry dynamics, and market conditions
• Typically ranging from SOFR + 600 to 900 basis points

Pricing Mechanisms

SOFR Floors:

• Minimum benchmark rates ensure base level returns
• Regardless of interest rate environments
• With floors typically 50-100 basis points higher than first lien floors

Pricing Mechanisms

Original Issue Discount:

• Many facilities issue at 97-99% of par
• Providing additional yield to investors
• While maintaining stated interest margins

Pricing Mechanisms

Upfront Fees:

• Commitment or closing fees of 1-2%
• Compensate arrangers and investors
• For execution efforts and capital deployment

Pricing Mechanisms

Prepayment Terms:

• Generally callable without premium after initial years
• Though some facilities include soft call protection
• Or prepayment penalties in years one and two

Default and Recovery

Events of Default:

• Include payment defaults, covenant breaches
• Cross-defaults to material debt, bankruptcy events
• And material misrepresentations, though standstill provisions limit immediate remedies

Default and Recovery

Recovery Expectations:

• Historical recoveries average 50-70% of principal
• Significantly lower than first lien (70-80%)
• But higher than unsecured debt (30-40%)
• Reflecting subordinated but secured status

Default and Recovery

Enforcement Limitations:

• Standstill periods and first lien control rights mean second lien lenders cannot immediately pursue remedies
• Instead relying on first lien actions or waiting out standstill periods

Default and Recovery

Bankruptcy Dynamics:

• Second lien claims remain secured in bankruptcy
• Receiving treatment as secured creditors though junior to first lien
• Potentially enabling recovery through plan participation or asset liquidation

Default and Recovery

Intercreditor Impact:

• Strong intercreditor protections for first lien lenders
• Can significantly impair second lien recovery
• Particularly regarding timing of enforcement and proceeds distribution

Risk Considerations

Recovery Risk:

• Subordinated lien position means meaningful loss potential in default scenarios
• Particularly when asset values deteriorate
• Or first lien claims consume available collateral value

Risk Considerations

Control Limitations:

• Standstill provisions and first lien enforcement control
• Leave second lien lenders dependent on senior creditor decisions
• During crucial restructuring or liquidation periods

Risk Considerations

Covenant Light Risk:

• Incurrence-based or light maintenance covenants
• Provide limited early warning mechanisms
• Potentially delaying awareness of deteriorating credit conditions

Risk Considerations

Refinancing Risk:

• Longer maturities provide extended tenure but eventually require refinancing
• Market conditions or credit deterioration
• Can make refinancing difficult or impossible

Risk Considerations

Interest Rate Risk:

• Floating rate structure exposes borrowers to rising benchmark rates
• Potentially stressing cash flow and increasing default probability
• Though SOFR floors limit lender downside

Risk Considerations

Market Liquidity:

• Secondary market trading exists but with wider bid-ask spreads
• And less depth than first lien markets
• Creating potential exit challenges during market stress

Market Evolution

Post-Crisis Growth:

• Second lien markets contracted sharply during the 2008 financial crisis
• But rebounded strongly
• Becoming an established component of leveraged finance capital structures

Market Evolution

Unitranche Competition:

• Growth in unitranche financing has reduced second lien issuance
• In some middle-market segments
• Though second lien remains relevant for larger transactions and specific structures

Market Evolution

Covenant Evolution:

• Market has shifted from maintenance to incurrence covenants in many transactions
• Mirroring broader market trends toward borrower-friendly terms

Market Evolution

CLO Demand:

• Continued CLO formation and demand for floating-rate assets
• Supports robust second lien investor appetite
• Providing reliable market access for appropriately structured deals

Conclusion

• Second lien debt occupies a strategic position in leveraged finance capital structures
• Providing borrowers with additional leverage capacity at costs below mezzanine or equity alternatives

Conclusion

• While offering lenders secured status and enhanced returns above first lien markets
• Its subordinated collateral position creates differentiated risk-return profiles

Conclusion

• Requiring careful analysis of recovery scenarios, intercreditor dynamics, and structural protections
• The interplay between first and second lien lenders through detailed intercreditor agreements
• Defines much of the product's complexity

Conclusion

• For borrowers, second lien enables capital structure optimization
• Balancing leverage, cost, and covenant flexibility
• For investors, it provides attractive floating-rate returns with secured status

Conclusion

• Success with second lien financing requires understanding its structural nuances
• Properly assessing subordination risk
• And navigating the complex dynamics between senior and junior secured creditors in both performing and distressed scenarios