While relatively new, the second-lien loan market has quickly established itself as a financing alternative for highly leveraged companies in search of liquidity. But investors relying on the strength of their liens may be in for a surprise during the next default cycle. Philip Scipio writes from New York, with additional reporting by Ben Harding.
It is no coincidence that the US default rate is falling to record lows as second-lien debt issuance is hitting its stride. While less than US$500m in second-liens loans were issued in the second quarter of 2002, US$7.5bn was issued in the second quarter of last year and more than US$22bn was issued in all of 2005.
This rapid growth has been mirrored in Europe, where the workout implications are even less established. Prior to 2005, the product was virtually unheard of in the European market, but last year it was employed both as a tool in stressed refinancings such as Chef & Nacker, KarstadtQuelle and Tacco and as a means of adding an extra layer of secured debt in primary financings such as Wind, which had the largest ever second-lien piece at €700m, Debenhams and Eutelsat.
Although levels dropped off by 32% in the fourth quarter, ratings agency Fitch said that total issuance of second-lien debt finished at €5.76bn in 2005, up from €1.9bn in 2004.
The newfound popularity of second-lien loans seems to be more than a passing phenomenon, according to a study released by Fitch Investor Services. While the second-lien loan is in the early stages of its evolution in the US, it will play a critical role in the workout of the next wave of restructurings.
The volume of second-lien deals will affect how debtor-in-possession (DIP) loans are financed, are likely to subordinate bondholders and may force some dilution for first-lien lenders, said one fund manager.
There is very little good practical evidence on how the loans will hold up under scrutiny or how these debt holders will behave toward first-lien holders and subordinated debt holders, a concern expressed by several restructuring houses.
Another issue brought up by European commentators is the voting rights granted to second lien holders. The Facility D structure means that holders of second lien debt are included as senior lenders for the purpose of “Majority Lender” decisions and can therefore be out-voted on decisions (since the second lien will generally only be a small proportion of the overall senior debt).
If the second lien is separately documented, the holders will generally have independent voting rights and will therefore have more opportunities to block decisions and exert a disproportionate degree of influence.
Although more second liens are now being documented alongside the senior lenders, it is the second scenario that could allow investors a disproportionately strong position in a distressed situation, a sobering thought given that the main buyers of second-lien debt have been hedge funds.