By Robert Rubino, Executive VP, Marketing Manager, Bank of America Business Capital
Second liens have come of age. Spawned by the credit crunch of the early 2000s, second liens originally were thought of as transitional or “rescue” capital. For the most part, they were the province of companies that needed to refinance but had little access to traditional capital sources.
Historically, proceeds from second liens primarily were used to pay off maturing debt, reduce bank debt leverage or provide incremental liquidity. However, as corporations and lenders have grown more comfortable with second liens, they’re being used more often and in a broader range of applications. New investors are flocking toward this asset class and are setting their sights on more traditional applications, including leveraged buyouts.
Also referred to as tranche B or junior secured debt, a second lien often works in tandem with an asset-based loan. Typically, it has the same rights and covenants as a bank loan except that it’s second in line in terms of repayment priority. A key reason a second lien is attractive to investors is that it gives them priority over general unsecured creditors in the event of an asset sale.
According to Portfolio Management Data, volume for second liens has increased five-fold over the last five years to more than $3 billion in 2003. While roughly half of the transactions in 2003 were to refinance existing debt, the others were used for purposes such as recapitalizations, stock repurchases, leveraged buyouts (LBOs) and acquisitions. One example is C-USA Holdings, where private equity sponsor Kohlberg & Company purchased a portion of motor-coach company Coach USA in a $140 million LBO financed, in part, with a $15 million second lien.
Companies are also “leveraging up” with second liens in order to provide financial sponsors with substantial dividends. In one recent case, the sponsor took a $70 million dividend by recapitalizing the company with an asset-based credit facility and a second lien. These kinds of transactions clearly indicate that the applications for second liens have broadened widely.
The Lure Of Second Liens
Second liens offer a number of attractive features from a borrower’s perspective, the chief one being they are significantly cheaper than other forms of junior capital.
Pricing: As new players have entered the market and competition has increased, pricing has come down considerably, by as much as 250 basis points over last year. According to Portfolio Management Data, the average price for second liens last year was LIBOR+739 basis points. However, given that price is driven by the risk profile, it varies widely. Although more expensive than bank debt, second liens continue to be less expensive than mezzanine loans and rarely require an equity component. Second lien investors also have been a contributing factor in the decline of minimum returns for mezzanine finance from 18% to approximately 16 percent.
Flexibility: Second liens are funded by private investors such as hedge funds and specialized finance companies. Since these investors are non-regulated, the guidelines for underwriting loans are more flexible. Rather than adhering strictly to internal credit risk ratings, the reward parameters can be established based on the risks presented by each individual deal.
Available: The pool of potential second lien investors has doubled over the past year. These investors have made it clear that they want to increase deal flow and create new applications for the capital they’ve accumulated.
The improving economy and easing of credit have resulted in a number of changes to the second lien market, including cash flow second lien financing and second liens that are larger than first priority liens.
Cash Flow Seconds
While second liens typically are structured as asset-based transactions, recently non-asset-based seconds have become prevalent in the market. This is really a different animal that has emerged in response to the compression in pricing for institutional cash flow deals. Rather than increasing the leverage profile to late 1990’s levels-when cash flow loans were typically four and a half times EBITDA (earnings before interest, taxes, depreciation and amortization) at LIBOR+ 400 basis points-underwriters are creating two tranche structures which allow the more aggressive institutional investors to buy both the 1st and 2nd lien tranches at blended yields consistent with late 1990’s.
For example, the first lien might be LIBOR+ 250 basis points while the second is priced at LIBOR+ 600. In an asset-based transaction, the second lien is issued by a completely different investor.
Compared to a cash flow second lien, from a borrower’s perspective an asset-based second lien contains fewer covenants and offers more operational flexibility in the event of declining performance. The biggest advantage, however, is the ability to prepay the most expensive piece of capital first. Since asset-based lenders have valued the collateral, they’re more comfortable using excess cash flow to prepay the second lien. In a cash flow deal, where there is no hard valuation of assets, lenders usually want the first lien paid down first before allowing significant amounts to be applied toward the second lien.
Larger Second Liens
Compared to the first lien, second liens traditionally have been smaller in size. Recently, however, more deals have been structured with larger second lien pieces. This happens for several reasons. One is that the company is in an industry that’s out of favor with the banks and the amount they are willing to finance is a smaller percentage of the total debt. An example would be an electricity generation start-up where there is no track record in cash flow transactions.
Another reason is that banks may not be comfortable enough with the class of assets the company has to pledge as collateral. Banks tend to prefer receivables and inventory, so in a situation where there’s a large fixed asset component, the second lien may be larger than the first.
Second Lien Outlook
Sources for debt capital, by their nature, evolve and change in concert with the economy. As the economy continues to improve, the second lien market will likely be impacted in several ways. Some of the larger second lien deals, those north of $100 million, will get crowded out by a more vibrant high-yield market due to high-yield’s broader investor base and lack of maintenance covenants. At the same time, the number of mergers and acquisitions and LBOs is expected to increase this year, which, in the middle market, could result in explosive second lien activity as owners and equity sponsors seek funding for those deals.
In addition, there continue to be companies in the general manufacturing sector that need new financing. As demand and consumption increase, more of those companies will be able to take advantage of second liens to refinance, reduce leverage and restructure their balance sheets. Finally, among the hedge fund community, the parameters of an acceptable deal should expand, which will facilitate additional deal flow.
It’s apparent from this last credit cycle that there’s a permanent place in the capital markets for secured debt provided by hedge funds, institutional investors and wealthy individuals. Now recognized as a valuable piece of capital for corporate America, second liens are here to stay.