Second lien debt is a type of secured debt originating from the United States. Although historically US-centric, European second lien financing have seen somewhat of a resurgence since the credit crunch, particularly in funding dividend recapitalisations.
In this article we will be covering:
- What is second lien debt?
- How did second lien finance develop?
- How does European second lien financing differ from the US?
- When is second lien financing used?
- Is a second lien loan secured or unsecured?
- Second lien debt vs mezzanine debt
- Is second lien debt subordinated?
- Financial covenants for second lien debt
What is second lien debt?
Second lien debt is a type of debt that ranks equally with senior debt as to payment before acceleration and that shares the same security package to senior debt. However, second lien debt ranks behind senior debt following a debt acceleration. In Europe (but not the US) it is also common for second lien debt to rank behind senior debt with respect to unsecured claims against the borrower and guarantors.
Second lien debt is considered riskier than senior debt but less risky than junior debt.
Second-lien loans may be either cash-flow loans (determined as a multiple of EBITDA) or asset-based loans (using appraisal valuations). Loans generally mature after five years but not before the first-lien lender’s loan. Second-lien loans may feature bullet payments or limited amortisation provisions.
How did second lien finance develop?
Second lien debt developed in the US in the late 1990s. The term ‘lien’ in the United States, means something akin to ‘security interest’. The term second lien finance was used to refer to debt that was a second-ranking security.
Second lien finance developed in the US as a method for companies with existing high yield bonds to raise relatively inexpensive debt. It was common for high yield bonds to contain ‘anti-layering’ clauses - provisions that prohibited a company from incurring new debt ranking between the senior and the bonds. However, these anti-layering provisions only prohibited debt subordination and not lien subordination. Second lien debt circumvented these provisions by only subordinating how the proceeds of the shared collateral was applied between creditors and not the right to payment.
Debt subordination means a lender must turn over payments received from a borrower to a senior lender. Lien subordination only requires the lender to turn over the proceeds from shared collateral, it does not include blockage provisions.
How does European second lien financing differ from the US?
When second lien financing came to the European market it developed slightly differently than in the US. This was largely because the European market already had an established mezzanine debt product, which was similar to the US second lien market.
In Europe, second lien financings have historically been documented in the same facility as the senior debt facility, whereas in the US second lien debt is usually documented separately. However, as the European second lien market has developed it has adopted separate loan agreements for many transactions. If the second lien debt is in the same agreement, then it is common for it to be syndicated with the senior debt. In the US, second lien debt may be syndicated separately. For more information on syndication, please see syndicated finance and loan syndication.
In the European debt markets, it is common for second lien debts to benefit from covenants that are identical to the senior debt covenants. In the US, by contrast, second lien debt usually has less strict or fewer covenants than senior debt.
The right to receive interest on European second lien debt may be subject to payment blockage and turnover provisions similar to those found in mezzanine debt. For more information on mezzanine debt please see mezzanine financing.
When is second lien financing used?
In the United States, second lien financing originated out of restructurings. It developed as a product for borrowers in financial difficulty that needed to raise capital quickly. These days, second lien financing may also be used in leveraged buyouts and, more occasionally, in plain vanilla deals.
In leveraged buyouts, a second lien loan may be used to fill small gaps between the financing needs of the borrower and the maximum thresholds senior secured lenders may lend up to.
Is a second lien loan secured or unsecured?
Second lien loans are a form of secured debt. Unlike unsecured debt, second lien loans benefit from a pledge of specific assets of the borrower (e.g. buildings, equipment).
Second lien loans will normally rank ahead of junior debt but behind senior (‘first lien’) debt.
Second lien debt vs mezzanine debt
The key difference between second-lien debt and mezzanine debt (apart from cost) is that second-lien is lien subordinated only, not debt subordinated like mezzanine debt. Debt subordination means a lender must turn over payments received from a borrower to a senior lender. Lien subordination only requires the lender to turn over the proceeds from shared collateral, it does not include blockage provisions.
The other major difference between second lien debt and mezzanine debt is the price. Second-lien loans are a form of senior loan and as such charge an interest rate comparable with senior loans (e.g. LIBOR plus 6%). Mezzanine loans are much riskier and tend to charge a much higher rate of interest. Mezzanine debt may charge a fixed coupon rate of between 15% and 18%.
Mezzanine finance may also include a ‘payment in kind’ (PIK) where the amount of principal can be increased in lieu of payment by the borrower. Mezzanine financings are also often unsecured by the assets of the borrower. If security is taken by a mezzanine lender then it will normally be deeply subordinated to the security interests of other lenders.
Is second lien debt subordinated?
Second lien loans are subordinated to first-lien loans on the capital pledged to secure the loan. However, second lien loans are not debt subordinated to first-lien loans. This means that second-lien lenders do not need to turn over payments received from a borrower to a senior lender. Although second lien loans are more junior than first-lien loans, they rank more senior than mezzanine loans and unsecured lenders.
Financial covenants for second lien debt
Covenants in European second-lien loans are identical to the senior debt covenants. However, if the senior lien is documented separately from the senior facility, there may be some additional headroom in the financial covenants.
The second lien debt will usually become repayable six months after the date from which the final instalment is due on the senior debt. Payments of principal will not be allowed before the senior debt is paid off. There may also be ‘call protection’ that requires a borrower to pay a prepayment fee for any amount repaid during the beginning of the loan.
Second lien lenders will only be allowed to accelerate the loan if there is a second lien debt payment default or an ‘insolvency event’ occurs.