In the past few years, the second lien loan market has grown at a consistently remarkable pace, from approximately $0.5 billion in 2002 to more than $28 billion in 2006, with growth in 2007 continuing. The second lien loan has evolved from a product used primarily to provide rescue financing to middle market companies to broader uses and larger sizes.
Demand for second lien loans has increased and supply has followed. As interest rates have dropped over the first half of the decade, debt investors sought higher yielding investments. With interest rates rebounding, the second lien market has matured and acceptance of the product in debt structures has reached new levels with each year. In addition, increasingly the second lien product has been used in new transaction types, such as project finance. While the second lien loan market provides that higher yield, the increased return comes with a greater degree of risk. The absence of significant default rates leaves uncertainty as to average recovery rates, and variations in key intercreditor terms increase such uncertainties.
With new product uses and greater risk, investors both originating second lien loans and acquiring such loans in the secondary market must be more careful than ever. Understanding the business of the borrower and its prospects are key to making an intelligent investment decision. Equally critical for investors to consider are the intercreditor rights with respect to first lien debt ahead of them. We have summarized below what we believe to be some key intercreditor issues and market developments on which second lien loan investors should be focused.
Intercreditor Issues Hard Cap on First Lien Debt
Without a hard cap on the aggregate amount of principal that can be incurred (including capitalized interest and fees) under the first lien facility, the second lien lender exposes itself to the real risk of losing collateral coverage. This cap must not only apply to increases in the size of the facility outside of bankruptcy, but should cover potential debtor-in-possession financing arrangements as well. Typically, the cap should step down with permanent repayments of principal and reductions of commitments. The cap often does not apply to accrued interest and hedging obligations. With an appropriately drafted cap in place, the first lien lenders would be required to get the consent of the second lien lenders to put additional financings in place above the cap — an invaluable right in a restructuring scenario.
Payment Subordination vs. Lien Subordination
Unlike mezzanine financing, second lien loans are generally not subject to payment subordination. Payment subordination prohibits payment to junior debt prior to payment in full of senior debt, regardless of the source of payment. In contrast, second lien loans are typically subject to lien subordination, which requires the turnover to first lien creditors of proceeds of shared collateral until the first lien lenders are paid in full.
However, in a lien subordination arrangement, if the shared collateral is insufficient to pay the first lien lenders in full and there is unencumbered collateral, the deficiency claim of the first lien lenders and the unsecured claim of the second lien lenders would share pro rata. In a default situation, where a bankruptcy filing is likely, second lien lenders would be well advised to consider whether there are any potentially valuable avoidance actions (which include preference or fraudulent conveyance actions); the proceeds of such actions will typically be unencumbered and available to second lien lenders even if the first lien lenders have not been paid in full. Investors in second lien products need to look out for provisions that can impose payment subordination-like terms. For example, intercreditor agreements now commonly provide that in the event that the first lien fails to perfect its lien, the second lien lenders are required to turn over proceeds of shared collateral until the first liens are paid in full. If there are significant unencumbered assets, second lien lenders need to be careful to ensure that the turnover cannot result in a worse result than if the first lien lenders had perfected its liens.
Take the following example: The first lien loan is $100, the second lien loan is $100, and trade claims are $100. In addition, assume the value of assets constituting shared collateral is $125 and the value of unencumbered assets is $100. Ordinarily, if the first and second lien are properly perfected, in a hypothetical bankruptcy liquidation, the first lien would receive $100, the second lien would receive $67.8 (equal to $25 for its allowed secured claim plus $42.8 for its deficiency claim as diluted by unsecured creditors), and the trade would receive $57.2. If the first lien failed to perfect, absent a specialized turnover provision addressing non-perfection, the first lien would receive $62.5, the second would receive $100 (having an allowed secured claim equal to the entire amount owed to it as the only secured creditor), and the trade would receive $62.5. If the turnover were to require the second to turn over the proceeds of collateral until the first is paid in full, the second would be required to turn over $37.5, leaving the first with 100, the second with $62.5, less than it would have received if the first lien had perfected. Moreover, this results from a risk that only the first lien was in a position to manage. In short, should second lien lenders be put in a worse position by a mistake on the part of the first lien lenders?
Right to Seek Adequate Protection
First lien lenders often propose intercreditor arrangements that require second lien lenders to waive their right to seek adequate protection and object to the use of their cash collateral. Absent an intercreditor arrangement, a secured creditor is entitled to adequate protection from the diminution in value of collateral resulting from the use of such collateral in the case. By waiving the right to seek adequate protection and the right to object to the use of cash collateral, a second lien lender is agreeing to absorb the risk of diminution in value of collateral without being heard. The first lien lenders will generally grant the second lien lenders some form of adequate protection; typically, at a minimum, the second lien lenders will receive “tag-along” rights to receive junior replacement liens and junior liens on any additional collateral for which the first lien lenders may bargain. The market also increasingly accepts the right of the second lien lenders to seek a “tag-along” junior superpriority claim. Adequate protection in the form of the right to seek current payment of interest and professional fees is still contested, and discussions regarding broader rights to seek adequate protection are likely to be contentious.
A second lien lender’s ability to seek current payment of interest after a bankruptcy filing may provide such lender with the opportunity to recover on their loan even if the first lien lender has not been paid in full. If the borrower has sufficient cash flow to pay post-petition interest, absent a waiver of such right, the secured lenders will often receive post-petition interest as partial adequate protection. This protection, however, is often subject to a proviso negotiated by the creditors’ committee; if it is ultimately determined that the lender is not oversecured (the condition to ultimate entitlement to post-petition interest), the amounts paid will be deemed to have been applied to reduce the principal amount of the debt. Where a second lien lender has successfully bargained for post-petition interest, the first lien lender will not be able to recover such payments unless the first lien lender has bargained for disgorgement of the payments to the second lien lenders, a provision not often seen in intercreditor agreements. Absent such a disgorgement provision, the second lien lenders will keep such payments, even if applied to principal, whether or not the first lien lender is ultimately paid in full.
Waiver of Rights that Unsecured Creditors Would Enjoy in a Bankruptcy Case
Secured and unsecured creditors alike enjoy certain basic rights. Among those rights are (i) the right to object and otherwise be heard on any issue before the court, (ii) the right to file and defend their claim, and (iii) the right to support or oppose any plan, or even to propose their own plan (if exclusivity has been lifted). First lien lenders have sought to curtail and in some instances eliminate the second lien lender’s ability to exercise the above-described rights. Ironically, in such instances, the “junior” unsecured creditors will retain those rights.
Right to Object to First Lien Lender’s Debtor-in-Possession Financing. First lien lenders typically require that second lien lenders waive their right to object to debtor in possession financing that is arranged or financed by the first lien lender. For first lien lenders, the issue is maximum control in any case in bankruptcy. Accordingly, first lien lenders are reluctant to compromise. Nonetheless, some second lien lenders are asking for, in addition to a hard cap on the amount of first lien debt (including debtor in possession financing), the right to object to the debtor in possession financing of the first lien lender on the grounds that the financing is not on commercially reasonable terms or that contains any terms relating to the provisions of a plan of reorganization. In addition, a second lien lender may seek the right to propose its own debtor-in-possession financing, or to participate in the syndication of any first lien debtor-in-possession financing.
Right to Object to First Lien Lender’s Use of Cash Collateral. First lien lenders have also been asking that second lien lenders waive their right to object to the use of cash collateral approved by the first lien lenders. Ordinarily, when the company is an operating company, cash is not likely to be a major part of the financing of a restructuring. In transactions such as project deals, where large reserves have been set aside for interest and construction expense, there may be reason for second lien lenders to take a different view. Early difficulty in a project theoretically could lead to a restructuring of the project using cash making the debtor-in-possession financing cap somewhat meaningless. As project second lien deals evolve there may be movement in this area to more limited rights to use cash collateral without the consent of the seconds in certain circumstances. In addition, where cash interest reserves have been set aside for the second lien lenders, they may ask for and receive a first lien on such cash interest reserves. Where they do not receive a first lien on the second lien interest account, second lien lenders are compromising a reserve the second lien funded for the benefit of the first liens.
Waiver of Right to Vote Claim in Connection with the Approval of a Plan. Some first lien lenders are asking second lien lenders to waive their right to vote their claim in connection with the approval of a plan of reorganization. From the first lien lender’s point of view, a silent second lien implies that the first lien lender will be directing the voting of the senior secured claim in bankruptcy as if the second lien lender did not exist. From the second lien lender’s perspective, waiving the right to vote one’s claim in bankruptcy is waiving a right fundamental to being a claimholder, let alone to being a secured claimholder.
Waiver of Right to Propose any Plan that Impairs First Lien Debt. First lien lenders sometimes ask second lien lenders to waive the right to propose a plan that impairs the first lien debt. These waivers typically do not prevent a second lien lender from voting for a plan that impairs the first lien debt. From the first lien lender’s perspective, this waiver preserves control over the case vis-à-vis the second lien lender where payment in full of the first lien debt is not certain. From the second lien lender’s perspective, the waiver impairs the second lien lender’s bargaining power in a case in bankruptcy, and waives rights that an unsecured creditor would have.
Covenant Defaults and Exercise of Remedies
In many deals, the first lien and second lien debt have identical covenants, including financial covenants. In such a mirror-document deal, upon the occurrence of an event of a default, the first lien and second lien lenders typically have independent rights to waive or exercise remedies. However, in most deals, the second lien lenders will have a waiting period of 120 to 180 days to exercise rights against the collateral upon an event of default. The length of such a waiting period will determine whether and to what extent the second liens will have the leverage to force the borrower into bankruptcy, or credibly threaten such a result. In addition, many second lien loans will cross default to the first lien only after the passage of 30 to 45 days.
Depending on the facts and circumstances of the particular deal, there may be greater control of covenants by either the first lien lenders or the seconds. In widely syndicated deals, the covenant protection granted to the second lien lenders will likely be very light. On the other hand, we have seen in certain private and club deals where the seconds have been able to negotiate tighter financial covenants in the second lien credit agreement, pursuant to the rationale that if the enterprise value of the company slips, it is the second lien lender that will be at greater risk.
Right of Second Lien Debt to Buy Out First Lien Debt and Any DIP Financing at Par Plus Accrued Interest
Second lien loan agreements typically include the right of the second lien debt to purchase the first lien debt and/or the DIP financing at par plus accrued interest (without any prepayment penalty). This right is increasingly limited to a very short window after acceleration by the first lien lenders, and the right of the second lien lender to exercise a par purchase option has become somewhat of a battleground. Obviously, a broader right to take out the first lien debt is preferred for the second lien lender.
While the second lien loan product has great appeal — a higher rate of return and access to collateral — and the market has clearly matured, the product is not without significant uncertainty. Investors should take extra precautions to review and understand the effect of intercreditor arrangements. By focusing on the key intercreditor issues, and recognizing the value components of compromises contained therein, second lien lenders and secondary market purchasers may be able to identify potential hidden value and/or tactical leverage opportunities in certain deals. Intercreditor rights will become critical as highly leveraged second lien deals default — a fate that many expected in 2006 and still more expect in 2007.