Capital Markets

Pushing the Cushion

Second-lien loans are a booming market. But will the hedge fund investors that back it stick around if times get tight?
Rob GarverSeptember 6, 2006

Companies that have maxed out their asset-based borrowing capabilities are increasingly able to find additional financing from lenders willing to take a back seat to other creditors by funding second-lien loans.

The total dollar value of outstanding second-lien credits has exploded in the past few years, going from $570 million in 2002 to over $16 billion in 2005. Through May of this year, total second-lien loan volume was $9.9 billion, according to Dealogic, an 83 percent increase over last year. Over the same period, the average size of second-lien transactions jumped 43 percent to $142 million.

This year, major second-lien deals include a $700-million debtor-in-possession package for Delta airlines and a $700-million credit line for the John Henry Co.

Second-lien borrowing is an attractive alternative for CFOs because it typically offers better terms than subordinated debt and allows companies to tap an unused portion of its assets for use as collateral. At the same time, it is attractive to lenders because it is a secured asset, making it less risky than standard mezzanine finance positions.

In a typical first-lien loan, the lender will discount the assessed value of the borrower’s collateral by about 15 percent, creating a cushion against depreciation, and fund a loan up to that discounted value. In a second lien transaction, the lender will, in exchange for a higher interest rate, accept the residual value of the collateral as security for additional funding.

In more than a decade of advising companies on corporate finance, Bradley E. Kotler, an attorney in the Chicago office of Latham & Watkins, has watched second-lien lending grow into what he believes is a permanent fixture on the financial landscape — and one that has, in many cases, become preferable to typical mezzanine finance deals.

“It really has taken a lot of the steam out of the mezzanine lenders and the bond market,” he says. “It is a cheaper vehicle from a transaction cost standpoint and in terms of the interest rate.”

It’s a vehicle that can be particularly attractive to non-public companies that haven’t had to go to the expense of complying with Sarbanes-Oxley disclosure provisions. A standard bond issue would invoke many of those requirements, negating a portion of any of the cash raised by the deal.

The combination of the Sarbanes-Oxley strictures and investor disinterest in the relatively low-yield bond market in recent years has created a sort of “perfect storm” in favor of second-lien financing says Kotler, in which borrowers avoid the transaction costs of going to the bond market and the discounts associated with unsecured borrowings, while investors get a collateral-secured interest-bearing asset.

With much of the capital funding these loans flowing from hedge funds, the growth in second-lien liquidity is not expected to slow anytime soon. Hedge fund investment capital, estimated at about $500 million in 2000, had doubled to $1.1 trillion in 2005, and is expected to nearly double again to $2.1 trillion by 2010, according to Hedge Fund Research.

But that doesn’t mean that there are no concerns about the impact of second-lien lending.

Although he regards second lien lending as a now-permanent factor in corporate finance and “an important piece of the capital structure,” Bank of America Business Capital executive vice president Robert C. Rubino points out one concern: These credits — and the creditors themselves — have never been tested in a serious economic downturn.

Compared to banks, which have whole departments dedicated to managing loans to borrowers whose businesses have hit hard times, “there is not a lot of work-out experience in the second-lien shops,” he says.

When default looms, hedge funds may look to sell off their interest in a second-lien loan and swallow whatever loss they take — but in an extended market downturn, the market for distressed credit quickly dries up.

What a hedge fund will do with a borrower that needs to work out an extended repayment plan under adverse market conditions remains to be seen, and may impact the availability of second-lien credit in the future.