The Ever- Changing Layer Cake of Junior Capital Financing and Intercreditor Agreements With the surge of junior capital growth in recent years, providers have had to become more creative than ever in structuring their loan documents and intercreditor relationships.

by Steven M. Ellis and We will describe below some of the that is paid-in-kind (PIK) by the issuance Stephen A. Boyko more commonly seen layers in the junior of additional notes. It is sometimes Ten years ago, the only junior capital capital cake as well as some of the more accompanied by warrants to purchase product readily available in the market exotic structures. For brevity’s sake, common or preferred stock of the bor- was the mezzanine loan (subordinated we will not discuss a number of other rower. The significant components of debt). Things have changed dramatically. products that regularly cross our desks the intercreditor agreement for this In the past five years alone, there has such as holdco notes, toxic holdco notes, layer are: been an explosion of new products of- redeemable preferred stock, convertible w Payment subordination. Upon the fered between senior debt and common preferred stock and the like. While some occurrence of an event of default equity. These products are commonly of the layers have now become perma- under the senior credit documents, referred to as junior capital. As an asset nent fixtures in the market, we expect payments on the subordinated debt class, junior capital has grown exponen- that structures and terms will con- are typically blocked for 180 days tially over the past several years. tinue to evolve as competition in junior (and typically blocked permanently The robust M&A and buyout markets capital market increases and lenders if there is a payment default). During have helped fuel this growth as hedge and their lawyers look for a competitive this blockage period, the subordinat- funds, CLOs (collateralized loan obliga- advantage to win deals. ed lender cannot receive payments tions), BDCs (business development on the subordinated debt. companies) SBICs (small business invest- The Traditional Mezzanine Layer w Remedies standstill. Another corner- ment companies) and mezzanine funds, The traditional unsecured mezzanine stone of the mezzanine structure is among others, have competed to find loan remains an active and robust part the remedies standstill. During the and finance the most attractive deals. of the junior capital world. Mezzanine remedies standstill (typically 120 to This competition has forced junior capi- loans have been around for a long time, 180 days), the subordinated lender is tal providers to become more creative and the intercreditor agreements in prohibited from exercising remedies in structuring their loan documents these deals have become “market” on or taking enforcement action against and intercreditor relationships. Junior many basic terms. A mezzanine loan the borrower for breach of the mez- capital is no longer a one-trick pony, but is unsecured and subordinated to the zanine loan agreement. rather a layer cake of financing options. senior lender’s loan with respect to the w Cap on senior debt. From the subordi- To describe junior capital as mezzanine right to receive payments. A mezza- nated lender’s perspective, probably debt and second lien debt ignores the nine loan has a cash coupon of 10 to 18 the most important provision in the reality of the complex and diverse struc- percent, and often has an additional subordination agreement is the cap tures that now exist. noncash coupon of two to four percent on senior debt. In these agreements,

the secured lender maY/JUNE 2008 41 there is typically a cap on the amount any proceeds to the mezzanine lender. you’re in the syndicated market. The rea- of senior debt that can be piled on In a bankruptcy, a secured mezzanine son: in the syndicated market the deals top of the subordinated debt—usual- lender typically agrees to waive all of are oversubscribed and many lenders ly consisting of the amount of senior the enhanced protections that it is en- do not even read the documents. Hence, debt committed at closing plus a 10 titled to receive as a result of its status there is little or no negotiating leverage. percent cushion. as a secured creditor, such as the right In contrast, in the private market there w Restrictions on amendments. The sub- to seek adequate protection or postpeti- are typically a handful of lenders in a ordination agreement also contains tion interest with respect to its secured deal (typically two or three) and these restrictions on amendments to the claim. All of the other bells and whistles lenders aggressively negotiate the terms senior and mezzanine documents in a traditional mezzanine intercreditor of the intercreditor agreement. with respect to, among other things, are in effect—the standstill, the block- interest rates, extending maturity age periods, the limits on senior debt, In the private market, the major friction dates and tightening covenants. etc. points in the intercreditor agreement are: w Freedom to act in bankruptcy. In a To get the benefits of the lien, the w “Plumber Rights”—Preserving Unse- bankruptcy the unsecured mezzanine mezzanine lender must accept a funda- cured Creditor Rights. A second lien creditor is free to pursue its rights as mental premise: it will not use its lien as lender doesn’t want to be treated an unsecured creditor and to object a sword against the senior lender. The worse than an unsecured creditor to actions taken by the senior lender value is purely downside protection. To (e.g., a plumber with an overdue (with the exception of attacking the the extent the borrower liquidates or invoice). The plumber issue is one senior lender’s lien or claim). is sold, the mezzanine lender with the that ripples through the intercreditor silent second lien is a secured creditor agreement—often there are waivers The Secured Mezzanine Layer that must be paid in full before any of the right to object to asset sales, (The Silent Second) unsecured creditors are paid. So, by foreclosure actions, debtor-in-posses- A secured mezzanine loan is the same as obtaining a silent second, a mezzanine sion financings, etc. A plumber has a traditional mezzanine loan except that lender leapfrogs the unsecured creditors the right to object to all of these ac- the mezzanine lender receives a lien on (including trade creditors) and ensures tions; so should second lien lenders. A the assets of the borrower. This lien is es- that it will be paid before them in a sale second lien lender should only waive sentially no different from the lien that or liquidation. its right to object to these matters in the senior lender obtains against the as- its capacity as a secured creditor. sets of the borrower. The subordinated The Private Second Lien Layer w Cap on First Lien Debt. Similar to a lender has its own security agreement. The rise of the second lien market is mezzanine loan, a second lien loan Its lien is perfected by UCC filings, mort- well documented, and the second lien, typically has a cap on the amount of gages, control agreements and the like. virtually unheard of five years ago, now the first lien debt. The cap is usually The security agreements provide for all occupies a significant (and permanent) the amount of first lien debt com- the rights and remedies that you would portion of the layer cake. But what you mitted at closing plus a 10-percent find in the first lien security agreements. may hear or read about the second lien cushion. The cap is then reduced by The differences are found in the market often does not tell the full story. payments on the term loans (amorti- intercreditor. The second lien is “silent” There are two second lien markets: zation, prepayments, etc.) and by per- because the mezzanine lender agrees to the private or “club” market and the manent reductions in the revolving limit its rights and remedies under its se- syndicated market. The private market is commitments. There is also typically curity agreements. A mezzanine lender dominated by traditional junior capital a “waterfall” that subordinates pay- with a silent second lien typically cannot investors and hedge funds. The syndicat- ments on the first lien debt in excess take foreclosure actions against the ed market is dominated by CLOs, prime of the cap until the second lien is paid collateral until the senior debt is paid funds, and ratings oriented investors. in full. Other negotiated items include in full. All of the rights and remedies set The terms of the intercreditor agree- whether there are separate caps forth in the security agreements that ments in these two markets vary dra- for hedges and bank products and allow the mezzanine lender to take col- matically. The easiest way to determine whether changes can be made to the lateral, foreclose on collateral, liquidate if you’re faced with a syndicated second borrowing base that would increase collateral, etc. are limited under the lien is whether you have leverage in the amount of credit available to the terms of the intercreditor agreement. negotiating the intercreditor agreement. borrower. The silent second lien lender agrees To the extent that the issues discussed w The Scope of the Standstill. The heart to discharge its lien if the first lien below are not well received—in fact, it is of a second lien intercreditor is the lender is discharging its lien, regardless common in the syndicated market that standstill. The standstill prevents of whether the underlying sale provides they will be rejected in total—you know the second lien lender from pursuing

42 64TH Annual CFA Convention Registration now open at www.cfa.com! its remedies against the collateral. often provides that the second lien The standstill period runs anywhere is automatically discharged. Second from 3 to 180 days, depending on lien lenders object to this provision the type of collateral (e.g., collateral desiring the ability to determine the that declines rapidly in value, such “commercial reasonableness” of the as produce, typically has a shorter sale before their liens are discharged. standstill). The standstill generally w Adequate Protection. Second lien commences upon an event of default. lenders want to retain the right Then the second lien lender must re- to seek adequate protection in a frain from pursuing any secured credi- bankruptcy proceeding like all other tor remedies against the borrower’s secured creditors. To the extent they assets until the standstill expires. First lien lenders are allowed to seek protection, the One major distinction between a often seek to add a issue becomes what happens when second lien intercreditor agreement and they receive it. If the adequate protec- a mezzanine intercreditor agreement is mezzanine concept tion is in the form of cash, the parties that there is no payment subordination to the intercredi- then negotiate how the cash is to be in a second lien intercreditor. Also, no tor agreement that applied. If the adequate protection is general remedies standstill prevents in the form of a lien on post-petition the second lien lender from demanding provides which, if assets, the second lien lenders gener- payment or accelerating the first lien is ally agree to subordinate its debt. avoided, subordinated or oth- their lien to the lien of the w “Big Boy” Risk. First lien first lien lender. lenders often seek to erwise set aside in a bankrupt- w Bankruptcy Issues. add a mezzanine con- cy or otherwise, the second Several bankruptcy issues cept to the intercreditor lien lender is still required arise in second lien inter- agreement that provides creditor agreements. These which, if the first lien is to turn over any proceeds issues may relate to retain- avoided, subordinated or it receives from the collat- ing “plumber rights,” the otherwise set aside in a eral, as if nothing happened. ability to object to debtor- bankruptcy or other- in-possession financing wise, the second lien and 363 sales; whether the lender is still required second lien lenders can to turn over any proceeds it receives caps on recurring fees, subordination seek relief of the automatic stay, etc. from the collateral, as if nothing hap- of the first lien debt to other debt, w Purchase Options. Almost all private pened. Second lien lenders generally tightening or adding covenants or second lien deals contain a purchase take the position that the lenders are events of default. The second lien option. It allows the second lien all “big boys” and each is responsible lender often insists that limits on lender to purchase the first lien debt for ensuring that their liens are valid amendments be reciprocal; that is, no at par. The issues that frequently and enforceable. A number of compro- tighter restrictions on the second lien arise in negotiating purchase options mises to settle this issue have grown than the first lien. are the triggers for the option, the out of battles between first lien and w Release of Liens. First lien lend- scope of the option and the time second lien lenders over the years. ers would like second lien lenders period the option is exercisable. Trig- w Amendments to Documents. First to discharge their liens if the first gers for the option typically include lien lenders and second lien lenders lien lenders are prepared to do so. one or more of the following: a first agree that certain amendments to Second lien lenders certainly agree lien default, a payment default on the their documents are not permitted that their liens will be released to first lien or the second lien, a first lien without the other’s consent. First lien the extent the release is permitted acceleration event or an exercise of lenders typically agree not to exceed under the second lien documents. remedies by the first lien lender. The the first lien debt cap or increase in- Where they stop short, however, is parties also negotiate whether the terest rates beyond a certain number when the first lien debt is foreclosing second lien lenders are required to of basis points. But other limitations after event of default or where the compensate the first lien lenders for are usually discussed, such as limits borrower decides to sell its assets prepayment penalties, bank product on extending or accelerating maturity after the event of default. The first obligations and amounts in excess of dates or amortization payments, draft of an intercreditor agreement the first lien debt cap. Often, the par-

44 64TH Annual CFA Convention Registration now open at www.cfa.com! ties also discuss whether the and typically cannot be commenced collateral without any interference from purchase option will be “evergreen” until the second lien debt is accelerated. the revolving lender. The intercreditor or whether it terminates after a cer- No limits exist on the ability of the first agreement primarily deals with lien sub- tain period of time (a “use it or lose it” lien lender to make amendments to its ordination. The key issue in these deals option). documents, other than amendments is access to the collateral. The working w Voting on a Plan of Reorganization. that would result in a breach of the first capital lender needs access to the prem- The second lien lender will insist on lien debt cap or an increase in the inter- ises, equipment and books and records having the unfettered right to vote est rate beyond a negotiated number of to complete work in process, and to on a plan on reorganization. This is basis points. In a syndicated second lien liquidate inventory and receivables. The generally nonnegotiable. transaction, the second lien lenders are enterprise value lender wants to ensure w Removal of Agent. In first lien-second treated more like equity than debt. This that it is adequately indemnified for any lien structures, the agent of the first is completely different from a private damage to its collateral from the use lien is often the agent for the second second lien deal. Thus, an investor by the revolving lender and adequately lien. The second lien lenders will want considering a purchase of a syndicated compensated for any costs and expens- to make sure that they have the ability second lien loan should be cognizant of es that occur, such as keeping the lights to remove the first lien agent as their the obligations that it is stepping into on or maintaining security. agent after an event of default. The under the intercreditor agreement. This concern is a practical one. Will the is especially important for distressed The Last-out Layer first lien agent pursue remedies on investors. The last-out structure has been around their behalf, especially if the second for a long time. Unlike the previous lien lenders are exercising “plumber The Split or Reciprocal layers, this layer simply has one credit rights” and objecting to actions of Collateral Layer agreement with a payment waterfall the first lien lenders? Given that time The split collateral deal has become that provides that one tranche of the is often of the essence, any delays in more common as different types of debt within the credit facility will be exercising the right could prove detri- lenders with different risk profiles team paid out last, after a senior “first-out” mental to the second lien lenders. up to get deals done. Where one lender tranche is paid in full. All mandatory pre- is a working capital lender and the other payments and liquidation proceeds are The Syndicated Second Lien Layer is an enterprise value lender, a split paid to the first-out lender before the In the syndicated world, there are typi- collateral deal makes sense. These deals last-out lender receives any proceeds. cally a number of second lien lenders are typically structured in the follow- In these structures, an agreement interested in a particular credit. It is a ing manner: The working capital lender often notes how the various tranches of competitive process. If a second lien takes a first lien on the working capital lenders are to interact with each other. lender decides to argue about the terms assets—cash, receivables and inventory. Sometimes it is a simple agreement of the intercreditor agreement, gener- The enterprise value lender takes a first where lenders which hold a requisite per- ally other lenders are willing to step in lien on the remaining assets—typically centage of the loan will control all mat- and take their allocation. Competition hard assets such as real estate and ters (e.g., lenders who hold more than for deal flow is intense, and this compe- equipment. Then, each takes a junior 50% of the outstanding principal amount tition limits the ability of prospective lien on the other’s assets. To illustrate: of the loan will control waivers and second lien lenders to negotiate the the working capital lender with a first amendments). Other times, a complex terms of intercreditor agreements. In lien on the liquid assets takes a second intercreditor or interlender agreement these agreements second lien lenders lien on the hard assets. Similarly, the will specify the rights associated with provide extensive waivers of their rights. enterprise value lender with a first lien each tranche of debt (e.g., which class of Many issues that they found successful on the hard assets takes a second lien on lenders control enforcement actions and in negotiating in private deals are lost the liquid assets. which class of lenders are subject to a in these negotiations; for example: the The intercreditor negotiations in standstill, which lenders control amend- ability to object to a release of collateral, these types of deals are limited. The ments and which lenders have consent a debtor-in-possession financing or a parties typically agree to leave the rights over certain items, etc.). sale of assets, and the ability to retain other party’s collateral alone. The The parties must work through the “plumber rights” both prior to and dur- working capital lender generally has credit documents and decide who has ing a bankruptcy. the ultimate right to proceed against control and veto rights with respect to In a syndicated deal, the second the liquid assets without any blocks or specific issues. The control of the issues lien lenders are often worse off than limits from the enterprise value lender, may also flip back and forth as leverage unsecured creditors. The standstills are and the enterprise value lender has a of the company goes up and down or typically longer than in private deals similar right to proceed against the hard as the amount of the debt each lender

46 64TH Annual CFA Convention Registration now open at www.cfa.com! holds goes up and down. Negotiating financings. The junior capital lender has has little covenant protection and also these agreements is often the most dif- more ability to control changes to the has limited control prior to a triggering ficult part of the transaction. first lien document than in traditional event. The first lien may be “dragged” into structures. The junior claim is classified amendments and waivers to the first lien The Unitranche Layer together with the rest of the first lien in documents, as long as a corresponding A unitranche deal is similar to a last-out a bankruptcy, which allows for postpeti- amendment or waiver is being made to deal in that it has one loan agreement. tion interest to the extent that the first the second lien documents. The upside But unlike the last-out deal, a unitranche lien is over-secured. The junior claim is down intercreditor agreement reverses has one tranche of debt where the also entitled to adequate protection the usual situation where the first lien blended cost of capital is roughly equal payments, which is not customary in a lender has the most control over what to that in a multitranche transaction. traditional mezzanine transaction. happens when the borrower violates cov- Loans can be held by one lender, sold off There are also serious disadvantages enants. In this structure, senior lenders’ in strips or sold off in first-out, last-out in a synthetic structure. There is only rights are limited to those that are usually pieces. Similar to a last-out transaction, one loan agreement, and that agree- afforded to the second lien lender. This the intercreditor arrangements can ment is unable to provide both sets of structure is not for every deal. In a typical range from no intercreditor (relying lenders with the rights that they are deal, the second lien is much larger than on the required lenders vote), to a very accustomed to receiving. For example, the first lien and the first-out lender is complex intercreditor agreement that a junior lender’s unilateral right to often in a solid collateral position. may be negotiated behind the scenes control its destiny with respect to While we have done a number of (without the company or the sponsor’s calling defaults or agreeing to a waiver these transactions, so far none of the knowledge). is curtailed. Instead, the intercreditor traditional first-lien, regulated lenders agreement specifies the circumstances have bought into a silent first deal. But The Synthetic Layer in which the junior lender has influence. it is clearly a product that has traction Synthetic structures have most often If the junior lender becomes a lender by as lenders are trying to find new ways to been used to replicate the economics assignment after the deal has been cut compete for deals. Whether this upside and intercreditor relationship of a tradi- with the borrower, the junior lender has down product will survive a pull back in tional mezzanine loan. A synthetic struc- little-to-no leverage to amend the agree- the debt markets, is unclear. It may fall ture is a one-loan agreement structure (a ments with the borrower. In these struc- in the wake of the covenant-lite deals one-stop or unitranche loan). From the tures, junior creditors typically do not that seemed to be everywhere, and then borrower’s perspective, all of the lenders have a separate agent for their tranche. all of sudden disappeared without trace. are participating in the same tranche Instead, they need to direct the first The layer cake of junior capital has with the same pricing. But behind the lien agent to take action, which may be evolved to meet the needs of the market. scenes a synthetic senior tranche is impractical in a restructuring or default Some of the layers we have discussed created by an intercreditor agreement. situation. Borrowers are typically un- are growing while others are shrinking. It is typically a complicated and highly aware of the synthetic structure, which Some are not changing; others are. The negotiated intercreditor agreement. The may result in contentious discussions, greatest opportunity for lenders who agreement attempts to create syntheti- or perhaps litigation, as these synthetic play in this space is understanding the cally a typical mezzanine structure. It structures unwind in a workout or bank- complexities of junior capital layer cake may provide for remedy standstills and ruptcy proceeding. and embracing this change. New layers payment blocks as in a mezzanine agree- will be added to the cake in the near ment. It may provide the junior lender The Upside Down Layer future as the market conditions change the ability to consent to amendments One of the newest and most exotic pieces and as distressed debt players look to or waivers of the financial covenants if of the layer cake is the “upside down” junior capital as a fertile ground to feed the deviation from the stated covenant intercreditor or the “silent first lien.” An their next wave of deal flow.TSL is more than 10 to 15 percent. A mutual upside down, silent first lien provides buyout option often exists where the se- the senior lender with first-out rights Steven M. Ellis and Stephen A. Boyko are nior and the junior lender can buy each with respect to payments and proceeds partners and co-heads of the Junior Capital other out upon certain triggering events. from collateral. The first-out lender often Group at Proskauer Rose LLP. The advantages of the synthetic receives increased pricing in exchange for structure are numerous. The junior ceding control of the credit to the second lender has a first priority security inter- lien lender until the occurrence of a trig- est in the borrower’s assets. There is gering event (often a payment default or faster execution with a one-stop loan a material breach of a financial covenant). than with a series of multitranche But otherwise, the first lien is silent; it

48 64TH Annual CFA Convention Registration now open at www.cfa.com!