REPRINT PERSPECTIVES ON THE CAPITAL MARKETS F A L L 2 0 0 3

The Junior Secured Tranche B Banks have significantly curbed lending based on cash flow; now companies are turning to junior secured as an alternative. by Michael T. Newsome ver the past several years, unaccept- ...... the business or its assets. These are able rates, substandard returns typically underwritten in one of two ways: and regulatory pressure have led banks To assure capital preservation, O  Asset Based—where the decision fo- and other senior lenders to significantly curb senior lenders have shifted lending that relies principally upon the cash their focus toward more cuses predominately on the liquidation value flow of the business. For growing or restruc- of the assets, net of the senior advances, as turing middle-market companies, filling the conservative, asset-based the ultimate source of repayment; or funding gap between senior secured debt credit structures that are  —where repayment is and without surrendering control is underpinned with predicated on the value of the business as a a challenge. In the void created by the vir- going concern. tual disappearance of cash flow loans, a new interests in assets (). tier of junior secured debt has emerged as a ...... In the case of an asset-based underwrit- supplement to that provides in- ing, the junior lender focuses on the adequa- many companies has declined, leaving room cy of the cushion between the senior lender’s cremental liquidity and . Although for another funding source...... HOW THE LOAN IS UNDERWRITTEN ...... For growing or restructuring This relatively new tier of capital car- Most importantly, buyer ries a variety of labels—junior secured loan, interest and value must be middle market companies, tranche B loan, second loan, or last out filling the funding gap participation. As banks have pulled back, sustainable over time, as an new capital sources, such as hedge funds, unforseen financial setback between senior secured debt specialized finance companies, mezzanine and equity without surrender- lenders, and insurance companies, have that would casue a lender to ing control is a challenge. stepped in to fill the breach in selected situa- rely on business value usually ...... tions where the risk can be reasonably quan- does not develope until several tified and adequately compensated. more expensive than senior secured debt, it These tranche B, or junior secured loans, years after the original financ- may supplant the need for even more expen- meld elements of senior secured term debt, ing was put in place. sive mezzanine or equity. cash flow loans and mezzanine debt. The ...... SENIOR LENDERS SHIFT FOCUS fundamental credit premise is that there is To assure capital preservation, senior value in excess of what a senior lender will advance and the realizable value of the lenders have shifted their focus toward more accept based on the intrinsic value of either assets. The junior lender may also consider conservative, asset-based credit structures the value of assets that are not pledged to the that are underpinned with security interests senior lender. Junior secured loans tend to be in assets (collateral). Secured bank financ- well-suited to situations where the assets are ings are purposely structured to leave a value relatively liquid, value is predictable, and the (HIGH) cushion between the amount of the debt (LOW) costs associated with liquidation are reason- and the realizable or fair market value of the Senior Secured Debt 5-8% ably quantifiable. Typical situations that may borrower’s assets. Many companies have meet these criteria are commodity distribu- experienced a double whammy in the search

N R U T E R tors or retailers where a senior lender is will- for adequate debt financing to take out ma- Junior Secured Debt 10-15% ing to advance 75 to 80 percent of the orderly turing financing arrangements. At the same liquidation value (“OLV”) of inventory (net time that senior lenders have steered clear of of liquidation costs). A junior lender would, cash flow deals and sharpened their reliance Mezzanine Debt 18-22% in turn, consider advancing an incremental on collateral, asset values have been severely PRIORITY 10 to 20 percent of the inventory OLV, par- eroded during the economic downturn. ticularly if other assets, such as trademarks, Bankers are willing to lend against hard col- Equity , or leasehold interests, are avail- lateral, but their take on value is pretty mi- able as additional support. (LOW) (HIGH) serly. As a result, senior borrowing capacity for With the enterprise value method, which

(continued p.2) 1 INSIGHT REPRINT F A L L 2 0 0 3 is akin to cash flow and mezzanine lend- ...... greater risk than senior debt and is priced to ing, lenders consider criteria other than the reflect that increment of added risk. Lenders liquidation value of tangible assets, such as Junior secured debt is com- typically seek all-in annual returns in the 10 the predictability of cash flow, strength of monly viewed as bridge financ- to 15 percent range (in the current low rate management, market position and share, ing that fills the gap until the environment). Depending on the lender, and intangible assets (e.g., brand names, pro- these financings can be arranged on a fixed or prietary technology, distribution territories, borrower can reduce its debt floating (tied to LIBOR or Prime) rate basis. customer base and/or contracts). The junior and bolster performance. Loan pricing is more attractive than the 18 lender is specifically evaluating the value of ...... to 22 percent returns that mezzanine lend- the business enterprise as a going concern, ers target. In addition, a junior secured loan based upon most of the factors that an equity In terms of the hierarchy, generally does not require warrants, so share- investor would weigh. Should the borrower the junior lien lender has priority over any holders do not suffer equity dilution. at some point hit a bump in the road, the , unsecured trade debt and Junior secured debt is commonly viewed junior lender needs to have a high degree contingent claims (by virtue of its security as bridge financing that fills the gap until of confidence that there are readily identifi- interests), and equity. Following an event of the borrower can reduce its debt and bolster able and capable prospective buyers for the default, these lenders generally have rights performance. The typical junior secured loan company, its business units, and/or its strate- and remedies that are comparable to the credit structure has a tenor similar to the gic assets. Most importantly, buyer interest senior lender, other than for their second- borrower’s senior debt, but requires little or and value must be sustainable over time, as ary interest in the assets. The relationship no amortization prior to maturity. In most an unforeseen financial setback that would between the junior and senior lenders is gov- cases, it is refinanced within a couple of years cause a lender to rely on business value usu- erned by an intercreditor agreement. without a prepayment premium. As a con- ally does not develop until several years after In the effort to arrange a junior loan, size sequence, this capital is more flexible than the original financing is put in place. matters. The providers of this tier of capital mezzanine debt. HOW THEY ARE STRUCTURED are looking for borrowers that are not large THE EXTRA EFFORT COULD BE REWARDING Junior secured loans are generally struc- enough to access the public high yield mar- The incremental risk of junior secured tured either as: ket, but still have scale within their indus- debt has proven to be of little interest to tries or markets. Ideal candidates tend to be banks. The field of lenders that is willing to  A subordinated lien behind the senior firms with revenues north of $100 million, lender[s] on all of the borrower’s assets (com- provide what is still a niche product is ex- although smaller companies can also access parable to a second mortgage on a house); or panding, but the market is not yet as well de- this market under the right circumstances. veloped as the mezzanine market. Although  A senior lien on “boot” collateral assets Junior secured loan borrowers are in reason- it may take some effort to find the appropri- (those assets that the senior lender is unwill- ably mature industries where cash flow can ate source for the situation, the potential ing to make a specific advance against). For be focused on debt reduction rather than savings relative to other alternatives can be example, boot collateral might include real capital expenditures or growth. very meaningful.  , leasehold interests, or intellectual GREATER RISK BRINGS HIGHER PRICE property such as trademarks. Obviously, a junior secured loan embodies

ABOUT ZACHARY SCOTT Zachary Scott is an and financial advisory firm founded in 1991 to serve the needs of privately held, middle-market companies. The firm offers a unique combination of in-depth knowledge of the capital markets and industry competitive dynamics, sophisticated analytical capabilities, and proven expertise in structuring and negotiating complex transactions. For more information on Zachary Scott, please go to ZacharyScott.com. Mark D. Working Michael T. Newsome Jay Schembs 1200 Fifth Avenue, Suite 1500 206.224.7382 206.224.7387 206.838.5524 [email protected] [email protected] [email protected] Seattle, Washington 98101 William S. Hanneman Ray D. Rezab Brian J. Kremen www.ZacharyScott.com 206.224.7381 206.224.7386 206.838.5526 [email protected] [email protected] [email protected] Frank S. Buhler Doug Cooper 206.224.7383 206.224.7388 [email protected] [email protected]

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