Number 382 April 15, 2004 Client Alert Latham & Watkins Corporate and Finance Departments Second Lien Financings—Answers to the Most Frequently Asked Questions The purpose of this client alert is to the two most common forms of this new answer some of the most frequently product which are being sold in the asked questions about second lien capital markets—second lien term loans financings. These financings have designed for sale in the institutional become increasingly popular over the loan market and second lien high yield last year or so, and we think they offer a bonds. As we discuss below, there are financing alternative that will remain on many similarities between these two the menu for years to come. There is a products. However, there are also a distinct lack of agreement in the market number of important differences. regarding some of the critical issues that At the end of this client alert, we have bankers and lawyers structuring these included a chart summarizing the key deals must address, and so we will not issues to address in structuring a second always offer a single answer for each of lien financing. The chart indicates how the questions we pose. However, there those issues are currently being There is a growing is also a growing consensus among the “ resolved in the debt markets. consensus among members of the finance community on many of these questions and we are the members pleased to report on that consensus as What is a Second Lien Term Loan? of the finance we see it. A typical second lien term loan is a “term loan B”1 secured by a lien on community on Perhaps the best place to start the substantially all of the borrower’s assets. dialogue is with the question “What is a many of these In some cases, the term loan B will be second lien financing?” The answer to questions and secured equally and ratably with a pari that simple question is surprisingly passu tranche of secured bonds. we are pleased complex. Some second lien deals are Alternatively, the term loan B might be secured mezzanine financings with to report on that the only second lien debt in the capital equity kickers. Others involve seller consensus as structure. In either event, the term loan paper issued in acquisitions to the B lenders will almost certainly be we see it.“ former owners of the acquired business sharing the capital structure with at or notes issued to the borrower’s equity least one other credit facility of the more owners. Still others involve asset-based traditional variety—possibly just a lenders secured by a first lien on current revolver or possibly a term loan and assets and a second lien on property, revolver—secured by a first lien on plant and equipment sharing the substantially the same collateral. The balance sheet with high yield bonds second lien term loan is denominated secured by a first lien on property, plant “second” because the two classes of and equipment and a second lien on creditors agree that, in the event any of current assets. The variations are their shared collateral is ever sold in a endless. In this client alert, we focus on Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. © Copyright 2004 Latham & Watkins. All Rights Reserved. Latham & Watkins | Client Alert foreclosure or other enforcement action, the capital markets at all. Some either before or during a bankruptcy borrowers may also perceive holders of proceeding, the “first lien” credit facility second lien debt to be potentially less (and all other “first lien” obligations, if “volatile” in a distress scenario than any, that are then outstanding) will be unsecured creditors to the extent those entitled to be paid in full before any of holders believe they are sufficiently the proceeds from the shared collateral secured to successfully ride out a period sale will be distributed to the “second of poor financial performance. lien” term loan lenders. The second However, there are costs to the borrower lien term loan is not contractually associated with providing collateral to subordinated in the traditional sense the holders of its junior debt. First, as (i.e., payment subordination), but it is part of the deal structure, the second subordinated in its claim to the proceeds lien covenant package will likely impose of the shared collateral. a more restrictive cap on the amount of additional first lien debt that may be What is a Second Lien Bond Deal? incurred in the future than would appear In its simplest form, a second lien bond in an unsecured high yield bond deal is much the same as a second lien indenture. In addition, depending on the term loan—it involves a bond deal value of the collateral and the cash flow secured by substantially all of the of the enterprise, the borrower’s ability issuer’s assets where the bondholders to obtain first lien financing in the have agreed with the holders of “first future may be impaired by the presence lien” debt that they will be second in of a significant tranche of second lien line as to distributions of proceeds from secured debt on its balance sheet. sales of shared collateral. As in the case Further, the total amount of additional of second lien term loans, the typical second lien debt that may be incurred in second lien bond deal is not the future will also be capped, usually contractually subordinated in the based on a maximum leverage ratio or traditional sense. The bonds are only other financial test. Finally, it may be second in line with respect to the harder for the borrower to tap the proceeds from sales of shared collateral. unsecured debt market in the future These bonds are usually called “senior because future unsecured creditors of secured notes” or “second lien senior the borrower would be effectively secured notes” or some similar variation subordinated to all of the second lien on that theme. debt. What are the Pros and Cons of a Why Would a First Lien Creditor Second Lien Deal for a Company? Want to Permit a Second Lien Deal? A borrower should get better pricing on In general, first lien lenders do not favor a second lien financing than it would by providing collateral to junior creditors. incurring unsecured debt on However, in some cases the proceeds substantially the same terms. In from the second lien deal are needed to addition, a borrower will get broader make a transaction feasible or are access to the debt markets because of earmarked to pay down first lien debt or the tremendous interest in second lien will effectively limit the amount of first paper across a range of institutional lien debt needed going forward. With a investors, including financial lower level of credit exposure, the first institutions, insurance companies, lien lenders may become significantly mutual funds, CBO, CDO and CLO funds more flexible and the increased and hedge funds.2 For some companies, “cushion” provided by the second lien this deeper level of market interest can debt may make the remaining first lien make the difference between being able debt easier to syndicate. In addition, the to do a deal and not having access to first lien creditors can protect their 2 Number 382 | April 15, 2004 Latham & Watkins | Client Alert interests through a lien subordination in the first place. We will then discuss agreement that strips the second lien which of these rights second lien creditors of most of the secured creditor bondholders and second lien lenders rights they might otherwise exercise to may be willing to part with. the detriment of the first lien creditors. This leaves the second lien creditors What is the Difference Between with a “silent second” lien. Debt Subordination and Lien Subordination? Why Would a Junior Creditor Basics. In traditional contractual be Willing to Accept a “Silent subordination, the debt claim itself is Second” Lien? subordinated. If a subordinated debt Even a “silent second” gives a second holder obtains anything of value in a lien creditor effective priority over trade bankruptcy from any source, it agrees to creditors and other unsecured creditors, turn it over to the holders of “senior up to the value of its interest in the debt” until the senior debt is paid in collateral. In terms of payment priority, full. In lien subordination, the liens are “silent second” status does not affect subordinated; the underlying debt claim the value of being secured—a second is not. What this means is that the lien creditor is always better off in this holder of second lien debt only agrees regard than it would be if it were to turn over proceeds from sales of unsecured. In addition, under the lien shared collateral to the holders of first subordination agreement in most deals, lien debt. The holder of a second lien the second lien creditors expressly secured claim does not have to turn over reserve all of the rights of an unsecured funds to the holders of first lien debt creditor, subject to some important distributed to it from other sources. exceptions. Priority vis-à-vis the trade. In its simplest terms, debt subordination places the Some Important Background subordinated debt behind the senior Information debt, but does not place it ahead of any other debt of the borrower (unless So far, we have established that second holders of that other debt agree, in turn, lien debt holders get paid second when to subordinate their debt to the it comes to proceeds of collateral.