Second Liens: Borrower Beware

Used wisely, second-lien loans can be a powerful funding tool, but finance chiefs should take care before signing on the dotted line.

Since the credit crunch of the early 2000s, non-investment grade companies and financially strapped businesses have used second-lien loans as a less-expensive alternative to senior-lien loans and to stock and bond issues. Used wisely, they can be a powerful funding tool for companies with limited access to the capital markets; Krispy Kreme Doughnuts Inc. and the Goodyear Tire & Rubber Co. each have tapped this market in recent months.

Despite attractive rates, however, and the current general willingness of lenders to part with funds, finance chiefs should take care before signing on the dotted line, says Ricardo Chance, a managing director at Trenwith Securities, an independent investment banking affiliate of audit firm BDO Seidman.

“Second liens are not something you expect to keep on your balance sheet forever. They are a transition, a bridge to something else,” he observes, adding that many executives haven’t figured out “where the bridge will lead.”

Oftentimes, says the banker, companies looking for a “rescue” from second-lien loans “leverage up” without addressing financial or operational problems. Take a highly leveraged company with anemic cash flow, he muses, mix in rising interest rates or falling credit ratings, and you have the recipe for a default that can force an asset sale — even the sale of the entire company.

Board members and executives that agree to second-lien loans, insists Chance, must make tough decisions about reworking the company’s cost structure, capital structure, and management if the business is to survive.

Cleaning Up the Leftovers

For a second-lien loan, as with any lien, a borrower offers collateral in the form of tangible or intangible assets. In the case of default, lien holders generally renegotiate the terms, but they have the right to sell the collateral to recover the principle and sometimes the interest. Second-lien holders are second in line to recover money from a collateral sell-off, behind senior (first-lien) holders but ahead of unsecured bondholders, trade creditors, and stockholders.

Since these loans pose more of a risk to a lender than senior debt, the borrower’s cost of capital will be higher. The fact that second-lien loans use “leftover collateral” raises an additional concern, says William Lenhart, a national director with BDO Seidman’s Financial Recovery Services practice.

First-lien loans generally use 70 to 80 percent of a company’s assets, including intangibles, as collateral, explains Lenhart; second-lien loans use whatever assets remain. In the unfortunate event of a collateral sell-off, he adds, a troubled company may have nothing left on which to base a recovery.

Lenhart observes that management’s intent, of course, would be to use those second-lien proceeds to rebuild the company’s finances and operations, and in fact that’s what most companies do. Standard & Poor’s leveraged markets analyst Steve Miller says that proceeds of second-lien loans generally are used to refinance more expensive debt, to pay down bank loans, to fund dividend payouts, or to add operating cash to the balance sheet.

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