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.

Witness this month’s $225 million deal announced by financially troubled Krispy Kreme Doughnuts. The arrangement included $150 million in second-lien financing that will be used to repay about $90 million in existing debt and to increase cash on the balance sheet, according to the company.

To take another example, Goodyear announced a $3.65 billion debt-restructuring deal, which included a $1.2 billion second-lien term loan. The interest rate on the new loan, 2.75 percent over the London Interbank Offer Rate (a widely used benchmark for short-term debt), will replace credit facilities due in 2006 that have rates of 4.0 percent and 4.5 percent over LIBOR.

A total of 34 non-investment-grade or unrated companies raised $5 billion worth of second-lien financing during the first quarter of 2005, says S&P’s Miller. That’s an aggressive pace, considering that in all of 2004 — a record-breaking year — 128 companies completed deals that raised $12 billion. In 2003, only 26 such deals were completed, raising $3 billion.

Debt, or an Equity Play?

Why the sudden spike? True, companies may have become more comfortable with second-lien loans, but BDO’s Lenhart suggests that lenders — especially nontraditional lenders such as hedge funds, mutual funds, and distressed-debt traders — are driving demand for what they view as a new high-yield asset class.

Lenhart warns that some of these lenders are looking for more than just principle and interest. “Second-lien loans have become a creative way for hedge-fund managers and other distressed-debt managers to seize control of a company,” he asserts.

Sometimes, observes the recovery expert, companies that react too slowly to financial difficulties are squeezed into a stringent second-lien agreement that includes an equity “kicker” — that is, a loan repaid with equity rather than cash. The seldom-used “exploding warrant” is even more threatening: When a company defaults on its debt service, the agreement “explodes into 51 percent of company equity,” says Trenwith’s Chance. It’s a legitimate lien device, he acknowledges, though he considers it an equity play rather than true debt.

Compared with, say, a leveraged buyout, second-lien defaults are more efficient in terms of timing, expense, and regulatory hurdles for lenders that want to seize control of a company, notes Eliot Relles, a partner with law firm Schulte Roth & Zabel. A spike in interest rates might well set a highly leveraged company on the path to bankruptcy — and possibly into the hands of savvy second-lien lenders.

Chance also cautions executives at troubled companies to tread carefully when arranging for second-lien debt. While the general abundance of capital is “creating a frothy value for distressed companies,” he says, “it may look like debt and smell like debt, but it could be an equity play.”

Marie Leone’s “Capital Ideas” column appears every other Thursday. Contact her at MarieLeone@cfo.com.

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