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.

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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