Second Lien Financing
Credit continues to be readily available for buyouts of all sizes at attractive terms. One notable features of leveraged acquisition financing in the past few years has been the growth of “second lien” debt financing in place of traditional “high yield” debt financing.
As the name suggests, the providers of second-lien financing get a security interest in the underlying collateral, but it is ranked second to the senior debt. Specifically, the second-lien lender agrees to subordinate its security interest to the rights of the senior lender. Over time, as the senor term debt is repaid, the second-lien financing achieves a higher position in the capital structure, as it remains senior to trade and other unsecured debt. Under the Bankruptcy Code, holders of second-lien debt will have priority over unsecured creditors, the right to adequate protection, the right to post-petition interest, and the right to object to sales of collateral unless they are paid in full from the proceeds of sale.
The growth and popularity of second-lien financing has nearly eclipsed traditional high yield financing, especially in large transactions. But even in the mid-tier arena, second-lien financing is making rapid inroads on traditional high yield financing. The difference in pricing between second-lien and high yield financing can be 200 to 300 basis points. Whether the second-lien position is adequate compensation for this reduced interest will be discovered when the next round of defaults and workouts hits the private equity markets.
In many ways, second lien financing is a product of the collateralized loan obligation market. CLOs are pools of capital that invest in collateralized loan obligations. The vast amount of cash that has poured into CLOs in recent years has increased the availability of financing structured as second-lien debt.
