Second Liens Are Hooking Dealmakers: Small and mid-cap companies are increasingly using second-lien indebtedness to fund acquisitions, dividend payouts, and other needs

The once staid middle piece of the capital structure, historically filled by so-called mezzanine debt, has become the hottest segment of the buyout financing market. The traditional capital structure of senior debt, mezzanine, and equity has evolved into a much more complicated structure of senior debt, junior or second-lien indebtedness, and equity. Second-lien lending, which basically is backed by the assets of a target company, grows out of the premise that the asset value or enterprise value of the business supports indebtedness in excess of traditional senior debt. With the abundance of private equity and hedge fund capital available for deployment, the second-lien financing market exploded to a volume of almost $14 billion in 2004, about four times the amount floated the year before and up from only $70 million in 2001. The applications show in many capital markets segments. Unable to realize desired returns in the stock market or in distressed debt securities, distressed debt investors and hedge funds are increasingly willing to accept higher risks to gain the more generous returns of second-lien debt. Investors, private equity firms, and corporations increasingly use second-lien debt to finance acquisitions, restructurings, and dividend recaps. Larger second-lien loans may be syndicated, pointing to the widening participation by a broad segment of financial institutions. According to data collected by J.P. Morgan Chase, 40 non-investment grade or unrated companies raised $5.5 billion in second-lien financing during the first quarter of 2005, compared to 139 deals worth $13.8 billion in all of 2004, 26 deals worth $4.1 billion in 2003, and three deals worth only $600 million in 2002. The numbers indicate that second-lien debt is becoming the fastest-growing sub-market for companies to raise money. While junior debt usually is more expensive for companies than first-lien debt, because of extra borrower risk in case of default, this market segment is replacing equity as a financing alternative for companies with financing needs. Second-lien loans are generally non-amortizing until any first-lien debt is repaid and are frequently non-dilutive to borrowers, since lenders may not require warrants or other equity kickers. In April of this year, Goodyear Tire & Rubber Co. became the largest player in the junior debt markets by issuing $1.2 billion in second-lien debt and $300 million in third-lien term loans as part of its debt restructuring. A typical second-lien term loan or “term loan B” is secured by a lien on substantially all assets of the borrower but is subordinated to the senior debt. Second-lien debt typically is more advantageously priced than unsecured debt. But more restrictive cap conditions may be imposed on any subsequent first-lien debt. Pricing also has become much more competitive because increased competition and market growth have drawn new players into the niche. Terms on second-lien loans are shorter than traditional mezzanine debt, at three to five years, and typically provide for no prepayment penalties. However, a borrower may find it difficult to obtain additional unsecured debt because it would be subordinated to both first- and second-lien indebtedness. From the creditors’ perspective, though, second-lien debt is always better than unsecured, providing priority over trade and other unsecured creditors. Second-lien debt has generated tremendous interest among institutional investors, such as insurance companies, financial institutions, and hedge funds, and it provides some companies that may otherwise not have had access to the financial markets with the ability to borrow. For instance, struggling companies, such as Krispy Kreme Doughnuts Inc., Trump Hotels & Casino Resorts Inc., and Anchor Glass Container Corp., have turned to junior debt because they have few other options. Frequently, companies use second-lien debt as a stop-gap measure in a restructuring or to fund operational needs, which can be refinanced at a more advantageous rate when finances or operations warrant lower-cost debt. Small and mid-cap companies are increasingly using second-lien indebtedness to fund acquisitions, dividend payouts, and other needs. Second-lien financing is particularly attractive to asset-rich enterprises in an environment in which asset values are on the upswing, thus increasing the value of the underlying collateral. Lender acceptance of junior debt and the general low interest rate market environment have contributed to the exponential growth in second-lien financings. According to Turnaround Management Association (TMA), as pricing on senior secured loans dropped to a level below LIBOR plus 200 basis points, asset-based lenders are adding junior debt to their proposals. As much as 30% of asset-based loans today are bid together with second-lien loans. The growth of the second-tier debt market has changed the capital structure of a typical middle-market company. According to TMA, a typical second-lien loan in 2000 was leveraged 3.5 times in the capital structure and priced at 14%. In 2004, the leverage multiple has increased to 4.2 times EBITDA through the second-lien financing, cutting the cost of debt to 10% from 14%. Given the size of the second-lien market and the variability of borrowers, there is a wide range of pricing for second-lien loans, from LIBOR plus 6% for larger companies – those with annual EBITDA of greater than $30 million – to as high as prime plus 10% for smaller borrowers. Availability of second-lien debt has brought down the pricing in the mezzanine markets to 12% to 14% and has allowed financial sponsors and, increasingly, strategic buyers to finance acquisitions with leverage multiples as high as 5 to 7 times EBITDA. Private equity sponsors have used second-lien financings extensively in structuring the buyouts. In June, Audax Group financed its $80 million acquisition of TMP Directional Marketing LLC, a phone directory business, from Monster Worldwide Inc. partially by second-lien financing provided by CapitalSource Finance. In 2005, Crescent Capital Investment Inc. bought Tender Loving Care Services out of bankruptcy for $177 million, structuring the deal with $80 million of equity, $50 million of senior first-lien financing, and $47 million of second-lien debt. Second-lien loans have become creative vehicles for hedge funds to acquire control of companies in default because certain junior debt agreements have a conversion-to-equity provision in case of financial distress. As such, second-lien lending becomes an equity play on the part of the investors. If a spike in interest rates and a high debt level sends a borrower into a downward spiral, the creditor could take control of the business without protracted legal proceedings. In bankruptcy, second-lien debt holders are entitled to compensation if the value of the collateral diminishes and cannot be crammed down, except in extraordinary circumstances. Thus, second-lien holders can demand equity for their debt, often at a premium. If not given equity, second-lien holders can block a restructuring. This “loan-to-own” strategy based on the ability to demand equity in a restructuring is one of the reasons hedge funds are so active in the second-lien debt markets. According to Greenwich Associates, in 2004, hedge funds that controlled assets in excess of $1 trillion constituted 82% of distressed debt trading. While the corporate sector currently is in robust health – the global corporate default rate of 0.7% at the end of 2004 was down from 1.7% a year earlier, according to Moody’s Investors Service – it’s unclear what the repercussions for the second-lien market would be in a recessionary economic environment. Current issues of second-lien loans have largely not been tested in a bankruptcy scenario. Meridian Automotive Systems Inc.’s bankruptcy filing in April is one of the first cases in which first-lien debt clashed with the second-lien debt. Hedge funds holding $175 million in second-lien debt are attempting to wrest control of the bankruptcy process with respect to structuring debtor in possession (DIP) and other issues. Second-lien creditors have been pushing for the sale of some of the company’s assets to satisfy their claims. Another case is the fight for control of WestPoint Stevens Inc. between a group led by financier Wilbur Ross, who owns about 53% of the textile maker’s first-lien debt, and Carl Icahn’s Icahn Associates, which controls more than 40% of WestPoint’s first-lien debt and about 52% of second-lien debt. Icahn seeks to convert the debt into majority ownership via a debt-for-equity swap. The case has raised multiple legal and financial issues, including valuation, standing of the second-lien creditors to bid in the auction, and distribution of proceeds among first and second- lien holders, among others. With the economy and M&A activity on the upswing, we expect the second-lien market to remain strong. The need for hedge funds to deploy their money and the lower cost of capital than mezzanine financing should fuel the continued competitiveness and viability of the junior debt markets. Compression in the mezzanine pricing levels is also likely. On the flip side, rising interest rates will substantially impair the borrowers’ ability to service debt. So it is only reasonable to expect that the record number of junior debt financings in 2003 through this year will result in increasing defaults in 2006 and 2007. Alex Kasdan is a Director of Investment Banking, and Erik Wissig is a Vice President, in the Los Angeles office of Trenwith Group, an investment banking, asset management, and valuation firm. (c) 2005 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com