Second-Lien Lending

Why hedge funds can drive the UK market

Niel James, Partner, Winston & Strawn, London

It is an ill wind (or economic down-turn) that brings nobody any good. However, in the UK at the moment, it is not just the challenging business climate which is encouraging the development of second-lien financing. Other more positive developments are also driving this type of funding.

Crucially, the type of player active in the UK secured lending markets has evolved. Now, it's not just traditional bank lenders who participate. It's also hedge funds. New investors such as these will likely accelerate change in, and the growth of, the UK second-lien market. If the United States is any indicator, that market is likely to grow fast: there the value of second-lien loans in the period 1997 to 2002 bumped along at under US$2 billion per year; in 2003 it jumped to just under $4 billion and in 2004 hit a record US$12 billion.

So, what is second-lien lending? What factors common to the U.S. will drive the market in the UK? Are there peculiarities to the UK market which may be an additional spur to the growth of second-lien lending here?

What is second-lien financing?

Second-lien financing encompasses a range of products from term loans to high-yield bonds. It can involve lending to borrowers on an asset-based or cashflow basis, or indeed a hybrid of the two. The second-lien holder might be secured on the same assets as the first-lien holder, or on a completely different asset class from that securing the first.

The key aspect of second-lien lending however is that (where the second-lien holder is sharing the same assets as security as the first-lien holder) the lenders will agree that in the event of any enforcement of security, and realisation of the assets, the proceeds on enforcement will be applied first to the first-ranking security holder and only to the second-ranking security holder once the first-ranking security holder has been paid out.

Observing this general principle, second-lien lenders have worked with first-lien lenders in the United States on many different types of financing structure. In general, both the first-lien lender and the second-lien lender will be secured against exactly the same group of assets. The second-lien lender is calculating that it is secured on the value in those assets in an enforcement situation after the first-lien lender has been paid out.

Alternatively, different groups of assets may be used to secure the first-lien holder as against the second-lien holder. So, the first-ranking lender might be secured against book debts and stock-in-trade, whilst the second-ranking lender might be secured against a piece of equipment or real property. In this situation, the second-lien lender is not secured behind the first-lien lender in the true sense, as the lenders are secured against different asset pools. However, the "second-lien" holder may accept certain restrictions on its enforcement rights, or subordination terms, which will enhance the overall credit position of the "first-lien" holder.

Finally, at the high risk end of these types of financings, a second-lien lender might factor into its calculations an element of "enterprise value" – that in an enforcement, the value ascribed to the business as a whole, additional to that given to the individual assets securing its loan, will allow the second-lien lender to be paid out in full in the event that the borrower is purchased as a going concern.

Given that the rankings between the first-lien holder and the second-lien holder are at the crux of making this type of financing work, the negotiation of the respective positions between the two lenders (or bond holder groups in the public arena) is crucial. Those negotiations (and the security trust deeds and/or intercreditor agreements which result) will focus on a number of familiar issues. These will include:

  • whether there should be caps or restrictions on the ability of the first or the second-lien holder to increase the amount of debt extended to the relevant borrower and secured by its lien;
  • the circumstances in which the second-lien holder might be able to enforce its security interest (or perhaps force the first-lien holder to do so);
  • restrictions or prohibitions on the amendment of the terms of the first-ranking debt and the second-ranking debt;
  • in certain situations, whether the second-lien holder has the option to "buy-out" the debt of the first-lien holder, so promoting itself to the position of first-lien holder in an enforcement.

The negotiations are not likely to be easy. The borrower will also have concerns about the terms of the agreement between the first and second-lien holders (for example, the restrictions which might apply to it raising more money from either the first or the second-lien holder, or from a third party, even if that third party is unsecured). In certain situations (particularly leveraged finance), the lien holders are unlikely to be the only providers of capital. There may also be a mezzanine lender (perhaps unsecured) and/or the vendor providing finance (on a deferred payment basis), as well as equity providers. All of this will make for a complicated and challenging negotiation.

Reasons for growth in the United States…

The expansion in second-lien financing in the United States over the last two to three years has been based on a number of factors some of which are already present in the UK, or are likely to apply here also in the near future.

First, the economic slowdown prompted many U.S. companies to look to second-lien lending as a source of rescue financing (or perhaps refinancing). As their business performance deteriorated and interest rates rose, it became harder for these companies to access more traditional cashflow lending sources and as a result borrowers sought to access debt capital from alternative providers.

Second, alternative capital providers responded to this demand. Newentrants improved the market's liquidity. Typical second-lien lenders include non-bank financial institutions, specialised finance companies, insurers and mezzanine lenders. They also include hedge funds. All of these investors have been looking for the higher returns on their cash that this type of financing provides. For hedge funds in particular, the attractions were clear.

In the acquisition finance market, as deal sizes increased, so capital structures became more demanding, and there was space for the development of second-lien lending. For "senior" first-ranking secured lenders, the "junior" second-ranking second lenders often filled the funding gap to which they could not "stretch". For the borrowers, second-lien financing was generally cheaper than mezzanine funding, and, unlike the traditional provider of private equity, was non-dilutive of ownership (especially attractive to the proprietors of the borrowing enterprise).

Third, certain types of lender, in particular asset-based lenders, became used to the idea of second-lien lender involvement in their transactions. Asset-based lenders focus their attention on the underlying assets of a borrower, linking their lending exposure to the underlying value of the assets securing it. This means that asset-based lenders are generally more comfortable admitting a second-lien lender into the financing equation than are traditional cashflow lenders. An asset-based lender has a greater understanding of what assets secure its loan, and their value, when measured against its exposure to a borrower. So, unlike a cash-flow lender, the asset-based lender is better able to allocate value in an asset (over which it itself has security or which is alternatively unencumbered) to a second-lien lender, without concerns that this prejudices its own position (provided the intercreditor and enforcement position is satisfactory). For asset-based lenders, there is the added attraction that second-lien lending often enhances their own product offering to borrowers, who can leverage their assets further using a second lien in conjunction with the asset-based lender's first-lien debt.

… and reasons to grow in the United Kingdom?

There are a number of reasons to think that second-lien financing will develop here, some of which are shared with the United States market, and others which are peculiar to the UK.

Recent economic circumstances in the UK have been similar to those which have prevailed in the United States. The corporate downturn has lasted longer than many anticipated. As the business environment remains tough, companies here are likely to come under the same pressures which applied in the U.S..

Depressed equity markets, and historically low interest rates, have driven institutions to alternative sectors in their search for good quality investment opportunities and, crucially, higher yields for their cash. Second-lien lending is such an opportunity – for hedge funds, as much as for other investors.

The UK investment (and lending) community has changed. It now includes specialised finance companies, mezzanine funds and hedge funds, as well as asset-based lenders and the traditional bank lenders. All are looking for new homes for their cash.

Additionally, growth in the UK leveraged finance market has meant that more innovative financing structures have to be utilised to fund some of the larger transactions. These deals might now require a combination of senior secured lending, second-lien financing, subordinated unsecured and/or mezzanine financing as well as equity funding in order to succeed. So, the demand for this type of lending is likely to increase as senior lenders and equity sponsors back larger and increasingly complex deals. More highly structured debt arrangements afford more investment opportunities, not just at the primary stage, but also in the secondary phases, particularly for investors such as hedge funds.

As asset-backed lending has found greater support in the UK, so second-lien lending will likely gain greater understanding, particularly amongst borrowers. They will realise that assets can perhaps be leveraged more effectively if made available to a range of lenders, each of which has a particular understanding of that asset and how debt can be raised against it – in effect, the sum of the (debt) parts may end up being greater than the whole (achievable from a single lender). This should contrast favourably with the approach of the traditional relationship lender. Asset-based lending encourages borrowers to leverage assets which might previously simply have been included by a cashflow lender within the general pool but without any real value being ascribed to them. So, for example, financiers and lenders are focusing on assets such as intellectual property, to assess whether or not such an asset could support a second-lien loan (and so achieve a higher effective advance rate than in atraditional cashflow deal).

As in the United States, the character of the UK market is likely to change dramatically in the next few years. The US market now has deep institutional liquidity; the institutional investor base has achieved a critical mass; it includes a wider range of "non-bank" investors, such as hedge funds; the syndicated loan market behaves more like the public capital markets (that is, in the ease with which debt is transferred amongst the investor base); traditional "relationship" banking might be said to have all but disappeared.

In the UK (and perhaps also in the rest of Europe), those changes are now happening – there is still deep bank liquidity, but institutional investors are becoming much more important; the market does not yet behave quite as it does in the United States (so far as the trading of positions between institutional investors is concerned), but with the increasing number of players, this can only be a matter of time; most important however, the whole nature of relationship banking is being questioned, and is likely to break down further, just as it has in the United States. Importantly, all these are factors which should play to the strengths of hedge funds. All of these developments will likely encourage the growth of second-lien lending here.

Some additional UK factors

Aside from the changes already mentioned, there are circumstances peculiar to the UK which will likely also help the advance of second-lien financing, and afford new opportunities for hedge funds here.

First, notwithstanding the reforms which have been implemented by the Enterprise Act and the move towards making the insolvency regime in the UK more of a court-driven process, there is still undoubtedly a much greater certainty of outcome for a secured lender in the UK than there is in the United States.

Whilst it is less likely to occur in relation to a second secured lender than an unsecured lender, in the United States it is still nonetheless possible for a second secured creditor to be "crammed down" at the direction of the bankruptcy court. In the UK this is highly unlikely. As a result, the second-lien holder's ability to protect its position in an administration (in effect, its "seat at the table") is much more secure than might be the case in the United States. There is greater "predictability" here. For a hedge fund, investing in second-ranking debt in the UK is likely to be a whole-lot more secure than doing so in the United States.

Second, now that administrative receivership has in effect been abolished in the UK, the administrator must take account of the concerns of all creditors in an administration. This would include not just the senior secured creditor (which in most instances will be his appointer), and the unsecured creditors, but also the second-lien holder. If it was the case therefore that the administrator of a seasonal business could secure greater realisation proceeds by perhaps delaying the disposal of an asset, he will be under greater pressure to do so than ever an administrative receiver would have been. This is because the administrator must have regard to the interests of all the company's creditors. He will no doubt be encouraged to do so by the presence of a vociferous, second-lien holder, such as a hedge fund!

Conclusion

It can only be a matter of time before second-lien lending takes its place in the UK as a further alternative source of funding for borrowers, as well as a useful addition for senior secured lenders (particularly asset-based lenders) as they increase the size of their deals, and extend the range of financing situations they can accommodate. These already include finance to companies to work through difficult trading situations or to refinance expensive debt or to better leverage their assets. The range of non-senior financing options is set to grow. Second-lien funding is one of those options. As it grows, and the UK market evolves, the investment opportunities for hedge funds here will surely also increase.

Neil James is a partner in Winston & Strawn's London office. He represents various financial institutions and corporates in acquisition, structured and asset-based financing transactions, particularly those with a cross-border dimension.