Lien and mean

No matter how healthy you feel, you can't help but become uneasy when vultures watch your every move.

The upswing in the economy has meant lean times for distressed investors over the past year. But a stack of tantalising carcasses may present themselves as a tasty treats in 18 to 24 months in the form of second-lien loans. In particular, the second-lien loans taken out by private equity sponsors are giving hope to distressed investors across the US. If the economy weakens, or if a company stumbles, many second-lien loans will be hit hard, and the vultures will gleefully swoop down to squat and gobble.

Fans of second-lien loans describe them as a fulfilling an important role in a company's capital structure. I think of them more as mispriced unsecured debt. The way many second-lien loans are structured, holders are not getting the reward for the risk they're taking. Of course, many investors understand risk but are hungry for yield in a lowinterest rate, tight-spread market, so they seek riskier credits.

Second-lien loans are defined as such based on the priority they claim in the event of a bankruptcy. First-lien loan holders will get first claim to a predesignated share of a company's assets, while second-lien holders are junior to these claims.

Many second-lien holders have an exaggerated sense of safety because they are senior in the capital structure to equity holders and people like trade creditors. But in the event of a real bankruptcy, many second-lien holders will be left with claims on next to nothing.

But private equity guys love secondlien loans. General partners are largely behind the enormous surge in secondlien issuances starting last year. Until 2003, the biggest recent year for second- lien loans was 1998, when $690 million worth of these loans were issued. Last year, the volume shot up to $3.26 billion, according to Standard & Poor's. In the first half of 2004 alone, $7.44 billion worth of second-lien loans were issued. The phenomenon is evident everywhere in the market, including the middle market (see charts).

For private equity firms, there is much to love about second-lien loans. They're cheap money. A buyout firm used to have to go to the mezzanine market and get priced at 12 to 14 percent, plus warrants. Now a firm can save 600 basis points through a second- lien loan. The scramble for these types of loans has put a serious squeeze on the mezzanine debt market to adjust their return hurdle and meet the new competitive challenge for capital. (I've recently seen business development companies and other mezzanine providers begin to offer second-lien loans, which is more difficult for them because of their cost of capital.)

For now, the second-lien revolution has been welcomed by – and fueled by – private equity firms. Cheaper debt helps a buyout firm goose its returns in an increasingly competitive environment and in a world with modest growth projections.

In particular, second-lien loans have been lavished on portfolio companies so that GPs can pay fat dividends to their LPs, bolster their IRRs and enjoy a group hug when it's time to raise that next fund.

TIME BOMB
In my view and the views of the distressed investors I speak to, the huge recent batch of second-lien loans represent a ticking time bomb. The vulture investors are sitting back and licking their chops. One recently told me, regarding all the second-lien activity: “This is absolutely great – give it 18 months.”

Granted, many second-lien deals are well structured. There are companies out there with asset values to support the second lien. But many other deals are based on best-of-all-possible-worlds models, where the room for error is limited. Many of the deals structured today are based on overly rosy expectations of growth and aggressive cash flow expectations.

Another problem is that liquidation values on assets are all over the place. If you own a gas pipeline, you might be in good shape. But if you own a specialised manufacturing facility, how much will you really get for your assets? What's the going rate for a demi-widget maker? Situations like this leave the second-lien holders, for all intents and purposes, holding unsecured debt.

Allow me to present two examples of private equity-backed second-lien deals that are being closely watched by distressed investors:

In April, Boston buyout firm JW Childs Associates bought Sunny Delight and Punica, two makers of juice-based drinks. The two companies were merged to form Sunny Delight Beverages. Although Punica is very strong in Europe, the company remains a turnaround story. Since 2000, Sunny Delight's share of the fruit drink market has plummeted on perceptions that the drink is more sugar than fruit. The company recently completed a debt offering that included a $40 million revolver, a $175 million first-lien loan and a $75 million second-lien loan. According to research produced by a debt-investment firm, the liquidation value of the assets supporting the first and second lien notes are somewhere between $100 million and $120 million. In the event of a bankruptcy, that will all go to the first-lien loan holders as recovery for their $175 million in obligations, but the second-lien holders find themselves with no recovery value. That's what's called an unsecured loan. And the outlook for the company remains murky as it refocuses its brand – Moody's recently lowered its credit rating on the second-lien loan to B2 from B1.

An even starker example of a second- lien loan at risk is Atkins Nutritional, which was acquired by Boston's Parthenon Capital a year ago. Parthenon arranged a first-lien loan of $215 million and a second lien of $78.5 million. This structure was based on an asset base of $649 million, but much of that is goodwill, considered “intangible.” Atkins, the low-carb diet marketer, is in danger of becoming yesterday's fad, and its only real asset is its brand, some real estate and perishable inventory. Its liquidation value is conservatively estimated to be roughly $90 million. This is bad news for the second-lien loan holders. Not surprisingly, in July, the second- lien loans were trading in the low- to mid-60 cent range. Now they are trading around 75 cents to 80 cents, but I think this is overly optimistic. The smart money is waiting for the second tub of spaghetti to drop.

Sunny Delight and Atkins are two companies with problematic business plans in a relatively strong economy. (I believe that Sunny D survives and Atkins dies, albeit slowly). If the economy softens or worse, there will be more situations like this. In most cases, the companies in question will not go bankrupt, but will stumble just far enough for distressed players to take advantage of some great investment opportunities. And this is why so many hopeful, hungry vultures are saying “thank you” in advance to the private equity industry.