The European private equity community is currently talking about the use of 'second lien' strips in European leveraged finance structures. This year, the high profile Brenntag, Invensys, Cognis and Samsonite deals (amongst others) have all included second lien debt in their structures. Second liens are a financing technique which has been imported from the United States. Whilst not a new technique, second liens have reappeared this year as a result of current market conditions and the need to exploit the liquidity offered by hedge funds, insurance companies, CDO and CLO vehicles (and the like) and other institutional lenders. This article explains what second liens are; why they may be an option on some deals and goes on to highlight some of the structuring issues which need to be considered if second liens are to be included in European deals.
WHAT IS SECOND LIEN DEBT?
Due to the differing natures of the insolvency regimes and types of security available in the US and in Europe and also in the classes of institutional lenders operating in the different markets, the US second lien model is changed in some significant ways when it is used in the European market.
THE US MODEL
In the US, 'second lien' financing is a term used both in the capital markets in relation to second lien bond financings and in the institutional investor loan markets in relation to second lien loans. As this article looks at the use of second liens in the context of European LBO financings, we only consider second lien loans (which have sometimes also been called 'junior' or 'junior subordinated' debt tranches).
US second lien loans are designed to appeal to institutional lenders who cannot participate in subordinated debt, such as traditional mezzanine, because their constitutions constrain them from investing in subordinated debt. Institutional investors make up 70 – 80% of the leveraged finance market in the US (constituting a different audience from Europe). Second lien loans are neither structurally subordinated nor contractually subordinated to senior debt in the traditional sense. The senior debt and the second lien debt claims can be said to rank equally as the senior lenders are not given the ability to shut-off payments from being made to second lien loan holders in a default scenario. At the same time, the holders of the second lien debt hold security over the same assets as the senior finance parties but agree that on any enforcement of that security the senior finance parties are entitled to be repaid first in full out of the recoveries from that security before any security recoveries can be applied to repay the second lien debt. In other words, it is only the second lien holders' claims to the proceeds of the security package that are subordinated to the senior finance parties' claims to those proceeds. Second lien strips are thought to work best where there is a significant asset-based element to the security as in those circumstances there is more chance of recoveries being left for second lien lenders on enforcement.
This structure means that a second lien loan can carry higher returns than a B or C tranche of senior debt (which otherwise would be the investment of choice for such fettered institutional investors) to reflect the higher risk profile of the instrument. To the extent of their security, the second lien holders rank ahead of trade and unsecured creditors and ahead of any subordinated debt, such as mezzanine or high yield bonds, and the second lien strip is therefore cheaper for the borrower than such subordinated debt.
THE EUROPEAN MODEL
Second liens have been adapted