The appeal of second lien

Anything that catches on in the US market ultimately makes it over to Europe as well. Financing techniques applied in private equity are no exception. The roots of private equity lie very firmly in North America, as do those of the principal financing tools used by it. The most recent example of a US leveraged finance instrument that is starting to make an impression in Europe is the second lien loan.

The concept beneath the strangesounding name is relatively straightforward, but interesting all the same. A second lien loan is simply an additional tranche of senior-like debt. The interesting part is that, although ranking behind the “first lien” holding senior loans, second lien loans are still senior to any mezzanine or high yield debt in the structure. That is why they are often characterised as “senior subordinated,” or “junior” loans, rather than true intermediate capital.

Although occasionally used as a bridge to high yield, a true junior loan is one that is a permanent part of the capital structure, very often sold to banks alongside the senior portions.

Second lien loans aren't entirely new in Europe. The concept has been employed on a number of occasions, although not particularly recently. A notable case in point is the DEM165 million (€80 million equivalent) 9-year HypoVereinsbank and Goldman Sachs-led subordinated tranche for the KKR-backed Wincor Nixdorf LBO in early 2000, which ultimately generated broad interest, though primarily from banks rather than institutions.

But apart from rare appearances in deals such Wincor Nixdorf, European demand has been limited in part because of the growing flexibility and attractive pricing of mezzanine products.

However, at a time when demand in the US seems to be growing exponentially, it appears that the first green shoots of a parallel market are beginning to show in Europe too. Take, for example, the recent financing arranged for Brenntag, one of Europe's largest chemical distribution companies, acquired by Bain Capital from German state railway company Deutsche Bahn in a €1.4 billion transaction. The €1.2 billion total loan package for the transaction included a €60 million, 9-year senior subordinated term loan ‘D’, together with a €180 million warrantless mezzanine facility arranged by ABN AMRO, Citigroup, Dresdner Kleinwort Wasserstein, Goldman Sachs, HypoVereinsbank and Société Générale.

DEAL DATA

WHY JUNIOR?
Other than the structural details of what is, after all, yet another hybrid product, the other key area of interest is the pattern of demand.

Looking again to the US, traditional buyers of second lien paper, as has been the case for some time with respect to longer dated senior debt, are institutional investors such as mutual funds. Although an increasing amount of senior leveraged paper is being sold to institutions in Europe as well – primarily CLOs – what, specifically, has led to the introduction of the second lien loan?

The answer is simply liquidity: deeper, and broader, demand. The European leveraged finance market, like its US counterpart, is quite simply on the receiving end of a large influx of cash in search of yield at present. One effect, which was analysed in this column last month in the context of the funding for Belgian cable operator Telenet Communcations, is the occurrence of transactions that, from the point of view of the market, start out as “decent” credits that are structured “appropriately”, only to suddenly run into stellar demand during the distribution process.

What makes the second lien loan particularly attractive is its combination of senior-like defensive elements, notably the covenants and collateral, with some yield pick-up over genuine senior loans, providing a compelling relative value argument. That said, the Brenntag term loan ‘D’ was structured initially with US investors in mind, although the bookrunners report interest from both the US and Europe.

Tellingly, perhaps, there are no signs that the amount ultimately raised will change from the initially marketed amount of €60 million. However, it must be remembered that the mechanics of the distribution process will be complex. With senior debt consisting of three term loan tranches, a revolver and an acquisition loan (provided for future consolidation plays, and to be undrawn at closing) and then mezzanine also to be syndicated alongside the second lien loan, changing the balance of this carefully worked out structure may prove problematic. Nevertheless, increasing the ‘D’ loan at the expense of the mezzanine would seem a possibility if the placing does prove a dramatic success, and would improve the prospect for secondary liquidity.

WHAT'S IN IT FOR THE SPONSOR?
From the point of the borrower and the equity sponsor, a second lien loan provides an alternative to more expensive intermediate capital. The potential saving is most significant, at least in cash terms, against the high yield bond.

Equally important, however, are the more limited call protection (in the case of Brenntag, there is none) and the simplicity of the yield structure (i.e. no warrants and no PIK interest), which mean the instrument is more flexible if an exit is expected within the typical four to five year call period of a typical high yield issue.

The attractions come at the expense of rather less desirable contractual elements, but then these terms feature in the senior debt in any case. (According to sources, this was a significant issue for Bain who apparently foresee an exit via an IPO for the company.)

Market practitioners do not question the acceptability of the junior loan from the sponsor/borrower perspective – although some take issue with the intercreditor situation should any transaction incorporating such a tranche subsequently run into difficulties. Concerns centre around the likelihood of difficult negotiations that may involve many different parties as a result of a capital structure that could have up to four different ‘layers’ to it – from senior through to junior debt, then mezzanine, then equity.

Whether in Europe demand will follow the trend seen in the US market is something that is difficult to answer at present. Given the nature of the European market, the product is likely to remain a specific solution to particular needs. In other words, the volume of second lien loans looks set to remain small.

Or does it? Bearing in mind the rapid expansion of demand for leveraged credit exposure in the latter part of last year and the increasingly sophisticated way in which both structurers and investors wish to see such exposure packaged, priced and sold, one can't be certain. As always, where an opportunity is perceived to present itself in financial markets, someone may already be plotting a plan for a decisive move to exploit it more fully.