Second Lien Loan Market

Syndicated vs. Book and Hold

ABF Journal—November/December 2005
by Colin P. Cross

The second lien loan market is once again expected to have a record year in 2005, after explosive growth from $3.2 billion in 2003 to more than $12 billion in 2004. Fueling this growth has been the extensive use of second lien loans for all purposes and the packaging of these loans into syndicates by large commercial and Wall Street investment banks.

The second lien loan market is once again expected to have a record year in 2005, after explosive growth from $3.2 billion in 2003 to more than $12 billion in 2004. Through the first six months of 2005, second lien loan fundings reached $9.5 billion compared to $7.6 billion in the first half of 2004, according to Standard & Poor’s/LCD. Fueling this growth has been the extensive use of second lien loans for all purposes and the packaging of these loans into syndicates by large commercial and Wall Street investment banks, thereby tapping into the voracious appetite for higher yielding paper by CLOs, prime rate funds, high yield funds, hedge funds, distressed investors, finance companies and insurance companies. The syndicated second lien loan is a newcomer to the debt capital markets, having emerged with noticeable volume only two years ago, but is having a big impact.

The origins of the second lien loan date to the late ’90s when a handful of specialized lenders pioneered the product by providing liquidity to companies often undergoing some sort of financial restructuring. The broken cash flow deals of the early and mid-90s, companies burdened with excessive subordinated or unsecured high yield debt, were able to find a life-saving shot of liquidity and, often, a newly restructured senior loan facility by tapping into second lien loans. The initial players were primarily asset-based senior lenders and a small group of second lien lenders who knew each other well and understood each other’s portfolio management strategy. In the event of a workout, these lenders well understood the actions needed and worked closely with each other to maximize recovery values.

With the explosion in the number of articipants, the market has become bifurcated into two distinct markets for second lien loans: the syndicated market and the directly originated, book and hold market. There are major differences between these two types of transactions. The syndicated market tends to have the following characteristics:

• Borrowers are larger, often with at least $30 million in EBITDA, usually more than $50 million.

• To provide time for a successful syndication, the agent will need at least 45 days (often up to 90 days) of lead time to complete due diligence, write a financing memorandum, conduct a road show with investors and
close the loan.

• The agent will be paid a fee for the placement and the term sheet will
invariably have flex language relating to pricing.

• Investors are numerous, typically buying pieces of paper in the $5 million to $10 million range. For an $80 million to $100 million deal, that could mean 20 or more investors. These investors seldom have direct origination teams, preferring to be a purchaser of paper that is originated, structured and managed by others.

• A syndicated loan will often have some liquidity for a post-closing trade. For larger loans, there are usually buyers—sometimes distressed debt buyers—willing and eager to buy this paper on the secondary market.

• Investors typically do not have an active portfolio management team, nor are they granted direct, unfettered access to management. As a result, they may prefer to trade out of problem loans rather than build the infrastructure necessary to actively manage a portfolio.

These syndicated second lien loans are very useful in situations where the borrower meets the investment criteria and has enough time to conduct a placement process. They account for the bulk of the growth in the second lien loan market over the past three years, where the demand from larger, more sophisticated borrowers utilizing this tranche of debt has been met by an equally eager group of investors seeking higher yields.

The direct originations market, on the other hand, is made up of lenders who are quite different from the investors in the syndicated market. These lenders have their own originations staff who source, structure, negotiate, conduct due diligence and close the loans with an intense level of directinteractions with both the borrower and the senior lender. They have a track record of working closely with senior lenders on many deals in the past. Post closing, they have portfolio management teams that stay in close contact with the borrowers and are well-informed at the time that a borrower needs an amendment or waiver, or an increase or other change in its loan facility. They actively track interim performance and meet with management on a regular basis. As a result of this hands-on approach, direct lenders are more likely to hold a loan to maturity rather than trade out of a loan position on the secondary market. For newly originated deals,
direct lenders can underwrite and close transactions very quickly, usually funding deals within 30 days or less, and sometimes committing to transactions in as little as 48 hours. Because they are both the agent and the holder of the loan, their term sheets do not contain flex language relating to changes in market conditions, and the borrower knows whom its lenders are long before the loan closes.

Given the more hands-on approach to both originations and portfolio management, direct lenders are an appropriate fit for transactions with a short time fuse or for storied credits that require a lot of diligence relating to recent losses, restructurings, management changes, etc. Additionally, the direct lender has a different set of investment criteria, often willing to fund companies with EBITDA of less than $20 million. Typically, however most deals done by these lenders are with borrowers that have EBITDA in the $10 million to $50 million range.

The factors that influence a borrower’s choice are fairly obvious. Companies that tap into the syndicated market are usually larger in size and cleaner from a credit perspective. They have more critical mass, often with significant market positions and/or well-recognized brand names. With more predictable cash flows, these companies should have a relatively low risk of default resulting from operating issues, making these
companies prime candidates for the syndicated market.

In instances where the company is less stable from an operating perspective, where existing leverage is high due to existing high yield debt on the balance sheet, or where the time needed to close a loan is very short, tapping into the market with a direct lender, sometimes utilizing a placement advisor is usually the best solution. The borrower in this instance will have the benefit of working with a lender or group of lenders who have an active portfolio management team to address borrower needs as they arise.

The next 12 to 24 months will be interesting times for the second lien loan business. While second lien loans often have a maturity ranging from three to six years, the reality is that the loans are often repaid early, resulting in a portfolio turnover of approximately 24 months. If that historical trend holds true, then in the near term we will be seeing a significant amount of turnover of loans booked in 2004 or earlier. Combine that with some interest rate increases or a hiccup in the economy and we will see a significant up tick in workouts involving second lien loans. It’s a safe bet that the distressed debt investors have taken note and are keeping their powder dry.