Vol 3 (2006) - Issue 3

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Second Lien Loans Workouts – What Can Be Expected if the Credit Cycle Turns?

Overview
The US credit markets are now five years into a relatively benign credit cycle. Borrower defaults have been and remain modest. This low incidence of defaults has led to attractive risk-adjusted returns for investors in leveraged loans. One result of these circumstances has been to draw new investors into the leveraged loan market, including hedge funds, CLOs and other non-traditional lenders. This increased supply of funds available for leveraged lending has been a significant factor in the narrowing of loan spreads. As a result, beginning in 2003, when US interest rates were at historical lows some of these investors sought out ways to earn a higher spread. The search for higher spread has led to the development of a robust market in syndicated second lien loans. In 2003, the syndicated second lien loan market was almost non-existent. Today it is a significant portion of the leveraged finance market.
In its most basic form, a second lien loan is a senior secured loan with contractual terms which provide that the second lien loan’s claim to recoveries from its collateral is second in priority to any first lien debt. The agreement with respect to the priority of the second lien loans is evidenced in an intercreditor agreement with the first lien lenders. The intercreditor agreement will often address additional issues such as:
(a) standstill periods when the second lien lenders may not exercise remedies with respect to the collateral;
(b) who will control any foreclosure proceedings as between the first and second lien lenders;
(c) the ability to have additional first or second lien debt secured by the collateral;
(d) the ability of the first lien lenders to compel releases of the collateral in certain circumstances; and
(e) certain rights of the parties in any bankruptcy proceeding of the borrower.
It is worth noting, however, what a second lien loan is not. It is not a subordinated loan. In any bankruptcy or liquidation of the borrower, the second lien lenders will share ratably in any unsecured assets of the borrower with all other unsecured, unsubordinated creditors of the debtor.
There is concern in the marketplace that with the increase in US interest rates by 3.75% since June of 2004, the credit cycle could turn down and the number of workouts (including for borrowers with second lien loans) could rise significantly. As the second lien loan market is a recent phenomenon, it has not been through a down cycle. There is uncertainty as to whether workouts with second lien lenders will be more difficult than workouts prior to the development of the second lien loan market. Participants in the marketplace should expect workouts to be longer and more expensive, and ultimately that there will be more failed workouts. Issues which will drive this result include identifying willing and experienced parties to participate in the workout and greater and more involved negotiations among and with the creditors.