A second lien term loan is debt issued to supplement first lien debt that is already in place or is to be issued simultaneously. As the name suggests, second lien debt is second in its rights over the collateral, after first lien debt. But it is still considered secured debt (not to be confused with unsecured debt). Given that second lien debt issuers can get paid only after the first lien debt is paid in full, second lien lenders accept greater uncertainty regarding repayment. To compensate for the incremental risk, second lien loans are more expensive than first lien loans.
Capital Type: Second Lien Term Loan
Typical Use: Finance growth, mergers and acquisitions and dividends, financial restructuring
Funding Mechanism: Fully funded at close
Security: Senior secured second priority lien, subordinated to first lien debt
Collateral: Typically, all assets of the company and pledge of equity. In certain circumstances, collateral can be limited to specific non-current assets such as M&E, real estate or intellectual property
Payment Priority: Second to be repaid from the proceeds of liquidation of its collateral after the first lien debt has been completely paid off
Who Should Consider a Second Lien Term Loan?
Second lien term loans should be considered by borrowers with the following attributes:
- When structured as a cash flow or EV loan, stable, largely predictive cash flows and a demonstrable track record of consistent financial performance, along with ownership by a party that can provide ongoing capital support during downturns.
- Senior debt to EBITDA less than 3.0x.
- For an asset-backed second lien structure, when the value of the underlying assets is quite meaningful and banks providing asset-backed financing are reluctant to share the first lien on their collateral, a second lien can be structured based on the value of assets. Typically, a second lien lender would provide an additional ~10% beyond the advance rates on the value of collateral provided by banks.
Advantages of a Second Lien Term Loan
Borrowers of second lien term loans enjoy the following benefits:
- Full utilization of debt capacity–when used in conjunction with first lien debt, a second lien term loan fully monetizes the assets or enterprise value of a company
- Second lien term loans are a practical solution for asset-heavy companies
- Low maintenance–reporting obligations limited to financials and covenant compliance certificates
- Typically, no amortization is required, which means cash flow is available for other corporate needs
Drawbacks of a Second Lien Term Loan
There are prominent considerations that borrowers of a second lien term loan should take into account:
- Relatively more expensive compared to a combination of other bank and non-bank debt
- Involved legal documentation–first lien and second lien loans will have separate agreements, as well as an intercreditor agreement among them
- Lenders typically require call premiums or prepayment penalties
Underwriting Process for a Second Lien Term Loan
Capital Providers: Typically, non-bank credit funds and Business Development Companies (BDCs)
- Recovery through ongoing cash flow generation of Capital Seeker or through refinancing. In a distressed situation, recovery through sale of Capital seeker as an ongoing business
- For asset-backed structures, recovery through liquidation of collateral in a distressed situation
- For recurring revenues based structure, recovery through collection of ongoing contractual payments
- Confirmation of business’ ability to generate cash flow and repay debt, ability of owner or sponsor to inject additional equity and liquidity
- For asset backed structures, liquidity and value of the collateral
- For businesses with recurring revenues, e.g. software companies, validation of company’s ability to generate recurring revenues and maintain healthy contract renewal rates
- Typical credit underwriting process focuses on the ability of the business to generate consistent cash flows and risks that may disrupt consistent cash flow generation. Underwriting involves analysis of business model, competitive dynamics, customer base and commercial terms, ownership history, historical financial performance as well as financial projections, operations and background of key stakeholders, including key executives
- Quality of earnings report produced by an accounting firm to validate the EBITDA of the business as well as any adjustments and an industry study to validate the company’s competitive position, size of the market, customer feedback, etc.
- For asset backed loans where Second Lien Term Loan is dependent on the value of fixed assets or intellectual property, such assets will be appraised by a certified appraiser to establish NOLV
Amortization: Typically, none
- Most commonly, leverage ratios (senior debt to EBITDA and total debt to EBITDA) and fixed charge coverage ratio
- Covenants related to appraised value of the collateral for asset backed structures
- Total debt to recurring revenues ratio for structures focused on recurring revenues
1. Company prepared unaudited monthly financials, audited annual financials, annual financial projections
2. Periodic appraisals of collateral for asset backed structures
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