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Second-lien lending rides a gusher.

With nearly 4,000 employees and 11 locations around the globe, ICON Health & Fitness Inc. is one of the largest manufacturers and marketers of fitness equipment in the world. It owns some of the best-known brands in the fitness industry--including NordicTrack, FreeMotion, ProForm, EPIC, HealthRider, Weider, Image and Weslo--and licenses Reebok and Gold's Gym brands.

But the Logan, Utah-based firm, privately held but with some public debt, found itself in something of a "cash-strapped position" last year, says CFO Fred Beck. The company, with $900 million in 2005 revenues, elected to enter into a sizable financing, led by Bank of America Business Capital, that included a $40 million second-lien loan from Back Bay Capital Funding LLC, a Boston firm working with the Bank of America unit.

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ICON's five-year second-lien loan is, in effect, a secondary piece of a larger, traditional asset-based revolving loan the company took out with a first lien; that loan, led by Bank of America, totaled $250 million spread among seven lenders. Beck says the collateral for the second-lien loan includes all of the company assets, including fixed equipment and intangibles like trademarks. The lenders "did an analysis of the cash flows and became comfortable with those values," he says.

Beck concedes that at six points over the prime rate, "this wasn't the cheapest piece of paper in the world." But the financing includes some prepayment incentives if the company's business improves and ICON can pay down some of the debt early, he notes.

The finance chief adds that the company just couldn't make the numbers work with a traditional revolver. "We've spent a lot on trademarks and debt, and on fixed equipment, and we saw this [second-lien loan] as a way to get money into the operating part of the business."

Once a minor product targeted for truly hard-up borrowers, second-lien loans have literally exploded in popularity in the past few years, especially as investment vehicles like hedge funds troll for higher yields and lenders direct assets into collateralized loan obligation (CLO) vehicles to offload balance sheet risk.

From just over $3 billion in volume in 2003, second-lien totals swelled to $12.0 billion in 2004 and $16.3 billion in 2005, according to Standard & Poor's (S & P). Representing just 1 percent of total institutional lending volume in the years 1997-2002, the percentages jumped to 3 percent in 2003, 8 percent in 2004 and 9 percent last year.

And the numbers just keep going skyward. S & P data for this year's first half show volume at $12.9 billion and the number of deals, 92, also at a record. Volume in both the first and second quarters topped $6 billion for the first time ever.

But, as with any type of financing whose growth seems almost nuclear-powered, concerns have been raised about whether things are going too far, too fast. That's particularly true in that hedge funds and distressed-asset lenders are prime forces in this type of lending, and may not have the stomach or the expertise to stay the course if things go south (see sidebar, "How Second Liens Complicate a Workout," on page 43).

Technically, a second-lien loan is a secured bank loan where the second-lien lenders share in the same collateral as the first-lien lenders. In return for agreeing with the first-lien lenders that they won't receive any proceeds of the collateral until the first-lien group is paid in full, second-lien lenders receive a higher spread.

Second-lien loans, despite their loftier spreads, are attractive to leveraged borrowers because they provide a floating rate with lower costs than a fixed-rate bond deal and lower prepayment costs. They're also less expensive than mezzanine debt, which often fills the gap between senior debt and equity.

The proceeds of second-lien loans are generally used to refinance expensive debt, to fund dividend payouts, pay down bank loans to increase operating cash, says Steve Miller, Standard & Poor's leveraged markets analyst. Typically, data on capital structures show, first-lien loans use 60 to 80 percent of a company's assets, including intangibles, as collateral; second-lien borrowings cover whatever remains.

Among the name-brand companies that have turned to second-lien loans in recent years are Goodyear Tire & Rubber Co., Dole Food Co. and Krispy Kreme Doughnuts Inc. Krispy Kreme, which had tumbled into a deep financial hole, took out a $150 million second-lien loan in April 2005 that it planned to use to repay $90 million in debt and boost the cash on its balance sheet.

The Goodyear deal involved a $3.65 billion restructuring, of which $1.2 billion was a second-lien term loan. It carried an interest rate of 2.75 percent over the London Interbank Offered Rate (LIBOR), and was targeted to replace credit facilities expiring this year with rates of 4 and 4.5 percent above LIBOR.

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Neil Marks, managing partner at Praesidian Capital, a mezzanine fund that works mostly with established middle-market companies, says the second-lien product came about when some entrepreneurial, nonbank lenders sensed there was more value in assets of some often-troubled companies than the senior lenders saw. With that, they felt that if they lent money at a higher rate, they could lend against "the next 10 percent of the collateral, and make a bet that if the company did liquidate, they would get their money back."

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According to S & P, most second-lien borrowings are done in conjunction with mergers or recapitalizations, with a small percentage in most periods going to refinancings, exits or other purposes. Few are huge. The average deal size peaked in 2002 at $210 million, and averaged just under $100 million in 2004-5; the average is slightly higher so far this year, according to S & P. The largest in this year's first half: $430 million as part of a leveraged buyout of NES Rentals, a services and leasing firm.

Borrowers are spread among a host of diverse industries. Forest products companies represent the largest group so far in 2006, with 20 percent, with computers and electronics next at 12 percent. Most of the companies are unrated or carry "junk" ratings with the major rating agencies.

And who are the buyers/investors? Hedge funds and distressed asset investors represented more than a third, according to S & P data for the first half, but collateralized loan obligation (CLO) vehicles represented fully half. Syndicators for the loans are often big Wall Street firms or major banks--names like Goldman Sachs, Deutsche Bank, CIT Financial Group, UBS Group, Merrill Lynch & Co., Bear Stearns, etc.

"In many ways, second-lien loans are a bear-market product, shining when the capital markets are choppy and intrepid hedge funds can extract high spreads from liquidity-challenged issuers," says S & P's Miller. "As long as the capital markets remain wide open," he wrote last year, "most players expect second-lien loans to be limited to 1) middle-market issuers that lack ready access to the high-yield market; 2) private issuers that want to avoid SEC disclosure rules; 3) the odd challenging situation."

As ICON's Beck notes, the loans don't come cheap. Spreads over LIBOR have averaged well above 600 basis points in the past few years, though they are in the low 600s so far this year. The average spread between first- and second-lien tranches, just 100 basis points back in 1998, has more than tripled, averaging around 350 in the past three years. Not surprisingly, spreads are generally higher for smaller firms than larger ones, given traditional risk assumptions.

However, even these rates don't match the cost of certain types of equity, or some mezzanine lending. "It's all about a continuum of risk vs. reward," says Praesidian's Marks. As a rule, he adds, second-lien financing "is less expensive than raising equity."

The first and second liens cover virtually all of a typical financing. In the first half of the year, S & P reported, the first lien represented 67 percent of the transaction, and the second lien 28 percent. That left 5 percent divided among other forms of debt--subordinated, senior secured, senior unsecured and any other form. Actually, subordinated debt levels in affected transactions have dropped steadily since hitting 11 percent in 2003.

The average debt/EBITDA (earnings before interest, taxes, depreciation and amortization) ratio for transactions with second-lien debt has climbed somewhat, from 4.2 in 2003 to 5 so far in 2006.

Will the second-lien market turn from sizzle to fizzle at some point? It certainly had a modest start. In a 2004 article in the ABF Journal, Colin Cross, managing director at Back Bay Capital Funding, traced the development of second-lien loans to 1997. Most of these earliest deals were small, in the $5 million to $20 million range, and were often underwritten based on the borrower's excess asset values in the event of a loan workout or liquidation. Total volume for the whole product rarely went over $300 million in the years 1997-2000, he added.

What has driven the recent growth, according to Cross, are two "macro factors: an aggressive search for yield by investors up and down the capital structure (increasing supply), and a broadened acceptance of the product by both senior lenders and borrowers (increasing demand) ... The second-lien product is now regularly considered as an alternative to traditional mezzanine and equity when structuring all leveraged deals, whether it is for a middle-market private company or a larger public company."

Nelson Carbonell, chairman and CEO of Snowbird Capital in Reston, Va., a mezzanine debt lender, says mezzanine debt and second-lien loans can compete with each on the balance sheet--but he believes mezzanine is superior for lenders. "A lot of supposed second-lien is priced like senior debt. You get the worst of both worlds--higher risk, and the return of a bank loan." All-in returns for mezzanine debt frequently come in at 1,000 basis points over LIBOR, and that can go considerably higher for small companies, he says.

If hedge fund growth is an indicator, look for second-lien lending and other high-yield debt to continue booming. Hedge funds took in a record $42.1 billion from wealthy investors, pension funds and endowments in 2006's second quarter, increasing industry assets to $1.23 trillion, according to Hedge Fund Research Inc. That quarterly total wasn't far short of the $46.9 billion the funds raised in all of 2005.

Barring regulation and perhaps an eventual shakeout, says Marks, there really is nothing poised to slow the second-lien market down. "Are [the lenders] getting paid for the risk they are taking? I can't answer that," he says--but as long as they think they are, it's hard to bet against the market for such financings continuing to thrive.

"A lot of these things are timing-driven--it all looks great at this point in the cycle," says Carbonell. "But much of this is what I would call fast money, and it doesn't take a lot to shift the marketplace pretty dramatically. A recession would clearly stress the system, but before that, if a couple of things go bad, if a big hedge fund went under, let's say, it could precipitate" a market shakeout.

RELATED ARTICLE: How Second Liens Complicate a Workout

Editor's note: Workouts of second-lien loans have become a significant issue for lenders--and for borrowers, if the lenders aren't experienced with resolving problem loans.

To successfully complete a workout, a borrower has to negotiate with its lenders on the terms and parameters of that workout. With second-lien loans in play, a borrower that needs to work out its capital structure should focus on two main issues before approaching its lenders. The first is with whom the borrower negotiates, and second is what the workout looks like.

Complicating matters is the fact that second-lien lenders are not traditional financial institutions with workout or restructuring groups. Additionally, many second-lien lenders are new to leveraged lending and have not been through a down credit cycle. The second-lien lenders' lack of infrastructure and workout experience may make them unwilling to devote the substantial time and effort that a successful workout requires.

For borrowers with public bonds or equities, there is an additional complication. Many investors in second-lien loans also invest in the borrower's public debt and equity securities and will not want to be restricted from trading those securities.

Moreover, participating in a workout means receiving detailed data that may be material non-public information. Receipt of that information could prevent the second-lien lender from trading. As a result, the borrower will need to understand the composition of its bank group and who will represent the second-lien lenders in the negotiations, as well as what and how much authority the representatives have.

A natural starting point is to ask the lenders' administrative agent to represent the second-lien lenders. However, in most second-lien loan transactions, the administrative agent acts for both the first lien- and second-lien lenders. This dual representation presents potential conflicts between the two lending groups, and the administrative agent may be unwilling to act for both.

Conversely, even if the administrative agent is willing to continue with the dual representation, the second-lien lenders may not accept it. If the administrative agent won't act for both the first- and second-lien lenders, in all likelihood, the agent will continue to act for the first-lien group, given the first-lien lenders' greater control over the collateral and any proceedings and the enhanced ability to provide a debtor-in-possession (DIP) financing in any bankruptcy.

If the administrative agent either will not or cannot act for the second-lien lenders, the borrower has to identify who will represent them. Given their lack of infrastructure and experience, the second-lien lenders themselves may not be willing to participate in the workout negotiations, meaning that the second-lien lenders will want professional help in the form of their own counsel and financial advisors.

Of course, the second-lien lenders will not bear the costs of this professional help, so it will fall to the borrower. For borrowers, this means they need to understand that if the administrative agent cannot represent the second-lien lenders, the borrower should help the lenders organize themselves to find a representative in the negotiations. It also means distressed borrowers may have to be prepared to pick up additional costs.

The second issue for borrowers is what will be included in the negotiations. The borrower needs to understand its current circumstances and needs, the goals of the bank group (which may be different than the borrower's) and what a successful workout will include. Again, the existence of second-lien loans will require greater planning and preparation.

For borrowers, a successful workout may involve a range of options, including:

(a) financial covenant relief to allow the borrower time to execute an operational turnaround;

(b) maturity extension;

(c) infusion of new capital;

(d) the incurrence of additional debt to fund certain needs;

(e) strategic acquisitions to realize synergies or efficiencies;

(f) sales of material assets;

(g) debt-to-equity conversions; or

(h) bankruptcy to implement any of the forgoing options or to keep creditors at bay.

The presence of any second-lien loans in the borrower's capital structure adds issues and complexity to any of these strategies.

Eric Goodison is a Partner in the Corporate Department and a member of the Finance Group at the law firm Paul, Weiss, Rifkind, Wharton & Garrison. He can be reached at egoodison@paulweiss.com.

By Eric Goodison

RELATED ARTICLE: takeaways

* Second-lien lending has become more acceptable and more prevalent, generating tremendous growth in the past few years.

* Hedge funds, distressed-asset lenders and collateralized loan obligation vehicles have been the primary forces driving the market.

* While second-lien loans may seem expensive, market participants say the prices are typically a good deal lower than mezzanine loans or issuing equity.

* Concerns have been voiced about the inexperience or lack of capacity for hedge funds to be involved in workouts if second-lien loans aren't repaid.
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Author:Marshall, Jeffrey
Publication:Financial Executive
Article Type:Cover story
Date:Sep 1, 2006
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