Second-Lien Loans: Increased Use In LBO Financing

Posted on November 30, 2017

Introduction

Total institutional leveraged loan new issuance in the first nine months of 2017 has already surpassed the previous calendar year record set in 2013. However, with refinancing and repricing transactions accounting for over 70% of such volume, on a net basis, new issuance volume is less extreme. Examining second-lien loans specifically, issuance has increased significantly this year, more than doubling calendar year 2016 total volume during the first three quarters. 

However, unlike total institutional leveraged loans (which comprise approximately 95% first-lien loans), leveraged buyouts(“LBOs”) were the largest driver of second-lien loan volume growth. We do not believe this is a one-off development, but rather the continuation of a trend that began a few years ago and more recently has picked up steam. More specifically, the trend we are referring to is a change in the funding structure that Private Equity (“PE”) firms are using to fund LBOs. Historically, it was common for such buyouts to be financed with a first-lien (senior secured) leveraged loan, an unsecured bond, and an equity contribution from the acquiring PE firm. More recently, however, many PE LBO sponsors are replacing the unsecured bond piece in the funding structure with a second-lien leveraged loan, resulting in all-loan debt financing. In this paper, we will discuss why we believe this development has occurred and whether it is likely to continue; compare and contrast the characteristics and new issuance process for bonds vs. second-lien loans; and summarize the pros and cons of each financing structure from an investor perspective. In addition, we will highlight certain key attributes that we believe are important to be successful investors in the second-lien loan market over the long term.

What is driving this change?

Exhibit 1 below compares second-lien loans to high yield bonds, highlighting the major differences between the two debt instruments. In addition, when referring to bonds, unless otherwise noted, we are referring to senior unsecured high yield bonds, which are commonly issued. Furthermore, it is important to emphasize that in many cases, because of the private nature of second-lien loans, investors typically gain greater access to information when compared to what is available in most high yield bond deals – a feature of second-lien loans we will reference throughout this paper.

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