"A thorough review of the Subject Company's loan documentation - extensive in most cases - by legal counsel to and the managers of the Lead Investor/Lender is essential . . ."
In an article entitled "Return-Hungry Investors Snap Up Riskier Loans" in The New York Times on April 6, 2005, it was reported that companies had raised $5 billion dollars in second lien loans in the first quarter of 2005. Financially-beleaguered Krispy Kreme Doughnuts recently raised $225 million dollars from lenders, including $75 million in first-lien loans and $150 million dollars in second-lien loans. There seems to be no slowing down the Ferrari-like pace of the second lien loan market.
As illustrated below, growth in second lien lending has been phenomenal. Just look at the rise in second lien lending over the last four and one-quarter years:
Year Dollar Volume Of Second Lien Loans
2001 $65 million
2002 $570 million
2003 $3.2 billion
2004 $12.0 billion
2005 (first quarter) $5.0 billion
Second lien loans are similar to mezzanine (unsecured subordinated loans), except holders are granted security interests or second liens in assets already pledged to a senior secured lender. In some cases, certain assets will only be pledged to the second lien lender.
The growth in second lien lending has been fueled by an aggressive search by lenders and investors, particularly hedge funds and private equity funds, for higher yielding debt instruments. A second lien lender receives a security interest that is subordinate to the senior lender's first security interest. This enables the second lien lender to gain priority over assets against trade and other unsecured creditors in the event of a bankruptcy or enforcement action. Second lien lenders enter into complex intercreditor agreements ("Intercreditor Agreements") with senior secured lenders holding first liens on assets governing their respective rights in collateral, bankruptcy, payment, standstill and other matters. Second lien loans have more favorable pricing, less restrictive prepayment penalties and no equity kicker, such as a warrant position, that are usually found in mezzanine loans.
Second lien lending has also fueled acquisitions, particularly by leveraged buy-out and other acquisition funds.
As the growth of second lien lending has exploded, the need for expert business and legal due diligence increases. Expert due diligence is essential for a second lien loan investment to be a success. I was surprised to hear a second lien investor at a recent seminar comment that when his firm was brought in as a participant in a second lien financing, it did practically no due diligence and relied almost entirely on the due diligence conducted by the lead lender in the transaction. His impression was that given the frenetic pace, fast timing and great number of second lien deals, it was hard to conduct meaningful due diligence before signing onto a second lien loan transaction. Given the volume and growth of second lien lending, the number of troubled and poorly-rated credits receiving second lien financing, and with the number of potential eroding credits and bankruptcies looming on the horizon, there is a compelling need for a prospective second lien lender to perform what can be termed prime due diligence before entering into a second lien loan transaction.
Prime Due Diligence
The investor or lender who leads the syndicate of investors or lenders ("Lead Investor/Lender") in a second lien loan transaction will conduct extensive business and legal due diligence on the borrower or borrowers ("Subject Entity"). If the Subject Entity is a public company, the due diligence starts with a comprehensive review of the company's public filings for its last five years (or sooner if the company has been public for a shorter period of time). Also, exhibits to these filings (such as certificate of incorporation, by-laws, preferred stock instruments, material contracts, loan agreements, etc.) should be carefully read by legal counsel. The Lead Investor/Lender will also review analysts' reports that have been issued along with the Subject Entity's material press releases over the last few years.
Legal counsel for the Lead Investor/Lender will carefully examine the Subject Company's loan documents with its first lien lender (credit agreements, security and pledge agreements, notes, UCC financing statements, intercreditor and subordination agreements), examine the Subject Company's liens and encumbrances, and review UCC financing statement search results from a service company retained by the Lead Investor/Lender. Legal counsel will also review from a legal perspective audited and unaudited financial statements of the Subject Company for the last 3 - 5 years. Managers from the Lead Investor/Bank will discuss with legal counsel the results of their business and financial due diligence of the Subject Company, including their careful review of the Subject Company's financial statements and financial condition and first lien loan documents.
Legal counsel will prepare a due diligence memorandum or report summarizing the results of their legal due diligence investigation of the Subject Company. Managers for the Lead Investor/Lender will prepare a due diligence memorandum or report summarizing the results of their business and financial due diligence review of the Subject Company.
Legal counsel for the Lead Investor/Lender should conduct a Google or Lexis/Nexis Internet search on the Subject Company. This search often yields important information on the Subject Company that may not be contained in SEC filings and may merit a further review with counsel to or the managers of the Subject Company.
A thorough review of the Subject Company's loan documentation - extensive in most cases - by legal counsel to and the managers of the Lead Investor/Lender is essential because these documents form the basis for the negotiation and preparation of the Intercreditor Agreement and related agreements and documents among the Subject Company, first lien lender and Lead Investor/Lender.
If the Subject Company is private, legal counsel will prepare a lengthy due diligence request checklist for the Subject Company to complete and supply requested documents and agreements. For a private company, the due diligence process can be longer since the company has no public filings readily available on the Internet.
If your investor/lender is a participating investor or lender - and not the lead - in a second lien loan transaction ("Participant"), we encourage prime due diligence to be undertaken by Participant's legal counsel and managers. This consists of: (a) trying to obtain and review the due diligence reports prepared by the Lead Investor/ Lender's counsel and managers; sometimes these can only be obtained by the execution of a confidentiality agreement; and (b) conducting legal, business and financial due diligence similar to that outlined in this article; if the Participant's investment or participation is quite small, the due diligence will most likely not be as comprehensive because of cost, shortened transaction timing and time commitment factors. When asking a Participant why it did not do more due diligence on the Subject Company before making its second lien participation investment, the usual reply is "no time." Some Participants are brought in hours before closing so this is somewhat understandable. However, we as a matter of practice encourage Participants to conduct prime due diligence by performing as much due diligence on the Subject Company and second lien transaction as they can, consistent with the procedures set forth in this article. Given the explosive and phenomenal growth of second lien lending, there are, and will be many more on the horizon, troubled and bankrupt companies with second lien loans on their balance sheets. Already second lien loan transactions in the Atkins Nutritionals, Sunny Delight and Meow Mix acquisitions are troubled. Many more will follow. Investors who have done prime due diligence can avoid many pitfalls, headaches and losses as a result of this practice.
Published October 1, 2005.
