Over the past decade, the market for second lien loans has experienced a roller coaster ride. Second lien loans were used sparingly in the late 1990s, primarily as small bridge loans with annual volumes of approximately $300 million, but by 2007, the market had grown exponentially with more than $30 billion issued. Supply was robust as private equity firms used second lien debt to finance leveraged buyouts due to its greater flexibility and better pricing relative to mezzanine products and high-yield debt.
This increased supply was devoured by a variety of debt purchasers including hedge funds, business development companies, CLOs and others attracted to the additional yield provided by second lien loans. Average bids of second lien loans hovered between 95 and 102 until the end of 2007, indicating that the market was quite comfortable with the pricing of the loans and the collateral backing the loans.
As one might expect, with the onset of the credit crisis in 2008, the market for new issuance decreased substantially to approximately $3 billion in 2008 and only $1.9 billion in 2009. At the same time, average bids for existing second lien loans plummeted into the 40s by late 2008 and into early 2009. Since late 2009, however, the market for second lien paper has substantially recovered. New issuance of second lien loans has climbed to approximately $7 billion in 2011 and average bids have returned to approximately 95.
During the early years of the credit crisis and subsequent recovery, many senior lenders were hesitant to deal with the large number of problem credits in their portfolios. Some did not have the internal capacity to work on numerous troubled credits simultaneously, while others were hesitant toward large write downs during a period of uncertainty. Regardless of the cause, the effects were the same — banks were executing many amend and extend transactions. The longer term result of these policies has caused a large amount of lender fatigue as investors have grown weary of “band-aid” solutions that put off a comprehensive solution for another day. In this environment, more firms have been utilizing positions in second lien loans to take control of situations.
As a backdrop, average debt multiples have recovered somewhat from the depths of the credit crisis. From the averages of 2008 through the first quarter of 2012, the average debt to EBITDA multiple through first lien debt has increased by about a half turn to approximately 3.5x for leveraged loans. In transactions that are analogous to “plain vanilla” restructurings, some holders of second lien debt have had success structuring transactions by bringing first lien debt to market levels — often through an equity investment or rights offering — and then equitizing their second lien holdings to gain control of companies post-recapitalization.
Some private equity firms have utilized credit bid strategies to maintain control of troubled portfolio companies. In a credit bid, secured lenders bid the amount of their debt as a portion of the entire proposed purchase price. Sun Capital Partners, which specializes in distressed investments, has successfully utilized this tactic over the past few years. One example was Big 10 Tires, a tire retailing company in the Southeast. In this case, Sun Capital credit bid its holdings of the company’s first and second lien debt — as well as amounts owed under DIP financing — to purchase the company. Sun Capital successfully renegotiated leases under provisions of the U.S. Bankruptcy Code and consummated the sale approximately three months from the bankruptcy filing. In turn, Sun Capital exited the situation through a subsequent sale of the company to Pep Boys.
An interesting hybrid case is that of Reddy Ice, a manufacturer and distributor of packaged ice products in the United States. Reddy Ice has filed a pre-packaged plan of reorganization that has the support of a majority of its lenders and major creditors. Under the proposed plan, first lien notes would be unimpaired and the holders of the second lien notes would receive preferred and common stock, pursuant to their participation in a rights offering.
Centerbridge, which holds a portion of the first lien notes and is said to control a large slug of the second lien notes, is backstopping the rights offering for the preferred stock and is receiving one share of Class A common stock — a super voting share — which would give it control of the reorganized company.
In addition, Centerbridge has committed to provide equity capital for the potential acquisition of Arctic Glacier, a competitor that is for sale and is operating under CCAA protection in Canada and Chapter 15 in the United States. Through its investment in different parts of Reddy Ice’s capital structure, Centerbridge has not only positioned itself to take control of the reorganized entity with a right-sized balance sheet, but also a large competitor that would provide significant synergies in a merger.
Venues for transactions that result in second lien holders taking control is not limited to bankruptcy. For instance, Avenue Capital Group was able to take control of the Quiznos sandwich chain in an out-of-court debt restructuring deal via an exchange offer that garnered 100% support from its first and second lien holders earlier this year. As part of the deal, Avenue Capital invested $150 million in Quiznos and converted some of its debt to equity in return for more than 70% of the equity of the company. All told, the deal eliminated more than a third of the company’s debt and included significant concessions from certain other creditors and stakeholders.
The restructuring of Aquilex Holdings, a provider of maintenance, repair, overhaul and industrial cleaning services to the energy industry, was also completed via an out-of-court exchange offer. It used a combination of an amendment, paydown of first lien debt and a conversion of second lien debt into preferred equity. As a result of the restructuring and an equity investment, affiliates of Centerbridge became the majority shareholder.
Private equity firms have also teamed up with third-party holders of second lien debt in recapitalization transactions in cases such as Jacuzzi Brands Corp., a manufacturer and distributor of branded bath and plumbing products. In that situation, the company had outstanding first lien debt that was both covenant-lite and below market rates (at LIBOR+225 basis points), but did have a change of control provision.
In order to stop the first lien lenders from exercising the change of control clause, the existing equity sponsor, Apollo Management, teamed up with the second lien lenders to buy the company. The transaction involved the equitization of second lien debt that was about to convert to cash pay from PIK, a new investment from the second lien holders (for new debt and equity) and from management and shareholders (for equity).
In some instances, third lien debt holders have also taken control in distressed situations, such as the proposed plan of reorganization of General Maritime, an operator of vessels providing transportation services for seaborne crude oil and petroleum products. Under the terms of the proposed plan, which modified an earlier version, the company would receive an infusion of $175 million in new capital from funds managed by Oaktree Capital Management. In combination with the equitization of the company’s third lien debt, which is also held by funds managed by it, Oaktree will receive approximately 95% of the new equity of the reorganized company.
Regardless of the ultimate form of the transaction, recent history has shown that second lien debt has increasingly become a popular means of currency to take control of underperforming and overleveraged companies. These types of transactions will continue to become more prevalent as more participants enter this arena through the continuous raising of distressed fund capital. In addition, the success that some funds have had using these tactics will lead to their increased use in other distressed situations.
Jason Solganick is a principal in the Restructuring and Special Situations Group in the New York office of Lincoln International. He has over 12 years of experience providing advisory services to sponsors, shareholders, lenders, management teams, bondholders, creditors and court-appointed representatives of financially stressed and distressed companies. Transactions include out-of-court workouts, debt amendments and forbearances, exchange and tender offers, distressed M&A and Chapter 11 reorganizations. In addition to transaction execution, advisory assignments often include raising debt (including DIP and exit financing) and equity capital, valuing businesses and assets, and providing expert testimony in Chapter 11 bankruptcy situations.