Distressed debt investors are casing the second-lien loan market, where they see increased liquidity and opportunities arising from court battles with first-lien lenders. Speaking at the Financial Research Associates' 2006 Distressed Debt Summit in New York last week, distressed debt investors said the second-lien market is shaping up to be a happy hunting ground.
"We see most future opportunities coming from the second-lien market," said Gregory Frenzel, managing director of Citigroup Global Markets. "Whether there is a recession or not, second liens will be a source of opportunity." Frenzel said the second-lien market will become a good source of liquidity in the distressed market as more overlevered companies find it difficult to meet projections and end up tripping covenants.
Investors foresee many court battles as first- and second-lien lenders fight for recoveries on their investments. Katalin Kutasi, a principal at Kellner Dileo & Co., said the feuds will stem from a growing dominance of second-lien lenders. She said a lot of companies may be forced to liquidate because different creditor groups will not be able to agree on recoveries. "The real battle will be between the first and second lien holders. There is a lot of documentation and rights that are untested," said Kutasi.
Frenzel said a lot of first-lien lenders assume they are in a better position than they actually are. He said first-lien lenders may not realize that their rights as a first lien lender are as not as solid as they originally anticipated. "Most first-lien lenders think they have an iron clad deal. But we are seeing companies cutting deals with the second-lien holders," said Frenzel.
Brian Trust, a partner at Mayer, Brown, Rowe & Maw, said more funds that invest in one part of the capital structure are taking positions in other areas, such as the second lien, to influence outcomes in restructurings. "Investors are looking to invest in first, second liens and bonds. There is now a lot of cross pollination to hedge investments," said Trust.
Hedge funds are buying second liens with the aim of gaining control of companies' capital structures. Philip Falcone, senior managing director at Harbinger Capital Services, said his fund often takes positions in the second lien to take an active role in bankruptcies. "We have bought second-lien pieces when they are at 70-80 as a function of getting control of the capital structure," he said.
But second liens lenders are also jumping into the market without knowing the risks, warned panelists. Meridian Automotive Systems is an example of a credit where second-lien holders will likely obtain less than they bargained for in the bankrupt auto supplier's restructuring. In August, Meridian's second lien fell to single digits after the company pulled its plan of reorganization (CIN, 8/21). The second lien is currently bid around four cents on the dollar.
James Millstein, managing director and co-head of the restructuring group at Lazard Freres & Co., said buyers are not always aware of what they are getting into when they buy second liens in the secondary market. He said the primary buyers of second liens are collateralized loan and debt obligations. As soon as they go into distress they end up in the hands of buyers that invest in the loans without realizing they afford them few rights in a workout.
