The average size of second-lien deals has grown over the past three months, indicating they are taking on an increasingly larger portion of the companies' capital structure. The average size of second-lien deals has grown to $111.7 million from $98.2 million in 2005, according to Dealogic. Recent large second-lien deals include Calpine Corp.'s $600 million second-lien debtor-in-possession financing; Astoria Generating's $300 million second lien, and Quintiles Transnational Corp.'s $320 million second-lien term loan "C."
Mary D'Souza, senior v.p. at GE Capital Markets, said second-lien deals started to show strong growth late last year and she expects these deals to continue to grow. She said the growth reflects tougher conditions in the high-yield bond market. "The increase in the second-lien deals is a function of the volatility in the high-yield market and the strong appetite for large, liquid second-lien financings from investors such as [collateralized loan obligations], hedge funds, prime funds and high-yield funds," D'Souza said.
She added that smaller issuers are increasingly finding second-lien deals more attractive because of the tougher regulatory environment. "Issuers of smaller high-yield deals are also finding it more attractive to go the second-lien route. This is partly because of Sarbanes-Oxley, which has made it more expensive to do public filings for high-yield deals," said D'Souza.
Issuers' preference for second lien is also a function of cost. Prepayment penalties are less strict than those for high-yield bonds and mezzanine debt. Most second-lien deals have a prepayment provision of 101 or 102. High-yield securities are generally non-call for three or more years, while mezzanine debt is generally non-call for two or more years. "In today's market, issuers may be finding that second lien provides more pre-payment flexibility and ease of execution," said John Brignola, partner at LBC Credit Partners.
While the average size of second liens grows, the pricing on these transactions continues to fall. The spread on second liens has steadily declined since the beginning of 2004, showing only a slight increase in May last year. The average discounted spread on second-lien loans was 533 basis points at the end of December 2005, 524 basis points at the end of January 2006 and 507 basis points at the end of February of this year, according to Standard & Poor's. The average spread was 614 basis points at the beginning of January 2004, according to the ratings agency.
The growth of the second-lien market is a growing concern for rating agencies, which point out that these deals may thwart bankrupt companies' ability to raise additional funds as they restructure. "Debt caps incorporated within second-lien deals may end up perversely limiting the future ability of issuers to tap additional available funding through either new unsecured notes or increased commitments for first-lien debt," warns Fitch Ratings in a recent report. It added that because of the reduced levels of untapped collateral value available in bankruptcy because of the growth in second liens, companies may find it harder to obtain DIP financing.
