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Second Liens Withstand HY Weakness, Hot Money Movement

Rising interest rates, the prospect of heightened defaults and increased opportunities for investors in emerging markets and U.S. equities could lead hedge funds away from the second-lien market.

Rising interest rates, the prospect of heightened defaults and increased opportunities for investors in emerging markets and U.S. equities could lead hedge funds away from the second-lien market. But despite widening spreads on these riskier loans, private-equity firms and bankers are predicting the second lien will stay strong. "As long as there are par bids for second-lien paper, there is still a new issue market," said Christopher Turner, a partner at Warburg Pincus and head of its capital markets group. He said it is not impossible to see a scenario where second liens could go away and there has been a tailing off in the aggressiveness of the deal. But there's still appetite. "We still continue to see very interesting proposals from our banking friends on second-lien loans and we're told there is still a very active trading market for second-liens and that many of them remain well bid," Turner said. He explained that several hedge fund investors have developed a good deal of infrastructure to analyze credit and Warburg Pincus continues to see proposals directly from hedge funds up and down the balance sheet.

"We're getting second lien deals done right now; they're not dead," saidTom Newberry, global head of the syndicated loan group at Credit Suisse First Boston. "With interest rates rising, it creates demand for floating rate, second-lien loans at the right yield. There is no indication that buyers are going to stop buying them." CSFB is currently leading a $75 million second-lien for SunCal Companies. And in the pipeline is a $450 million tranche jointly led with Goldman Sachs for Danielson Holding Corp. and a smaller loan for Cannon Communications. The benefit of second liens for issuers, he explained, is that they are more flexible than mezzanine loans, which generally carry higher yields and can contain material non-call periods.

"From a mezzanine perspective, that would be wishful thinking," laughedJeffrey Dickson, managing principal of Prudential Capital Partners when asked if second liens were dying. "The rapid growth of second liens has taken some market share from mezzanine loans. I don't think the second lien market will disappear. It is becoming institutionalized and I think there is room between mezzanine and the first lien for it." Last month Prudential raised a $775 million middle-market mezzanine fund after initially targeting $600 million.

Second liens first popped on the radar in 1998, seemed to wane, then came back in 2003 and took off last year. "I think we saw a peak level of liquidity, at least for the current credit cycle, in the fourth quarter of '04 and I think it will be a while before we resume that peak," Turner said. Standard & Poor's states that in 2004, 128 second lien loans were launched totaling $11.98 billion. There were 26 second liens totaling $3.1 billion in 2003. For the first four months of 2005, 51 second liens were launched for $6.2 billion, an increase from 49 second liens for $5.4 billion during the same time period in 2004.

Some of the bigger second liens in the 2005 market include a $1.2 billion second lien for Goodyear Tire & Rubber Company and Resorts International Holdings' $350 million second lien. Last week Bear Stearns launched a seven-year, $250 million second lien for MetroPCS Wireless.

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