European second-lien issuance increased 200% in 2005, propelled by sponsors looking for a cheaper alternative to mezzanine financing. Even though European second-lien issuance slowed some in the fourth quarter of last year, it clocked out at E5.7 billion, compared with E1.8 billion in 2004, according to Fitch Ratings.
The increase in U.S. institutional investors into the European market has helped push the product into the forefront. "A lot of U.S. hedge funds and [collateralized loan obligations] set up in Europe in the last few years, so a lot of liquidity originating from the States has come into the European market," said Michelle De Angelis, who covers the product for Fitch. "I think that second lien was kind of imported mainly to appeal to hedge funds looking for greater returns on secured debt instruments."
While hedge funds like the returns, issuers have been drawn to the fact that second liens are cheaper than traditional European mezzanine debt. Sponsors have been keen to include second liens as either a full or partial replacement for mezzanine. De Angelis explained that although called a second lien, the debt resembles European mezzanine but with a few differences. A second lien is a cash-pay instrument, priced at 600-700 basis points, compared to mezzanine with a higher all-in-pricing but a substantial pay in kind element. More importantly, second liens rank ahead of mezzanine debt in the security structure. The second lien, as well as mezzanine debt, often has standstill provisions regarding enforcement, as well as payment blockages. In 2005, second liens were predominantly used as a layer of capital between senior debt and mezzanine.
"Second lien has largely taken the form of old European mezzanine," said Pablo Mazzini, a director at Fitch. "Second lien has introduced more competition for the traditional mezzanine product, prompting downward pricing pressure. Mezzanine lenders often have to comfort themselves with third ranking security with no warrants."
Fitch does not anticipate second liens totally replacing mezzanine. During the second quarter of 2005, second-lien volumes were 42% higher than mezzanine, but mezzanine rallied and had a total year issuance of E10.8 billion compared with E5.7 billion for second lien. The emergence of stretched senior-style second lien means the product will not entirely replace mezzanine in Europe.
"Second lien was always in Europe in the form of mezzanine," said Herman Guelovani, NIB Capital Bank. "Mezzanine is a traditional European second secured instrument, whilst in the USA, mezzanine is mainly unsecured, almost preferred equity." He noted that the emergence of second liens in the U.S. market over the last four or five years came first through restructuring, but more recently as a debt tranche in its own right. "However, U.S.-type second lien is more stretched senior than a separate asset class as mezzanine is," he said.
Guelovani noted that loan funds and hedge funds have been the main buyers of second liens and that as long as there are jumbo deals to be done, second liens should continue to be a big part of the market. "But if there is a credit crunch or more interesting opportunities arise elsewhere, hedge funds and credit opportunity funds may leave the market," he said. "Then [the] second lien may shrink in size and importance for the European market."