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| Kate Kutasi |
As interest rates move upwards and defaults increase, fallout is anticipated in the rapidly growing second-lien arena with problems compounded by a lack of uniformity within the documentation. This may leave some investors on the wrong side of the trade, but it could be a boon for distressed buyers picking up the pieces. "In some cases there is a basic knowledge gap in how second liens work and many of the provisions are untested in an actual bankruptcy or restructuring scenario," noted Kate Kutasi, manager of the distressed and high-income portfolio at Kellner DiLeo Cohen & Co., a New York-based hedge fund with $500 million under management.
Second liens first appeared on the radar in 1998 but it was not until 2003 that the product really took off. Standard & Poor's states that in 2004, 128 second liens were launched totaling $11.98 billion. This year the pace has not abated despite weakness in the high-yield market (LMW, 5/9). But Kutasi is quick to point out that second-lien paper is not generic. "There are major differences in collateral coverage and documentation," she noted.
There have been significant variations in the documentation--particularly between the earlier deals issued in 2003 and the later deals. Specifically, second-lien deals are calling for numerous waivers by investors, including waiving their voting rights in bankruptcy. To date there have been no test cases, but Kutasi expects litigation to ensue. "Whether those waivers survive challenges in bankruptcy court and in subsequent litigation remains to be seen," Kutasi said.