Second lien loans differ from mezzanine debt and preferred equity in several respects; each have different sets of rights. Preferred equity, for example, should not be subject to bankruptcy concerns, as it is not debt; and both preferred equity and mezzanine debt generally take over the manager’s control rights as a primary remedy, which can be quicker than a foreclosure proceeding on the real property asset. They do not, though, have a hard security interest in that asset, and do not automatically get notice from county recorders when a foreclosure proceeding has commenced.
Second lien loans are less frequently seen than in prior decades, since they are now generally not allowed on transactions primarily financed by CMBS-securitized or insurance company-backed first-lien loans. Those buyers simply don’t want any competing claims on the primary asset. Other primary lenders, however, are more forgiving.
Different Lending Metrics
Second-lien debt investments must be evaluated differently than those involving 1st-lien debt. The overall loan-to-value ratio increases with 2nd-lien debt, providing less of an equity cushion for that layer of the capital stack. Since 2nd-lien creditors are also subordinate to the 1st-lien creditor, and is therefore relatively riskier then 1st-lien debt, the interest rate is often higher.
2nd-lien loans differ from mezzanine debt and preferred equity in several respects; each have different sets of rights. 2nd-lien loans have a hard security interest in the primary asset; this confers several rights, most importantly against declines in value that occur after a bankruptcy filing has occurred. It also automatically gets notified by county recorders when a 1st-lien creditor files for foreclosure. This is different from preferred equity or mezzanine debt, which instruments generally take over the manager’s control rights as a primary remedy; this can be quicker than a foreclosure proceeding on the real property asset, but are less certain in outcome.
The fact that a 2nd-lien loan does have a mortgage or trust deed on the property – i.e., that it is secured – does set it apart from other creditors.
- Priority vis-à-vis unsecured creditors. Secured claims are entitled to receive their full value in the collateral before anything is given to unsecured claims; but, to the extent that a secured creditor is undersecured, it shares ratably with other general unsecured creditors (including trade creditors).
- Post-Petition Interest. Secured creditors are, under the bankruptcy code, entitled to post-petition interest on their claims; undersecured creditors are not. This can be significant, given that bankruptcy proceedings may run for several years.
- Protection Against Decline in Value. Secured creditors can be protected against post-filing declines in value. This right is broad, and gives the creditor a say in collateral substitutions and debtor-in-possession financings, and may also include court-ordered grants of additional (or substitute) collateral or periodic cash payments. An extremely valuable right.
- Reduced “Cram-Down” Risk. Each class of creditors generally gets voting rights in any reorganization, but a class’s objections may still be overcome (“crammed down”). It is generally much harder for a class of secured creditors to be crammed down, compared to a class of unsecured creditors.
As earlier noted, however, the 2nd-lien loan still needs to “share” its interest in the collateral with that of the 1st-lien lender – and those primary lenders are not always willing to do that. The CMBS market and insurance companies generally don’t allow 2nd-lien loans on their collateral properties, because they are considered to (i) slow down the process of foreclosure for that 1st-lien holder, (ii) make it more difficult for a 1st-lien holder to agree a favorable reorganization in bankruptcy, since other secured lenders can vote against their proposed plan and thus increase the risk of some “cram-down” loss of principal, and (iii) thus push the 1st-lien holder to foreclose on the property (which is somewhat expensive and time-consuming) earlier than it might otherwise do.
Other lenders can accept these risks as long as an agreement is reached defining each others’ rights in certain situations. These are generally called “intercreditor agreements.”
Intercreditor Agreement Considerations
As earlier noted, many 1st-lien lenders avoid 2nd-lien loans on the property because they don’t want to have to deal with competing claims on the asset. When they do allow it, most 1st-lien lenders generally seek to make “silent” the 2nd-lien holder – to have it agree that it won’t exercise some of its rights, so as not to harm or inconvenience the 1st-lien lender. These usually involve four key elements:
(a) Prohibitions (or limitations, sometimes time-related) on the right of 2nd-lien holders to take enforcement actions;
(b) No-challenge covenants (again, sometimes time-related) as to the 1st-lien lender’s exercise of its foreclosure actions;
(c) No-challenge covenants as to the validity or priority of the 1st lien; and
(d) Waivers of certain other secured creditor rights.
The 1st-lien lender seeks the enforcement delay to make sure that it mitigates the risk of not being “first in time” in filing a lien. Instead of being fully “silent,” 2nd-lien creditors generally just agree to be “quiet” for a while by establishing “fish-or-cut-bait” or “standstill” periods (usually 90-180 days) as to refraining from exercising their rights. Aggressive 2nd-lien holders even seek “use-it-or-lose-it” provisions forcing the 1st-lien holders to make a timely election of remedies, or else forfeit their right to take future remedial action.
Intercreditor agreements also often clarify the right of the 2nd-lien creditor to purchase the 1st-lien obligations, for an agreed period after a default / bankruptcy event. Some consider these rights to be valuable because, once exercised, a 2nd-lien creditor steps into the 1st-lien holder’s shoes and will be free to exercise all of the rights of a secured creditor, which will give them more leverage in negotiating a reorganization plan. Other observers place less importance on them, since a 1st-lien lender will often agree anyway to sell their loan if an at-par offer is made.
On the other hand, preferred equity should generally not be subject to bankruptcy concerns, as it is not debt. Thus, each of the possible means of subordinate or mezzanine financing instruments should be well understood – both on their own terms and in the context of the available alternatives.
A version of this article was earlier published at Think Realty.