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Insight Newsletter
The Junior Secured Tranche B Loan
Banks have significantly curbed lending based on cash flow; now companies are turning to junior secured debt as an alternative.
by Michael T. Newsome
Over the past several years, unacceptable
default rates, substandard returns
and regulatory pressure have led banks
and other senior lenders to significantly curb
lending that relies principally upon the cash
flow of the business. For growing or restructuring
middle-market companies, filling the
funding gap between senior secured debt
and equity without surrendering control is
a challenge. In the void created by the virtual
disappearance of cash flow loans, a new
tier of junior secured debt has emerged as a
supplement to senior debt that provides incremental
liquidity and leverage. Although
more expensive than senior secured debt, it
may supplant the need for even more expensive
mezzanine or equity.
.........
For growing or restructuring
middle market companies,
filling the funding gap
between senior secured debt
and equity without surrendering
control is a challenge.
..........
SENIOR LENDERS SHIFT FOCUS
To assure capital preservation, senior
lenders have shifted their focus toward more
conservative, asset-based credit structures
that are underpinned with security interests
in assets (collateral). Secured bank financings
are purposely structured to leave a value
cushion between the amount of the debt
and the realizable or fair market value of the
borrower's assets. Many companies have
experienced a double whammy in the search
for adequate debt financing to take out maturing
financing arrangements. At the same
time that senior lenders have steered clear of
cash flow deals and sharpened their reliance
on collateral, asset values have been severely
eroded during the economic downturn.
Bankers are willing to lend against hard collateral,
but their take on value is pretty miserly.
As a result, senior borrowing capacity for
many companies has declined, leaving room
for another funding source.
.........
To assure capital preservation,
senior lenders have shifted
their focus toward more
conservative, asset-based
credit structures that are
underpinned with security
interests in assets (collateral).
..........
HOW THE LOAN IS UNDERWRITTEN
This relatively new tier of capital carries
a variety of labels—junior secured loan,
tranche B loan, second lien loan, or last out
participation. As banks have pulled back,
new capital sources, such as hedge funds,
specialized finance companies, mezzanine
lenders, and insurance companies, have
stepped in to fill the breach in selected situations
where the risk can be reasonably quantified
and adequately compensated.
These tranche B, or junior secured loans,
meld elements of senior secured term debt,
cash flow loans and mezzanine debt. The
fundamental credit premise is that there is
value in excess of what a senior lender will
accept based on the intrinsic value of either
the business or its assets. These loans are
typically underwritten in one of two ways:
• Asset Based — where the credit decision focuses
predominately on the liquidation value
of the assets, net of the senior advances, as
the ultimate source of repayment; or
• Enterprise Value — where repayment is
predicated on the value of the business as a
going concern.
In the case of an asset-based underwriting,
the junior lender focuses on the adequacy
of the cushion between the senior lender's
advance and the realizable value of the
assets. The junior lender may also consider
the value of assets that are not pledged to the
senior lender. Junior secured loans tend to be
well-suited to situations where the assets are
relatively liquid, value is predictable, and the
costs associated with liquidation are reasonably
quantifiable. Typical situations that may
meet these criteria are commodity distributors
or retailers where a senior lender is willing
to advance 75 to 80 percent of the orderly
liquidation value ("OLV") of inventory (net
of liquidation costs). A junior lender would,
in turn, consider advancing an incremental
10 to 20 percent of the inventory OLV, particularly
if other assets, such as trademarks,
real estate, or leasehold interests, are available
as additional support.
.........
Most importantly, buyer
interest and value must be
sustainable over time, as an
unforseen financial setback
that would casue a lender to
rely on business value usually
does not develope until several
years after the original financing
was put in place.
..........
With the enterprise value method, which
is akin to cash flow and mezzanine lending,
lenders consider criteria other than the
liquidation value of tangible assets, such as
the predictability of cash flow, strength of
management, market position and share,
and intangible assets (e.g., brand names, proprietary
technology, distribution territories,
customer base and/or contracts). The junior
lender is specifically evaluating the value of
the business enterprise as a going concern,
based upon most of the factors that an equity
investor would weigh. Should the borrower
at some point hit a bump in the road, the
junior lender needs to have a high degree
of confidence that there are readily identifiable
and capable prospective buyers for the
company, its business units, and/or its strategic
assets. Most importantly, buyer interest
and value must be sustainable over time, as
an unforeseen financial setback that would
cause a lender to rely on business value usually
does not develop until several years after
the original financing is put in place.
HOW THEY ARE STRUCTURED
Junior secured loans are generally structured
either as:
• A subordinated lien behind the senior
lender[s] on all of the borrower's assets (comparable
to a second mortgage on a house); or
• A senior lien on "boot" collateral assets
(those assets that the senior lender is unwilling
to make a specific advance against). For
example, boot collateral might include real
property, leasehold interests, or intellectual
property such as trademarks.
.........
Junior secured debt is commonly
viewed as bridge financing
that fills the gap until the
borrower can reduce its debt
and bolster performance.
..........
In terms of the capital structure hierarchy,
the junior lien lender has priority over any
subordinated debt, unsecured trade debt and
contingent claims (by virtue of its security
interests), and equity. Following an event of
default, these lenders generally have rights
and remedies that are comparable to the
senior lender, other than for their secondary
interest in the assets. The relationship
between the junior and senior lenders is governed
by an intercreditor agreement.
In the effort to arrange a junior loan, size
matters. The providers of this tier of capital
are looking for borrowers that are not large
enough to access the public high yield market,
but still have scale within their industries
or markets. Ideal candidates tend to be
firms with revenues north of $100 million,
although smaller companies can also access
this market under the right circumstances.
Junior secured loan borrowers are in reasonably
mature industries where cash flow can
be focused on debt reduction rather than
capital expenditures or growth.
GREATER RISK BRINGS HIGHER PRICE
Obviously, a junior secured loan embodie
greater risk than senior debt and is priced to
reflect that increment of added risk. Lenders
typically seek all-in annual returns in the 10
to 15 percent range (in the current low rate
environment). Depending on the lender,
these financings can be arranged on a fixed or
floating (tied to LIBOR or Prime) rate basis.
Loan pricing is more attractive than the 18
to 22 percent returns that mezzanine lenders
target. In addition, a junior secured loan
generally does not require warrants, so shareholders
do not suffer equity dilution.
Junior secured debt is commonly viewed
as bridge financing that fills the gap until
the borrower can reduce its debt and bolster
performance. The typical junior secured loan
credit structure has a tenor similar to the
borrower's senior debt, but requires little or
no amortization prior to maturity. In most
cases, it is refinanced within a couple of years
without a prepayment premium. As a consequence,
this capital is more flexible than
mezzanine debt.
THE EXTRA EFFORT COULD BE REWARDING
The incremental risk of junior secured
debt has proven to be of little interest to
banks. The field of lenders that is willing to
provide what is still a niche product is expanding,
but the market is not yet as well developed
as the mezzanine market. Although
it may take some effort to find the appropriate
source for the situation, the potential
savings relative to other alternatives can be
very meaningful.
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