Everything You Always Wanted To Know About Second Lien Financings

Transcription

1 Everything You Always Wanted To Know About Second Lien Financings A LATHAM & WATKINS PRESENTATION May 19, 2004 Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership Copyright 2003 Latham & Watkins. All Rights Reserved. 1

2 Speakers James Chesterman Peter M. Gilhuly Banking and Leveraged Finance Group Insolvency Group Latham & Watkins, London Office Latham & Watkins, Los Angeles Office David G. Crumbaugh Marc P. Hanrahan Banking and Leveraged Finance Group Banking and Leveraged Finance Group Latham & Watkins LLP, Chicago Office Latham & Watkins LLP, New York Office Kirk A. Davenport David S. Heller Corporate Finance Group Insolvency Group Latham & Watkins LLP, New York Office Latham & Watkins LLP, Chicago Office

3 What Are We Going to Cover Today The Various Flavors of Second Lien Financings The Pros and Cons From All Perspectives Debt Subordination vs. Lien Subordination What Makes Secured Creditors So Special? What Makes a Silent Second Silent (and What are the Practical Implications)? Some Common Real World Scenarios How Do We Document These Transactions? Conclusions 3

4 The Various Flavors of Second Lien Financings We are here to talk about the two most common versions Second Lien High Yield Bonds Second Lien Term Loans We will not discuss some of the more esoteric flavors (seller paper, sponsor loans, distressed/rescue paper) We will not discuss secured mezzanine financings 4

5 The Various Flavors of Second Lien Financings Second Lien Bonds Often called Secured Senior Notes or Second Lien Secured Notes, these creatures are just like any other high yield bonds except they are secured No maintenance covenants or cross default provisions Key covenant differences from an unsecured high yield deal include Hard dollar cap on future first lien debt Very tight ratio limiting future second lien debt In other words, the liens covenant becomes the key limitation on future debt incurrence, not the debt covenant - future unsecured debt may only be a hypothetical possibility for some time 5

6 The Various Flavors of Second Lien Financings Second Lien Term Loans Investors are usually typical Term Loan B purchasers (e.g., hedge funds) Maturity longer and certain other economic terms are richer than typical Term Loan B paper Covenants are lighter than first lien debt: Sometimes very close to high yield covenants Other times, it s the 1 st lien covenant package ratcheted back There will always be a limit on the amount of 1 st lien debt (may include a cushion ) Financial covenants fewer in number and less restrictive than 1 st lien debt 6

7 The Various Flavors of Second Lien Financings Second Lien Term Loans (cont d) Mandatory prepayments same categories as 1 st lien mandatory prepayments, but no mandatory prepayments required on 2 nd lien debt so long as 1 st lien debt requires that such mandatory prepayment be applied to 1 st lien debt Not cross-defaulted to 1 st lien debt until passage of day period; in some bond like deals, only crossacceleration/cross payment default Change of control often cast as put option rather than event of default Prepayment premiums often apply (but better from the borrower s perspective than typical high yield bonds) 7

8 Market Data There has been exponential growth in the second lien financing market in the last year Second lien loans raised over $5.23 billion in the first four months of 2004, compared with approximately $3.26 billion for all of 2003 Volume of second lien loans for the first four months of 2004 was almost double the total deal volume for 2003, increasing from 26 to 49 deals The increase in second lien bond deals has also been dramatic (although somewhat less astronomical) 8 Source: Standard & Poor s / Leveraged Commentary & Data

9 Volume and Number of Second Lien Loans $7,000 $6,000 Volume Number 57 $5,000 In Millions $4,000 $3, $2,000 $1,000 $ /1-5/13 5/14-12/31 1/1-5/13 5/14-12/31 9 Source: Standard & Poor s / Leveraged Commentary & Data

10 Average Deal Size of Second Lien Loans /13/2004 $300 $200 $190 $100 $98 $68 $33 $28 $22 $125 $104 $116 $90 $ Q03 1Q04 4/1-5/13/04 10 Source: Standard & Poor s / Leveraged Commentary & Data

11 Average Debt/EBITDA Ratio for Transactions with Second Lien Loans /1/2004 to 5/13/ x 6.0x 4.0x 2.0x x 2003 (26) 4Q03 (12) 1Q04 (30) 4/1-5/13/04(19) First Lien Bank Debt Second Lien Bank Debt Other Senior Debt Sub Debt 11 Source: Standard & Poor s / Leveraged Commentary & Data

12 Recent Precedent Company Transaction Date Midwest Generation, LLC $1,000,000, % Second Priority Senior Secured 2004 Notes due 2034 U.S. Security Holdings, Inc. $146,000,000 First and Second Lien Credit Facilities 2004 Calpine Generating Company LLC $1,705,000,000 First Priority Secured Floating Rate Notes due Second Priority Secured Floating Rate Notes due 2010 Third Priority Secured Floating Rate Notes due % Third Priority Secured Notes due 2011 Transwestern Publishing Company, LLC $665,000,000 First and Second Lien Credit Facilities 2004 Cebridge Connections, Inc. $350,000,000 Senior Secured First and Second Lien Term Loan 2004 Plastech $50,000,000 Senior Secured Second Lien Term Loan 2004 Playtex Products, Inc. $460,000,000 8% Senior Secured Notes due Carmike Cinemas, Inc. $150,000,000 Senior Secured First and Second Lien Credit 2004 Facilities American Casino & Entertainment $215,000, % Senior Secured Notes due NRG Energy, Inc. $475,000, % Second Priority Senior Secured Notes due Tri-State Outdoor Advertising $50,000,000 Senior Secured First and Second Lien Credit Facilities

13 Recent Precedent Company Transaction Date Atlantic Express Transportation Corp. $115,000,000 12% Senior Secured Notes due 2008 and Senior 2004 Secured Floating Rates Notes due 2008 Tensar $112,000,000 Secured First Lien Secured Second Lien Facilities 2004 Leedsworld $93,000,000 Secured First Lien Secured Second Lien Facilities 2004 Ranpak $140,000,000 Secured First Lien and Secured Second Lien Facilities 2004 Roller Bearing $220,000,000 Secured First Lien and Secured Second Lien Facilities 2004 Cognis Deutschland GmbH& Co. KG 745,000,000 Floating Rate Second Lien Notes due and Senior Notes due 2014 Mueller Group, Inc. $100,000,000 Second Priority Senior Secured Floating Rates due Nellson Neutraceuticals $360,000,000 First and Second Lien Term Loans 2004 Holland USA $92,500,000 Secured First Lien and Secured Second Lien Facilities 2003 NRG Energy, Inc. $1,250,000,000 8% Second Priority Senior Secured Notes due

14 Recent Precedent Company Transaction Date American Reprographics Company, LLC $355,000,000 First and Second Lien Credit Facilities 2003 Calpine Corporation $400,000, % Second Priority Senior Secured Notes due Dynegy Holdings Inc. $300,000, % Second Priority Senior Secured Notes due % Second Priority Senior Secured Notes due 2013 Advanstar Communications, Inc. $70,000, % Second Priority Senior Secured Notes due Calpine Construction Finance Company, L.P. $365,000,000 Second Priority Senior Secured Floating Rate Notes 2003 due 2011 Holland USA $66,500,000 Secured First Lien and $26,000,000 Secured Second Lien 2003 Facilities Venetian Macau, S.A. $120,000,000 Tranche A Floating Rate Senior Secured 2003 Notes due 2008, Tranche B Floating Rate Senior Secured Notes due 2008 Advanstar Communications, Inc. $360,000,000 Second Priority Senior Secured Floating Rate Notes 2003 due 2008, 10.75% Second Priority Senior Secured Notes due

15 Recent Precedent Company Transaction Date Dynegy Holdings Inc $1,450,000,000 Second Priority Senior Secured Floating Rate Notes , 9.875% Second Priority Senior Secured Notes due 2010, % Second Priority Senior Secured Notes due 2013 Calpine Corporation $2,550,000,000 Second Priority Senior Secured Floating Rate Notes 2003 due 2007, 8.5% Second Priority Senior Secured Notes due 2010, 8.75% Second Priority Senior Secured Notes due 2013 Dayton Superior Corporation $165,000, % Senior Second Secured Notes due O Sullivan Industries $100,000, % Senior Secured Notes due Environmental System Products, Inc. $300,000,000 Senior Secured First and Second Lien Credit 2003 Facilities Wynn Las Vegas, LLC and Wynn $370,000,000 12% Second Mortgage Notes due Las Vegas Capital Corp. Venetian $850,000,000 11% Mortgage Notes due Transportation Technologies $265,000,000 Senior Secured First and Second Lien 2002 Facilities 15

16 The Pros and Cons of Second Lien Financings (The Company s Perspective) Why would a company ever want to give collateral to its junior creditors? Better interest rate Better market access May be only way to get deal done Why would a company not want to do a second lien deal? Limits future financing options Cap on future first lien debt Strict limit on future second lien debt Practical limitation on future unsecured debt Incremental transaction costs 16

17 The Pros and Cons of Second Lien Financings (The Senior Bank s Perspective) Historically, first lien creditors have enjoyed exclusive control of collateral First lien creditors are naturally inclined to object to sharing their collateral with junior creditors First lien creditors fear that second lien creditors may assert rights that will interfere with their ability to call the shots and realize value in the collateral They never want to wake up in a distress scenario and wish they didn t have to deal with second lien creditors competing interests 17

18 The Pros and Cons of Second Lien Financings (The Senior Bank s Perspective) First Lien Creditors, given the choice, would prefer debt subordination (to be discussed) to lien subordination However, if their exposure is reduced, they can get to yes They may be getting paid down with the proceeds of the second lien deal They may only get to yes if the second lien is a silent second 18

19 The Pros and Cons of Second Lien Financings (The Second Lien Creditor s Perspective) Second Lien Creditors Will Accept a Silent Second Lien Because it is Better to be Secured than Unsecured Black letter bankruptcy law provides that you are entitled to the value of your interest in collateral in bankruptcy Secured creditors collect ahead of the trade and other unsecureds (to the extent there is value in their interest in the collateral) Secured creditors can get post-petition interest if they are oversecured Secured creditors have better rights in bankruptcy (even though some of those rights may be waived as part of making the lien a silent second) Bottom line: secured creditors recover more in bankruptcy than unsecured creditors 19

20 Debt Subordination vs. Lien Subordination What are the key differences? Debt subordination involves an agreement to turn over to holders of senior debt everything received from the borrower from any source Debt subordination also typically includes payment blockage provisions 20

21 Debt Subordination vs. Lien Subordination What are the key differences? Lien subordination only requires turnover to first lien creditors of proceeds of shared collateral There is no payment blockage in typical second lien deals Waiver of rights is generally confined to the special rights of secured creditors relating to collateral only Rights of unsecured creditors are specifically preserved (with a few narrow exceptions) Antilayering covenants in existing high yield debt may only restrict debt subordination and not lien subordination Depends on exact wording of covenant (subordinated in right of payment vs. in any respect ) 21

22 What Makes Secured Creditors So Special? Pre-bankruptcy Right to foreclose and realize value This remedy is almost never consummated, but its existence creates negotiating power In bankruptcy Priority vis-à-vis trade and other unsecured creditors Post-petition interest Adequate protection rights Harder to be crammed down Right to credit bid More leverage in plan negotiations 22

23 What Makes Secured Creditors So Special? In Bankruptcy Adequate protection rights entitle a secured creditor to protection against diminution in the value of its collateral during a bankruptcy Adequate protection rights are very broad and crop up in a variety of circumstances Right to object to mischief relating to collateral Right to object to uses of cash collateral Right to object to sales of collateral Leverage to prevent/modify DIP financing Right to request current payment of post-petition interest Adequate protection is where much of the action is in these intercreditor discussions 23

24 What Makes a Silent Second Lien Silent? Second lien creditors must agree by contract to give up some of their rights General idea is to preserve whatever rights you would have had as an unsecured creditor but defer to the first lien creditors as to how to exercise the special rights of secured creditors First lien creditors want to drive the bus Second lien creditors want to make sure that in allowing 1st lien creditors to drive the bus the interests of 2 nd lien creditors are not unfairly disregarded The collateral trust agreement or intercreditor agreement will spell out just how silent is silent This is where the flashpoints are in negotiations 24

25 What Makes a Silent Second Lien Silent? There is some consensus in both the bond and the term loan markets about the extent to which second lienholders should waive their secured creditor rights There are some areas that are still hotly contested Adequate protection waivers Scope and duration of enforcement standstills Waiver of right to vote in bankruptcy The bond market conventions are more settled than the term loan market conventions 25

26 What Makes a Silent Second Lien Silent? Issue Waiver of right to exercise remedies against collateral High Yield Market Typically waived until 1 st lien debt is paid in full Term Loan Market Waiver often expires after days Practical Implications: First lien banks drive the bus (at least for a while) Term loans may get into the mix after standstill expires Company is more likely to be pushed into bankruptcy after standstill expires 26

27 What Makes a Silent Second Lien Silent? Issue Waiver of right to challenge first liens High Yield Market Waiver almost always given Term Loan Market Waiver almost always given Practical Implications: Not a significant concession by the second lien holder since challenging the first liens is probably a dangerous game People in glass houses shouldn t throw stones 27

28 What Makes a Silent Second Lien Silent? Issue Waiver of right to oppose adequate protection for 1 st lienholders High Yield Market Waiver almost always given Term Loan Market Waiver almost always given Practical Implications: Not a significant concession Second lienholders want to see first lien debt get paid Second lienholders should have tag along rights if first lien creditors obtain new collateral 28

29 What Makes a Silent Second Lien Silent? Issue Waiver of right to seek adequate protection for 2nd lien holders High Yield Market Typically waived until 1st lien debt is paid in full (subject to tag along rights) Term Loan Market Sometimes waived, but may be a fiercely negotiated point Practical Implications: Second lienholders should have tag along rights to protect liens on quick assets and to reduce opportunities for mischief This is a very broad waiver and can have real consequences However, in many cases, if second lienholders have tag along rights and virtually all of the company s assets are already part of collateral package, this waiver may be acceptable 29

30 What Makes a Silent Second Lien Silent? Issue Advance consent to uses of cash collateral approved by 1 st lienholders High Yield Market Advance consent usually given Term Loan Market Advance consent usually given Practical Implications: Use of cash collateral is critical to the company in bankruptcy First lien lenders will typically negotiate a strict operating budget as part of their agreement to release cash collateral for use in the business Second lien lenders will not participate in these budget negotiations First lien debt will drive the bus 30

31 What Makes a Silent Second Lien Silent? Issue High Yield Market Term Loan Market Advance consent to DIP financings approved by 1 st lienholders Practical Implications: Advance consent usually given (if 1 st lien creditors share the pain ) Advance consent usually given (if 1 st lien creditors share the pain ) possibly subject to a hard dollar cap Probably not much likelihood of a 2 nd lien creditor successfully objecting to a DIP loan that primes (or is pari passu with) the 1st lien debt if other constituents support it Is important to limit advance consent to share the pain scenarios 31

32 What Makes a Silent Second Lien Silent? Issue Waiver of voting rights on a plan of reorganization High Yield Market Often not waived at all. If waived, usually limited to waiver of right to vote for a plan that 1 st lien creditors vote down Term Loan Market Generally not waived Practical Implications: This waiver is objectionable in that it can cause second lien creditors to be in a worse position than unsecured creditors in plan negotiations Consequences could be very expensive 32

33 What Makes a Silent Second Lien Silent? Issue Release of second liens outside of bankruptcy High Yield Market Automatic release for asset sales that satisfy bond covenants. On/off switch often in hands of 1 st lienholders even where no asset sale involved (unless all or substantially all of collateral at stake). Note TIA issue Term Loan Market Automatic release for asset sales that satisfy second lien covenants only. Second lien term lenders want their own on/off switch Practical Implications: Not a significant concession in most scenarios Second lienholders likely have an asset sale covenant that will limit opportunities for mischief Unlikely that first lienholders will release any collateral except where they are getting paid down with sale proceeds However, possibility for mischief is still present 33

34 What Makes a Silent Second Lien Silent? Issue Release of second liens during a bankruptcy High Yield Market Advance agreement not to object to collateral sales approved by 1 st lien debt Term Loan Market Advance agreement not to object to collateral sales approved by 1 st lien debt Practical Implications: Not a significant concession 2nd lien creditors would not likely succeed in blocking a Section 363 sale supported by other constituents Bankruptcy process and fiduciary duties keep opportunities for mischief to a minimum 34

35 What Makes a Silent Second Lien Silent? Issue Scope of collateral package High Yield Market Limited by Regulation S-X Section Also usually includes generous basket. Also note Trust Indenture Act Section 314(d) issue Term Loan Market Same as 1 st lien debt Practical Implications: Failure to obtain subsidiary stock pledges could be significant, depending on nature of hard asset collateral TIA Section 314(d) is a headache 35

36 What Makes a Silent Second Lien Silent? Issue Right of 2 nd lien debt to buy out 1 st lien debt at par plus accrued High Yield Market Almost never included Term Loan Market Sometimes included during limited window following acceleration Practical Implications: Not a huge point for either side If 2 nd lien debt has both the will and the means to repay the 1 st lien debt at par, a deal will likely be struck without regard to what the documents say 36

37 Some Real World Scenarios Let s assume the following fact pattern: Widgets.com has borrowed $1.0 billion under its first lien bank credit agreement and issued $1.0 billion of second lien high yield bonds/term loans The banks have a blanket first lien on all of Widget s assets except real estate The bonds/term loan have a blanket second lien on all of Widget s assets including real estate At the time Widgets files for bankruptcy, the collateral is worth $1.5 billion and the real estate is worth $500 million In two years, when a plan of liquidation is confirmed, the collateral is sold for $1.2 billion and the real estate is sold for $300 million 37

38 Real World Scenarios Variation #1 Covenant default occurs on first lien debt What rights do second lien creditors have? 38

39 Real World Scenarios Variation #2 First lien debt holders negotiate with Widgets.com to consensually sell collateral to pay down first lien debt Can second lien holder object? What if the assets sold were not part of the collateral? 39

40 Real World Scenarios Variation #3 Payment default occurs under first lien debt Second lien debt can accelerate (probably) Unsecured (or undersecured) creditors can put company into bankruptcy 40

41 Real World Scenarios Variation #4 Payment default occurs plus 180 days pass Standstill period expires if second lien debt is term loan flavor 41

42 Real World Scenarios Variation #5 Company files for bankruptcy First day motions are proposed for: Use of cash collateral First lien defensive DIP financing What rights do second lien creditors have? 42

43 Real World Scenarios Variation #6 Company files for bankruptcy and seeks permission to sell inventory in ordinary course of business First lien debt seeks adequate protection (e.g., asks court for replacement lien in real estate) What rights do second lien holders have here? To challenge first liens adequate protection motion To assert their own adequate protection rights ( Hey what about me? ) 43

44 Real World Scenarios Variation #7 Company files for bankruptcy First lien creditors ask for cash payment of postpetition interest as adequate protection Can second lien creditors object? Can second lien creditors ask for cash payment of postpetition interest for themselves during the bankruptcy? 44

45 Real World Scenarios Variation #8 Company files for bankruptcy First day motion to approve DIP financing by third party potential acquiror Motion includes credit bid rights and rights to convert DIP to equity What rights to second lien creditors have? 45

46 Real World Scenarios Variation #9 Company files for bankruptcy Company files first day motion for Kmart-like mass liquidation Can second lien creditors object? 46

47 Real World Scenarios Variation #10 Company files for bankruptcy and elects to sell crown jewel assets under Section 363 First lien creditors can object on Section 363 grounds What right do second lienholders have? 47

48 How Do We Document These Transactions? Collateral Trust Agreement vs. Intercreditor Agreement Second lien bond deals tend to use collateral trust agreement because of perceived independence associated with this arrangement Second lien term loans tend to use intercreditor agreements because of perceived control benefits to first lien holders No important substance to this distinction 48

49 How Do We Document These Transactions? Special Disclosure Issues in Bond Deals Risk Factors must explain collateral package Section 3-16 of Regulation S-X 49

50 Second Liens In Europe: A Different Ball Game Banking and capital markets developed differently in Europe, with stronger lead bank relationships, with mezzanine being sole subordinated debt source Restructurings generally take place out of court due to different bankruptcy regimes, therefore consensual, leading to greater hold out issues Second lien loans are predominantly mezzanine in LBOs with relatively standard intercreditor provisions Second lien bond market intercreditor positions are still evolving 50

51 Second Lien Loans / Mezzanine Originally provided by commercial banks with very few independent mezzanine investors, leading to less negotiation Well established market Guarantee and security package follows senior Usually includes debt subordination as well as lien subordination Identical covenant and default package to senior (backed off approximately 10%) Independent waiver and consent rights are typical Standstill customarily days 51

52 Second Lien Bonds European Style Evolution towards US model from historic structurally subordinated deals in telecom sector Very few deals (Focus Wickes; Baxi; Cognis); all unregistered Intercreditor position still moving around Guarantee and security package follows senior debt Payment blockage similar to US high yield market Standstills vary; mezz style on Cognis; Focus Wickes a hybrid with permanent standstill on collateral Unanimity provisions reduced to 90% in Focus Wickes/ Baxi 52

53 SUMMARY - CONCLUSIONS If you are the first lien debt: Must Haves Control over enforcement actions for some period of time Ability to force asset sale free and clear of all liens Agreement not to object to asset sales in bankruptcy Ability to put DIP in place Ability to obtain adequate protection without objection from 2 nd lien debt Agreement not to challenge first liens Like to Haves Control over enforcement actions forever Ability to release both first and second liens outside of bankruptcy Agreement not to object to any action taken by 1 st lien creditors Ability to vote claims of 2 nd lien creditors Ability to put DIP in place ahead of 2 nd lien debt but behind first lien debt 53

54 SUMMARY - CONCLUSIONS If you are the 2 nd lien creditor: Must Haves Ability to assert rights of an unsecured creditor Ability to vote your claims in a bankruptcy Tag along rights whenever 1 st lien creditors get new collateral Like to Haves Limitation on duration of enforcement standstill Unfettered adequate protection rights Right to buy out 1 st lien debt at par plus accrued 54

55 SUMMARY - CONCLUSIONS If you are the company: Must Haves Some room for future borrowing capacity on a secured basis (first or second lien) Like to Haves Lots of room for future secured borrowings (both first and second lien) Lots of room for future unsecured borrowings 55

56 SUMMARY - CONCLUSIONS The second lien market is here to stay Most of the critical intercreditor issues are the subject of a market consensus (particularly in bond land) In the term loan market, a number of key issues are not yet resolved Duration of enforcement standstill Extent of waiver of adequate protection rights As long as the market continues to reward companies who are willing to provide collateral to their junior creditors, these products will have a place on the corporate finance menu 56