Second-lien recovery prospects are improving, increasing first-lien risk, S&P report finds

By Sara Rosenberg

New York, Aug. 23 - Second-lien recovery prospects are improving as lenders have gained material collateral management rights, and, as a result, first-lien lenders' risk of loss under a default scenario have increased, according to Standard & Poor's Ratings Services' latest research report entitled "Second-Lien Evolution Creates Higher Recovery Prospects-At First-Lien Lenders Expense".

When second-lien bank loans crossed over into the syndicated loan market from the rescue financing market, they tended to lack the same protective provisions or awareness of each party's lending philosophies.

In fact, first-lien lenders largely barred second-lien lenders from having any material collateral management rights before or during bankruptcy.

But, two structural factors have indicated a departure from these previously "silent" second liens - the existence of second-lien financial covenants and a relatively short standstill period.

For example, in regards to covenants, while only 39% of separately documented second-lien bank loans included a leverage covenant in the first quarter of 2004, 71% included a total leverage covenant in the first quarter of 2005 and 86% included a total leverage covenant is the second quarter of 2005.

And, the use of separate credit agreements for second-lien loans, which has increased so much during 2005 that doing so now appears to be the normal and preferred means by which to document these structures, has improved negotiating leverage of second-lien lenders.

Separate credit documents almost always enable second-lien lenders to be the sole voters on their covenant amendments, while the combined documentation approach typically forces second-lien lenders to vote on covenant amendments in conjunction with first-lien lenders. That means that with separate documentation, second-lien lenders could keep a borrower in default despite the willingness of first-lien lenders to agree to the resolution of a first-lien covenant violation, S&P explained.

Furthermore, the incidence of limitations to the standstill provision is much more pronounced in separately documented transactions than under combined documentation in which the standstill is often permanent. Of the 30 transactions rated by S&P that use a single credit agreement to govern both first- and second-lien rights, 24, or 80%, include permanent standstills preventing the second-lien lenders from interfering with the first-lien lenders' management of collateral during insolvency. Conversely, of the 87 second-lien structures documented with separate credit agreements only 15, or 17%, include similar permanent standstill provisions.

Although 180 days still appears to be the normal standstill limitation, several transactions lately have contained 90- and 45-day standstill limitations. These shorter standstill periods are expected to enhance second-lien lender negotiating leverage and increase the likelihood that first-lien lenders will act in such a way that preserves recovery value for all lenders.

"We believe the pendulum has swung sufficiently back to the point where second-lien lenders do indeed have material collateral management rights. Consequently, we believe that second-lien recovery prospects generally are improving. Conversely, we believe first-lien lenders' risk of loss given default has increased," an S&P news release said.

The result of the review is that, when appropriate, negotiating leverage will be reflected in S&P recovery ratings applied to structures with both first- and second-lien loans. As a result, second-lien loans on the border between recovery rating categories are more likely to be assigned the higher rating, while the accompanying first liens on the border between recovery ratings are more likely to be assigned the lower recovery rating, the agency said.

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