By Claire Ruckin
LONDON (LPC) - Banks and funds are competing for second-lien leveraged loans as they battle for higher yielding assets to bolster their returns.
Borrowers renewed their appetite for second-lien loans in 2017 as a means of increasing overall leverage on a deal, while maintaining control over who holds the paper -- something that could not be achieved via the public high-yield market. It also didn't come with restrictive call protection associated with bonds.
However, for the majority of 2017, private equity firms shunned banks to pre-place second-lien loans directly with cash-rich funds, guaranteeing placement on the most expensive and risky part of a capital structure and avoiding any costly risks that could arise during a syndication process.
Yet deeply technical and liquid markets saw banks offer increasingly attractive terms and two large second-lien loans for Dutch-headquartered business services firm TMF Group and UK-based payment processing company Paysafe were syndicated at the end of last year.
Despite some caution from institutional investors, having been burnt on subordinated debt in the financial crisis, many have appetite for second-lien loans as a way of boosting returns, especially when pricing has come down significantly on senior paper.
Second-lien is also more attractive from a yield perspective than bonds, offering average margins of 750bp-775bp, compared to bond yields of 550bp.
"It is arguably a lot safer to take a strip of second-lien on a deal you like than take a higher margin on senior paper in a less credit-worthy deal. CLO investors have subordinated buckets to fill and second-lien is much more attractive than bonds when it comes to yield," a senior investor said.
TMF's €200m eight-year second-lien facility closed in December to pay 687.5bp over Euribor, with a 0% floor at 99.5 OID, while Paysafe's US$200m and US$250m-equivalent euro-denominated second-lien loans closed at the end of November to pay 725bp over Libor with a 1% floor and 700bp over Euribor with a 0% floor, respectively, at 99 OID.
"Syndicating second-lien can save 50bp-100bp for a sponsor if it goes well," a syndicate head said.
The success of TMF and Paysafe encouraged confidence among sponsors of smaller financings to syndicate second-liens. An €80m second-lien loan backing Citic Capital's buyout of French packaging firm Axilone closed in February to pay 775bp over Euribor, with a 1% floor at 98.
"TMF and paysafe helped smaller syndicated second-lien deals get over the line," a second syndicate head said.
MIXING IT UP
In 2018, however, funds fought back and proved competitive on pricing, preventing a wholesale trend for syndicated second-liens. Now the market is seeing a mix of both syndicated and preplaced second-lien loans.
Funds available to take pre-placed second-lien loans include Alcentra, Apollo Capital Management, MV Credit, Ares, Park Square (NYSE:SQ) Capital, EQT, GSO and Partners Group.
"There is a trade off to be done between a market that has an appetite for second-lien but isn't certain until placed versus someone coming in and doing it in one go to remove any threat of flex or widening," the second syndicate head said.
In March German-based wheelchair manufacturer Sunrise Medical and Luxembourg-headquartered investor services firm SGG both preplaced second-lien loans.
"Locking down costs, fixing margins and getting rid of expensive flex by preplacing the most junior pieces of the capital structure to de-risk can be attractive. Yes there might be a slight cost premium but this is compared to a downside of materially more than that," a third syndicate head said.
At the same time UK forecourt operator EG Group has wrapped up a second-lien loan and Advent ‘s £1bn public-to-private buyout of listed UK electronics and technology business Laird includes a £100m second-lien facility that is set to be syndicated.
LOSS IN FEES
After a deliberation process, Clayton, Dubilier & Rice has decided to preplace a £285m second-lien loan, which forms part of a wider £1.75bn-equivalent leveraged loan financing backing Motor Fuel Group's £1.2bn acquisition of MRH, the UK's largest petrol station and convenience retail operator. Syndicating it had been an option.
The preplacement of MFG's second-lien delivered an approximate €5.7m loss in underwriting fees to the banks, based on a 2% fee.
Despite banks losing out on 2%-3% underwriting fees on second-liens, sponsors are having to pay out that same amount to the funds they are preplacing the paper with, in the form of an arrangement fee.
So in order to be competitive, funds need to be cheaper than the margins and flex offered on an underwrite. Flex can see a sponsor on the hook for an additional 150bp.
"Sometimes the downside of underwriting is just too great, other times they make sense, especially for the more well known, larger credits. If the preplaced funds push back and want higher pricing then we may see even more underwrites, there is a natural competition between the two liquidity sources that is keeping them both on their toes," the third syndicate head said.