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Mortgaging the future?

Highly leveraged companies are turning to expensive loans from hedge funds and other alternative lenders as banks pull in their horns. Will they regret it later?

With interest rates lately hovering at historic lows, getting a bank loan should be a snap. But many U.S. companies haven't been able to lately. Burned by corporate scandals and defaults that ripped through their loan portfolios just as the economy fell into a post-9/11 recession, banks have been tight with corporate credit, avoiding the riskiest borrowers and insisting on tough terms to protect themselves against further losses.

Hardest hit by the pullback, perhaps, have been middle-market companies that are already carrying significant debt loads. When obligations come due and it's time to refinance, these companies often have trouble persuading banks to go along. That's where a relatively new financing instrument is increasingly coming into play: the so-called second-lien term loan

Also called "tranche B loans" or "additionally secured term notes," second-lien debt generally is characterized by one of two criteria. Either the lenders take a secondary claim on a company's assets that already are being used as collateral in an existing loan (not unlike a second mortgage on a house), or they secure their interest by using other assets that banks may not honor as collateral, such as brand names, trademarks and other intangibles.

Among the first to use second-lien loans were retailers offering secondary claims on inventories in late-1990s restructurings. More recently, a wider array of companies have turned to the structure, capitalizing on demand from hedge funds, specialty finance firms, mutual funds and other nontraditional lenders for high-yield investments in a low-rate environment. Most deals are priced at a spread over LIBOR, which is currently about 2 percent (see table). Many carry double-digit yields, higher than most junk bonds' payouts today.

"There's been an explosion of interest from hedge funds and mutual funds," says S. Randy Lampert, a managing director at investment bank Morgan Joseph & Co. who has worked on several second-lien transactions.

Private equity firms also are taking advantage of the instrument's popularity. Many of the more recent second-lien deals have supported leveraged buyouts and recapitalizations of distressed companies. On April 6, for instance, Chicago buyout firm GTCR Golder Rauner used a second-lien loan to finance $100 million of its $500 million acquisition of Prestige Brands International, maker of Prell shampoo and Comet cleanser.

But second liens also have potential pitfalls for both borrowers and lenders. When companies that have issued second-lien debt want to raise additional capital later, holders of the old paper may object to more bank debt -- which is senior to the second liens -- being tacked on to the company's balance sheet. In a bankruptcy or restructuring, these investors may not want to step aside if there aren't enough assets to cover both the primary and secondary claims.

"A lot of these hedge funds and opportunistic lenders can be very aggressive," says one investor who's familiar with the second-lien market. "They are lending because it's a hot place to make money now. They don't care about their reputation with companies and might be less likely to compromise in a dispute."

Consequently, as big banks begin loosening their grip on credit in an improving economy, companies that have taken on second-lien debt may find that they've set the stage for brawls among their creditor groups.

"One of the issues for companies is that it does complicate their capital structure," says Allen Weaver, senior managing director of Prudential Capital Group, a division of the Newark, New Jersey, insurance giant that manages and invests in nonpublic asset classes.

Those complications may well become harmful distractions to the scores of companies that have been capitalizing on this alternative funding sourc e.

Second wind
Second-lien term loans have become popular with middle-market companies seeking to refinance maturing obligations. Here are some of the most recent deals completed this year.

Amount raisedInterest*
DateIssuer($ millions)cost
5/10 BlueLinx Corp. $100 8.00%
5/6 Holmes Group 85 7
4/28 Meridian Automotive Systems 175 9
4/27 Polymer Group 125 4.75
4/23 Tensar Corp. 28 8
4/21 Cognis 199 N/A
4/15 Adams Outdoor Advertising 25 3.5
4/6 Prestige Brands International 100 4.75
3/30 AMS Services 20 6.5
3/26 WRC Media 145 6
*Spread over LIBOR.
Source: Dealogic.

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