What is “First Lien/Second Lien Debt”?
First lien and second lien debt are both senior forms of debt, which have equal standing in terms of principal and interest payment but have different standing with respect to the collateral. A lien is a claim on collateral pledged to secure the financing. The first lien debt has the first claim on collateral, while the second lien has a second priority claim. Revolvers, also a form of senior debt, can be secured by their own pool of assets or share collateral with first lien debt.
First lien lenders are often banks but can also be institutional lenders. In contrast, second lien lenders are almost always institutional lenders. An intercreditor agreement, or ICA, usually outlines the terms between lenders. Unitranche facilities can also be bifurcated into first and second lien tranches.
Key Learning Points
- First lien and second lien debt instruments have different levels of priority against pledged collateral
- First and second lien loans are both secured loans with equal rights in terms of the payment of interest and principal
- First lien lenders are usually banks and second lien lenders are typically institutional investors
Types of Subordination
In lending, there are two types of subordination: payment subordination, which is the prioritizing of debt according to which tranche has the right to receive interest and principal payments first in case of a default, and lien subordination, which is the prioritizing of debt according to which tranche has the right to the proceeds of liquidated collateral. First and second lien debt are widespread in highly leveraged capital structures that often have one or more tranches of debt secured by the company’s assets. Those tranches of debt can either stake out separate sets of collateral, share the same collateral, or establish priority claims on the collateral. First and second lien debt refers to the priority of their claims on the assets.
Examples of usage
Most leveraged capital structures will have first-lien debt in the form of either an amortizing bank loan (term loan A) or a non-amortizing term loan (term loan B or C). If two term loans are present in the same capital structure, term loan A will be considered the first lien as the bank lenders will demand the first claim on the assets. As more companies (and financial sponsors) seek flexibility within the capital structure, term loan As are less common due to their restrictive covenants and cash-intensive amortization schedules. Covenant-lite term loan Bs have become more popular and have assumed the first lien position. This first lien status also supports their use in collateralized loan obligations, adding additional liquidity to the market.
In case of a liquidation, the total liquidation value will be divided among the first lien lenders according to their pro-rata share of the first lien debt. The second lien lenders will share in the remaining proceeds if any.
The following example shows a typical capital structure with 1) an undrawn revolver, 2) First lien term loan A, and 3) second lien term loan B. There are insufficient assets to cover the first and second lien claims, so the second lien will not recover the entire loan. We can see the debt recovery based on the liquidation of assets results in bankruptcy.
Since both the term loan A and B are senior in status, it is important to note that both will continue to receive interest and principal payments until a settlement is reached. This highlights the difference between payment subordination and lien subordination and reveals the unique difference between first and second lien debt.
First-lien creditors have a priority claim on assets, while second-lien creditors have a second claim. The priority claim on assets only relates to the disbursement of proceeds when liquidating assets in a bankruptcy. Both creditors are considered pari passu, or on equal footing, regarding their seniority in the capital structure for the payment and repayment of mandatory interest and principal.