First and second lien loans are common forms of debt financing used by companies and individuals. A lien gives the lender a claim on collateral pledged by the borrower as security for the loan. Let’s take a closer look at how these lien structures work and the key differences between them.
What is a Lien?
A lien is a legal claim or charge on an asset that a lender can take if the borrower defaults on the loan. The pledged asset acts as collateral for the loan. Common examples include:
- A mortgage lien on a house
- A car loan lien on a vehicle
- A UCC lien on business assets like equipment or accounts receivable
The lien gives the lender the right to seize and sell the collateral to satisfy the outstanding debt if the borrower fails to make payments or meet other obligations of the loan agreement.
First Lien Loans
A first lien loan is debt that has the highest priority claim on the pledged collateral. If the borrower defaults the first lien lender gets paid before any other creditors.
First lien debt is generally considered the safest form of debt capital for lenders It carries lower interest rates than subordinated debt since it is higher in the capital structure
Common examples of first lien loans include:
- Revolving credit facilities
- Term loans
- Senior secured notes
Banks are frequent providers of first lien loans. The first lien lender has the power to force liquidation of assets if covenants are violated.
Second Lien Loans
A second lien loan has a subordinate claim on collateral relative to first lien debt. The second lien lender only gets paid after the first lien lender’s claim is satisfied in full in a default scenario.
Second lien debt carries more risk than first lien debt. As a result, it demands higher interest rates, more stringent loan terms, and tighter covenants.
Second lien lenders are still paid before unsecured creditors and equity holders. But their subordinated position means full recovery of principal is less certain in a distressed situation.
Comparing First and Second Lien Loans
While first and second lien loans share similarities, there are some key differences:
Collateral Claims
- First lien debt has priority claim on collateral
- Second lien is subordinate if collateral value falls short
Typical Lenders
- First lien – Banks, credit funds
- Second lien – Hedge funds, private credit funds
Interest Rates
- First lien rates are lower
- Second lien rates are higher due to more risk
Covenants
- Tighter covenants on second lien loans
- Varying degrees of covenant flexibility
Risk and Return
- First lien offers safety with lower yields
- Second lien has higher risk and reward
Using Multiple Liens
It’s common for borrowers to utilize both first and second lien structures. A company might use a first lien term loan for most of its financing needs but supplement it with a smaller second lien loan to boost returns for junior creditors.
Layering loans this way can benefit both borrowers and lenders. Borrowers get more total debt capacity while lenders can dial in their desired risk/return profiles.
Understanding lien structures is key for both borrowers seeking financing and lenders evaluating credit opportunities. First lien loans offer security for risk-averse lenders while second lien loans allow investors to pursue higher yields through subordinated exposure. Evaluating collateral coverage and covenant protections is critical in assessing the risk of junior capital.
Real Estate Mortgage Example: Lien on a House Property
For everyday consumers, a common real-life example of a lien can be seen with mortgages to purchase a home or a related real estate property.
- Creditor: The lien on the mortgage provides the lender with the legal right to seize the underlying property if a term specified in the lending agreement is not met.
- Debtor: The homeowner commits to borrow funds from a bank in order to purchase the home, so the bank placed a lien on the property until the mortgage is paid in full, which the home buyer must honor.
In conclusion, the only method for the lien on a house to be removed (and the property to truly belong to the homeowner) is for the mortgage obligation to be paid off in its entirety.
Lien Definition in Debt Financing
The term “lien” in the context of debt financing describes a lender’s legal claim on an asset belonging to the borrower.
As part of the financing arrangement, the borrower formally agreed to pledge certain asset(s) as collateral to offer further assurance to the lender that the promised payments (i.e. interest and scheduled amortization) will be received.
In the event that the borrower (i.e. the “debtor”) fails to fulfill a specified obligation, the lender (i.e. the “creditor”) has the right to seize and liquidate the assets that were pledged as collateral.
Most often, lenders such as banks require collateral as part of their contractual agreement in order to protect their potential downside risk in terms of managing capital losses.
The formal contract between the creditor and debtor will state the specific terms that establish the lien, namely the contractual obligations of the borrower required to be met (e.g. interest expense, principal amortization, and repayment of the outstanding principal at maturity), followed by the consequences of not meeting said obligations.
For instance, a corporate borrower missing an interest expense payment or failing to meet principal amortization requirements on time can cause the underlying company to enter technical default.
While the process of recouping the original principal can become rather complicated in a Chapter 11 reorganization, the lenders with liens on the now-bankrupt company are prioritized in the court proceedings and are thus more likely to receive full recovery.
Legal Definition of Lien (Source: LII)
What is a First Lien and Second Lien Mortgage? | Titan Impact Group
FAQ
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