1st Lien

By Irina Balalaeva, International Fixed Income Group of Cbonds
Updated March 31, 2024

What is First Lien?

In the realm of secured debt, a "first lien" refers to a legal claim or priority position that a lender holds over specific assets pledged by a borrower. This designation ensures that if the borrower defaults on the loan, the lender with the first lien has the primary right to seize and liquidate the collateral to recover their investment. Essentially, it establishes a hierarchy among creditors, ensuring that first lien debt holders are prioritized over other debt holders, including senior debt holders, in the repayment process. This secured nature of first lien positions makes them less risky for lenders, leading to lower interest rates compared to other types of debt.

First Lien Explained

Imagine you’re lending money to a friend, but to secure your loan, they agree to let you hold onto their prized guitar until they pay you back. Now, let’s add a twist – several friends are lending money to the same person, each securing their loans with different items like a laptop or a camera. Here’s where first lien comes into play.

In this lending scenario, being the one with the first lien is like having dibs on picking an item first if your friend struggles to repay everyone. If things go south and your friend can’t repay all the loans, you get the first shot at taking back your collateral – in this case, the guitar. Other friends, who might have second or third liens, have to wait their turn. The idea is that by having this priority system, lenders can feel more confident about getting their stuff back, and they might even offer a lower interest rate to your friend because their risk is lower.

In the financial world, this concept works similarly. When a business takes out a loan and uses its assets as collateral, the lender might insist on being in the "first lien" position. If the business struggles and can’t repay the loan, the lender with the first lien gets the first crack at seizing and selling the assets to recoup their money. It’s a bit like a queue – the first in line gets served.

Benefits

1. Priority in Repayment. One of the primary advantages of first lien debt is its priority in the repayment hierarchy. In the unfortunate event of a borrower default, first lien debt holders are first in line to recoup their investment, ahead of other creditors. This priority position enhances the likelihood of recovering the full amount lent.

2. Lower Risk for Lenders. Lenders often perceive first lien debt as less risky compared to other forms of debt. The security provided by collateral and the priority status reduce the lender’s exposure to potential losses, leading to a lower level of risk.

3. Lower Interest Rates for Borrowers. For businesses seeking financing, opting for first lien debt can translate into lower interest rates. Since lenders perceive this form of debt as less risky, they are inclined to agree to more competitive interest rates in order to attract borrowers. Lower interest rates contribute to reduced borrowing costs for the business, making capital more accessible.

4. Attractive to Alternative Lenders. In an environment where traditional banks may be cautious, alternative lenders, such as Business Development Companies (BDCs), often step in to provide first lien debt. These lenders offer speed, flexibility, and transparency in the financing process, making them a valuable resource for businesses in need of capital.

 Risks

1. Market Value Fluctuations. The value of collateral securing first lien debt can be subject to market fluctuations. In cases where the collateral’s value diminishes significantly, lenders may face challenges recovering the full amount, exposing them to potential losses.

2. Limited Recovery in Default. While first lien debt holders have priority in repayment, there’s no guarantee that the full amount will be recovered in the event of borrower default. If the collateral’s sale doesn’t generate sufficient proceeds, lenders might not recoup their entire investment.

3. Asset Specificity. The effectiveness of first lien debt hinges on the value and liquidity of the pledged assets. If the assets are highly specialized or lack widespread market demand, selling them in a default scenario might prove challenging, affecting the recovery process.

4. Interest Rate Risk. Though first lien debt often comes with lower interest rates compared to riskier forms of debt, it is not immune to interest rate fluctuations. If interest rates rise, the cost of servicing the debt may increase, impacting the financial health of the borrower.

 Difference Between First Lien and Second Lien Debt

1. Priority in Claims. First lien debt holds the primary claim on the collateral, meaning it stands first in line for repayment if the borrower defaults. In contrast, second lien debt takes a secondary position, following the claims of first lien debt holders. This hierarchical structure significantly shapes the risk and potential recovery for lenders.

2. Collateral Seizure Rights. The legal right to seize and liquidate collateral is a defining feature of lien debt. First lien debt holders possess the initial right to seize specific assets in the case of default. Only after satisfying the claims of first lien debt holders do second lien debt holders gain the right to liquidate remaining collateral, underscoring the sequential nature of these rights.

3. Risk and Return Profiles. The priority accorded to first lien debt translates into a lower level of risk for lenders, leading to comparatively lower interest rates. Lenders providing second lien debt, accepting a subordinate position, are exposed to higher risk, resulting in relatively higher interest rates. This risk-return dichotomy reflects the dynamics of securing debt against a company’s assets.

4. Lender Types. While first lien lenders can include both banks and institutional lenders, second lien lenders are predominantly institutional. The nature of the lender underscores the varying risk appetites and preferences in the financing landscape. Intercreditor agreements often define the terms and relationships between these lenders, outlining their respective rights and obligations.

5. Asset-Specific Priority. In the event of liquidation or default, the prioritization of assets plays a crucial role. First lien lenders have the first claim on the total liquidation value, receiving their share based on the pro-rata distribution of first lien debt. Second lien lenders enter the distribution process only after satisfying the claims of first lien debt holders, potentially sharing in the remaining proceeds.

6. Industry Application. Both first and second lien debt structures are prevalent in highly leveraged capital structures, often featuring tranches of debt secured by a company’s assets. The industry context, risk tolerance, and capital structure preferences influence the choice between first and second lien debt. For instance, first lien debt might be favored in more stable industries, while second lien debt could be a strategic choice in riskier or evolving sectors.

 First Lien Debt vs. First Lien Loan

While the terms "first lien debt" and "first lien loan" may sound interchangeable, they denote distinct aspects within the realm of financing and debt structures.

First lien debt refers to a type of secured debt that holds the highest priority in the repayment hierarchy in the event of a borrower default. As stated above, first lien debt refers to a type of secured debt that holds the highest priority in the repayment hierarchy in the event of a borrower default. A first lien loan, on the other hand, specifically refers to the financial arrangement where a borrower secures a loan with collateral, and the lender holds the first claim on that collateral in case of default. It is a subset or specific instance of first lien debt, representing a tangible financial agreement between a borrower and a lender. The term is commonly used to describe the practical execution of first lien debt in a lending context. First lien loans can be utilized by businesses, including small and medium-sized enterprises (SMEs), to secure necessary capital for various purposes, such as expansion or technology upgrades.

 Underwriting Process for First Lien Term Loans

1. Capital Providers. The journey begins with identifying suitable capital providers. Banks, certain non-bank credit funds, and Business Development Companies (BDCs) are key players in the landscape of first lien term loans. The choice of provider can impact the terms, costs, and overall structure of the financing.

2. Underwriting Thesis. The underwriting process is guided by a clear thesis, outlining the rationale for extending the loan. Lenders focus on assessing the borrower’s ability to generate consistent cash flow, the potential for recovery in case of default, and the overall liquidity and health of the business.

3. Recovery Focus. Whether through ongoing cash flow generation, refinancing, or liquidation of collateral in distressed situations, the underwriting process places a strong emphasis on the potential avenues for recovery. Lenders seek assurance that their investment is safeguarded, even in adverse scenarios.

4. Business Model Analysis. An in-depth analysis of the borrower’s business model is integral to the underwriting process. Lenders delve into the competitive dynamics, customer base, commercial terms, and the overall viability of the business. The stability and predictability of cash flows play a crucial role in mitigating risk.

5. Financial Performance Validation. Quality of earnings reports, typically produced by accounting firms, are instrumental in validating the borrower’s financial performance. This involves scrutinizing EBITDA, adjustments, and industry-specific factors. An industry study further validates the competitive position and market dynamics.

6. Collateral Examination. For asset-backed structures, a collateral examination becomes a critical component. Lenders review and analyze accounts receivable performance, inventory records, and record-keeping systems. The objective is to ascertain the liquidity and value of the collateral supporting the loan.

7. Owner’s Financial Condition. In certain cases, especially when personal guaranties are involved, the underwriting process extends to an analysis of the owner’s financial condition. This provides additional insight into the financial stability and commitment of the borrower.

8. Covenant Considerations. Financial covenants form an integral part of first lien term loans. Leverage ratios, fixed charge coverage ratios, and other relevant metrics are assessed to ensure the borrower’s ability to meet these obligations. For asset-backed structures, covenants related to the appraised value of collateral may be included.

9. Reporting Requirements. Ongoing reporting obligations are established, encompassing unaudited monthly financials, audited annual financials, and annual financial projections. Periodic appraisals of collateral may also be stipulated, especially in asset-backed structures.

10. Amortization and Financial Covenants. Banks typically require mandatory repayment, often ranging from 2% to 10% of the original loan amount annually. Financial covenants, such as leverage ratios and fixed charge coverage ratios, are monitored throughout the loan term.