The Tranche B lender niche has evolved. Tranche B lenders used to review only a chosen borrower’s enterprise value or asset value to determine if it will exceed the value advanced against by a senior secured lender. Today, Tranche B lenders create a broad range of structured finance products to meet the needs of a borrower's circumstances and capital structure, rather than adhering to a strict borrowing formula. This article discusses Tranche B financing structures in detail.
Nature of Tranche B or "Second Lien" Loans
In today’s finance culture, it is common practice for equity and debt sources to implement capital structures for companies consisting of multiple layers – common and preferred stock, shareholder debt, subordinated/junior debt and senior debt. These sophisticated, multilayered structures put renewed focus on the relationship among capital providers and, in turn, highlight the importance of intercreditor agreements to that relationship. Recently, the intercreditor structure has been extended to include the newest layer on the structured finance scene – the Tranche B loan. All lenders and participants in the capital structure must educate themselves about the lenders offering these loan products and their impact on the intercreditor relationship.
The Tranche B lender niche has evolved from the concept that a chosen borrower’s enterprise value or asset value will exceed (or will exceed once the senior term debt is paid down) the value of what a typical senior secured lender is comfortable advancing against for the same borrower. The Tranche B lender quantifies that excess value and helps to bridge any debt gap the borrower may have by lending against this value in the form of a term facility and taking a secured position against the borrower’s stock and/or assets. Unlike the relatively standardized terms and conditions that have developed for institutional subordinated debt or mezzanine financing, there are no apparent "market" terms and conditions for Tranche B loans. Instead, each Tranche B term loan is seemingly a new finance creature that evolves to meet the needs of the borrower’s circumstances and the borrower’s existing or newly implemented capital structure.
A "typical" Tranche B loan meets the capital needs of highly leveraged companies when senior lenders are unable (or refuse) to provide a borrower with additional capital and where mezzanine financing or private equity is either too expensive or simply unavailable. Lenders in today’s market that offer Tranche B loans currently include a mix of hedge funds, distressed-debt funds and other nonbank financial institutions; however, many senior lenders and banks are beginning to offer Tranche B products to compete in the marketplace.
Loans structured by Tranche B lenders must be flexible to fill a gap in capital structure and provide liquidity to borrowers. As a result, they can vary in form ranging from junior secured loans, last-out participations, "pari passu" loans or second lien loans. Nevertheless, Tranche B lenders are generally junior lenders providing junior secured debt. There is a distinction, however, between Tranche B loans that are treated "pari passu" with the senior lender with a delayed amortization and Tranche B loans with pure second lien status.
Not surprisingly, the pricing in the Tranche B loan "market" is significantly higher than pricing on senior secured loans, often prime plus 5-6.5% and sometimes higher, in the mid-to-high teens. In addition to the debt feature, Tranche B loans are sometimes structured with warrants in cases where the Tranche B lender has leverage to negotiate an equity kicker. Interest on Tranche B loans is usually structured as current cash pay with or without a PIK component. The Tranche B lender’s time frame to maturity usually tracks the maturity period of the senior lender. In rare cases, Tranche B lenders can negotiate earlier maturity relative to the senior lender, but only in circumstances where it can be demonstrated to the senior lender’s satisfaction that the capital shortfall with the borrower has closed. Except for high-risk loans (or in circumstances where the senior lender permits the borrower to use portions of excess cash flow to prepay Tranche B debt), Tranche B loans do not typically amortize based on the reasoning that the Tranche B lender benefits from the senior debt amortization relative to its lien position. Tranche B lenders will usually agree to second priority lien provisions but try to position themselves as "pari passu" in right of payment with the senior lender, except upon liquidation of collateral.
Intercreditor Terms for Tranche B Loans
Before a senior lender is introduced to a Tranche B lender on a transaction, the senior lender should understand the circumstances that brought the Tranche B loan to the borrower’s table. Since the Tranche B loan product is now a generally recognized source of financing, it is critically important to the senior lender’s position in the capital structure to develop a strategy for the intercreditor relationship. In order to effectively negotiate a priority position in an intercreditor agreement with a Tranche B lender, senior lenders must be prepared to respond to a Tranche B lender’s strategy.
Though Tranche B lenders do not typically amortize the principal of their loans, they do expect their interest to be paid on a pari passu basis with the senior lenders. Senior lenders expect complete payment blockages against Tranche B lenders if the block is triggered by the borrower’s failure to make required payments to the senior lender, or to perform as required under certain fundamental covenants in the senior credit agreement. Whether a senior lender is able to get a complete payment block depends on the circumstances. Tranche B lenders resist payment blocks under the theory that their liens and liquidation proceeds are what should be subordinated to the senior lender, not their debt, and this argument is often successful. However, when senior lenders have leverage to negotiate a payment block, the provisions often mirror what is found in subordination agreements with unsecured subordinated or mezzanine debt. In both cases, the senior lender typically permits the junior lenders to accept and retain nonaccelerated, regularly scheduled payments of interest on the junior debt as long as there is no default under the senior lender’s documents and the borrower is able to meet leverage tests and/or earnings tests established by the senior lender. It would not be uncommon to find that the hurdles to satisfying these tests in the intercreditor agreement are more onerous than the financial covenant tests set in the senior credit agreement. By establishing stricter financial covenant tests in the intercreditor agreement relative to the junior debt payment schedule, the senior lender has added confidence that the borrower’s performance is exceeding the senior lender’s expectations when money is going out the door to pay junior creditors. Of course, just like any other junior lender, a Tranche B lender would want to PIK its interest during the payment blockage for as long as its payments are blocked, or want a "catch up" clause that entitles it to receive previously blocked payments on an expedited basis after the payment blockage trigger event is cured or waived. In some cases, the senior lender’s ability to block payments to the Tranche B lender may differ depending on whether the default was caused by the borrower’s nonpayment or the borrower’s breach of or failure to perform under a key covenant. In the case of a payment default, the blockage is usually permanent in nature and ends only when the lender waives the payment default and is paid all missed payments. In the case of a key covenant default, and again depending on the circumstances, the Tranche B lender may agree to a limited period of time that its payments are blocked, with the time period ranging from 60-279 days, with a 90-day payment block being typical. In negotiating the time period for covenant-related payment blocks, the senior lender must consider factors such as realistic exit strategies.
It is customary for the Tranche B lender to subordinate its liens on the borrower’s collateral to the liens of the senior lender. Moreover, in planning for its exit in liquidation, the senior lender typically (and rightfully) demands that its loans are paid in full with all collateral proceeds before any amounts are paid by the borrower to junior creditors. Often, the Tranche B lender will attempt to negotiate exceptions to this rule in the intercreditor agreement that allow the Tranche B lender to move on collateral under certain circumstances. For instance, the Tranche B lender might:
- try to obtain a first lien on and pledge of the borrower’s stock in an asset-based deal;
- request the right to dispose of collateral if the senior lender has not taken action during a specified period of time;
- negotiate for a right to proceed against key man life insurance policies that it has required the borrower to implement; and/or
- request a first lien position in specified collateral (i.e., real estate) and a second lien on all remaining collateral.
Even where some or all of the foregoing concessions are made to the Tranche B lender, it is prudent for the senior lender to demand the right to at all times manage the subject collateral without interference generally from the Tranche B lender.
Additionally, an aggressive senior lender with significant leverage may require that any security interest granted to a Tranche B lender be in the form of a "silent" second lien (i.e., junior at all times to the interests of the senior lender). The terms of any silent second lien structure must be spelled out in the intercreditor agreement and effectively would prohibit the Tranche B lender from having any rights in the borrower’s collateral until the senior lenders are paid in full. The essential elements of a silent second lien from the senior lender’s perspective include the following:
- an unequivocal prohibition to any challenge to the senior lender’s perfection or validity;
- agreement by the Tranche B lender to automatically release collateral if the senior lender releases collateral (which, as discussed below, often triggers a right by the Tranche B lender to "buy out" the senior lender’s position in the capital structure); and
- a grant by the Tranche B lender to the senior lender of exclusive rights to dispose of collateral and foreclose and enforce the senior lender’s rights and remedies with respect to the collateral prior to the running of any standstill period (described below).
Moreover, intercreditor agreements typically require that, prior to any payments being made on account of the debt held by the Tranche B lender (whether pursuant to a confirmed plan or upon a disposition of collateral), the senior lender must be paid in full. To effectively provide for this result, appropriate "constructive trust" or "turnover clauses" must be written into the intercreditor agreement.
Tranche B lenders prefer to avoid remedy enforcement standstill provisions under the theory that the senior lender is protected by its superior lien rights and other provisions identified above that the senior lender has negotiated to protect its position in the capital structure. Some senior lenders will insist on standstill provisions while others may not have a consistent approach and will evaluate their efficacy based on the facts and circumstances of each borrower and capital structure. The standstill provision is designed to prevent a Tranche B or other junior lender from exercising its contractual, common law and statutory remedies against the borrower for some period of time after the occurrence of certain seminal, problematic events in the lender/borrower relationship. These events include the borrower’s failure to make required principal and/or interest payments, the borrower’s failure to perform up to its financial covenant levels and any bankruptcy or similar proceeding or workout transaction involving the borrower. It is fairly typical for the length of the standstill period to be the same as the payment blockage period described earlier. For example, if the payment blockage period is 90 days, then the standstill provision will essentially provide that a Tranche B lender cannot make any claim for payments or take any other enforcement action against the borrower for 90 days after a junior default notice is delivered to the senior lenders indicating the Tranche B lender’s intent to enforce its remedies if the junior default is not cured within such period. It is important to note that an extended standstill effectively could force a senior lender to move against the collateral after the initial standstill period expires or risk losing control of collateral enforcement to the Tranche B lender. In order to minimize this risk, the senior lender must evaluate its borrower’s business and assets in order to effectively negotiate a standstill period that it believes will give it enough time to address and begin implementing an exit strategy and enforcement action relative to the borrower and the collateral. Also, the standstill period typically terminates automatically if the senior debt accelerates or if a bankruptcy or similar proceeding occurs. Once the senior debt accelerates or the borrower is forced into bankruptcy, the relationship between the senior lender and the Tranche B lender is somewhat altered and the previously discussed bankruptcy-specific provisions in the intercreditor agreement are triggered. These bankruptcy provisions serve to protect the senior lender’s position with respect to the borrower and its collateral relative to what a Tranche B or other junior lender might attempt under such circumstances.
Modifications and Amendments
In most multilayered financing transactions with senior and junior debt, the junior creditors often successfully negotiate a cap on the amount of senior debt that has lien and payment priority above them. The same circumstances exist when there is a Tranche B loan. The "senior debt cap" is typically 10%–20% above the current maximum principal amount of senior debt (less any permanent reductions), plus indebtedness related to hedging agreements, cash management and other obligations, plus an additional amount deemed necessary by the senior lender for protection of collateral, enforcement, interest, "DIP" financing, etc. Also, it is not uncommon for a senior lender to agree to restrictions on its ability to increase the principal amount of the senior debt beyond the cap and increase the interest rate margin (other than the default rate) by more than an agreed upon number of basis points (usually 100-300 basis points), as well as restrictions on its ability to shorten the amortization of the senior debt. It is also not uncommon for a senior lender to agree to restrictions on borrowing base changes or its ability to implement reserves. With respect to their junior debt, Tranche B lenders often negotiate aggressively for the same flexibility as the senior lenders to amend or modify their debt terms, and the end result is often arrived at after intense negotiation.
Additional Common Tranche B Provisions
There are a variety of other common provisions that Tranche B lenders attempt to negotiate into intercreditor agreements. Tranche B lenders often seek to have overadvances by senior lenders treated as junior debt. Senior lenders resist this request on the theory that overadvances might be inadvertent or could be necessary to preserve collateral. In addition, a senior lender may echo the argument of the borrower that it needs the flexibility of an overadvance (whether intentional or inadvertent, swing line or otherwise) without, it is important to note, ever truly permitting an overadvance in its senior credit agreement with the borrower.
Tranche B lenders also request, as one of their basic terms, the option to purchase a senior lender’s credit position upon collateral release requests or defaults under the senior credit agreement. The theory behind the Tranche B lender’s request for this purchase option is to ensure that the Tranche B lender has the ability to protect or preserve its collateral position relative to other creditors and to control the outcome of any future liquidation. These provisions are usually acceptable to senior lenders if, at the purchase option closing, they are entitled to receive (i) payment in full of all fees, expenses, principal and interest, (ii) any prepayment fees, (iii) cash collateral for outstanding letters of credit and (iv) indemnification for unpaid checks and related items.
When supplementing an existing credit facility or replacing an existing bank group with new financing, a Tranche B loan may be the best financing source available to a borrower who is looking to access capital to shore up its financials and provide critical cash for its business’s continued viability. Thus, it is critical that senior lenders understand and work with the Tranche B lender in order to positively impact the overall capital structure and benefit the senior lender.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.