Second lien loans are rapidly becoming European sponsors' favored choice when adding a subordinated layer to their buyout financings and so boost leverage. This dynamic is taking volumes to post-crisis highs as the deep demand for paper threatens to push out bonds from all but the largest capital structures.
Indeed, the resurgence in second lien debt is changing the very make-up of Europe's buyout market. For the first time in the post-crisis era, the portion of buyouts taken by first lien-only structures has fallen below 50%, dropping this year to 45% of deals. First lien-only structures were responsible for 61% of buyout transactions in 2017, and 75% in 2016.

The fall in senior-only buyout deals comes as first lien leverage multiples look to be stabilizing. "The European market is fairly clear cut in most areas now, and features such as leverage and pricing tend to be fairly standard," one investor source said. After rising steadily from a post-crisis low of 3.4x in 2009, average first lien leverage multiples looked to have topped out at roughly 4.9x. First lien leverage multiples can be pushed further on the best deals, but investors reckon 5x is pretty much the upper limit for most decent credits in Europe today.
Typically, if a sponsor wanted to boost total leverage in any meaningful way, it would turn to the bond market. This is still true to some extent — after all, a first lien loan plus bond package has financed 14% of all buyout deals so far this year — but sponsors are increasingly opting to stay in the loan market to add additional leverage through a second lien loan.

So far this year, a first plus second lien financing has funded 27% of buyout deals, which is up from shares of 21% and 16% in the last two years, respectively, including both privately placed and syndicated second lien loans. This increase has kept the pressure up on total leverage multiples, which have risen this year to stand at an average of 5.4x for buyouts in Europe. Given that M&A multiples have also increased in the last few years and equity contributions have largely been static for around five years, the addition of extra debt therefore has a tangible benefit when it comes to sponsors' rate-of-return calculations.

The move toward second lien loans does not appear to be a phase, but rather part of a longer-term trend, according to bankers. "When we meet sponsors these days the first question they ask is 'where we are on second lien?'," said one originator at a major European bank, who added that private equity interest in high yield debt had diminished considerably this year. Among the recent launches, European dental services operator Curaeos, Netherlands-based pharmaceutical firm Zentiva NV, U.K.-based home-related digital platform operator ZPG PLC, and Exclusive, a France-based value-added distributor of cyber-security and cloud migration solutions, have all brought either pre-placed or syndicated second lien loans, while CVC Capital Partners Ltd.'s buyout of Finnish hospital operator Mehiläinen Oy is tipped to come with a first and second lien structure (six banks are mandated to arrange that financing).
Flexible friend
The reasons for this interest in second lien loans are clear. In the first instance, loans offer sponsors more flexibility given they come with significantly looser pre-payment protections than bonds. Against the typical unsecured bond structure of eight years with a three-year non-call period, a second lien loan will typically come with a short non-call period followed by protections at 102 and 101 — meaning if issuers choose to prepay the loan in the first or second years, they have to do so at 102 cents or 101 cents on the dollar, respectively.
The importance that sponsors give to this feature is hard to overstate in many cases. "If an investment performs well and deleverages as we expect, then we will want to revisit the capital structure within a few years. We do not want to be stuck in a financing that is expensive and no longer appropriate to our needs," said one private equity source, who expressed their clear preference for second lien debt over high yield debt.
Second lien loans also have other administrative benefits, especially when combined with a core first lien facility. In particular, legal, listing, and other cost savings can run well in to the millions of euros, say sources, and together these factors mean second lien debt volumes have increased rapidly over the past couple of years (albeit from a low base), to reach €3.2 billion in 2017, and €1.5 billion so far in 2018.

But this liquidity comes at a price when compared with the high-yield alternative. The spread on a second lien loan will typically come at a 350- to 400-basis point premium over the first lien loan, with returns sometimes boosted further by a floored base rate. A rough rule of thumb suggests this is some 200 basis points above where an unsecured bond may price. Flora Food Group, for example, placed a €685 billion unsecured euro bond issue earlier this year to back its KKR & Co. LP-led carve-out from Unilever PLC at a yield of 5.75%. The group's euro-denominated term loan closed at Euribor plus 350 with a 99.5 original-issue discount, to yield 3.63%.
Changing landscape
The market for second lien loans is changing. In the past few years, these loans were pre-placed by sponsors to a close-knit group of relationship lenders. For sponsors, this gives certainty on costs as it removes sometimes chunky flex risk, and means they only have to pay their arranging banks a backstop fee of roughly 25 basis points rather than a full underwriting commission.
But as investor interest in the sector has deepened, so syndicated deals have become more prevalent. These can offer better terms for borrowers through tighter pricing, that is estimated by investors to be in the E+700 region with a 99 original-issue discount. Call protections, too, are likely to be even looser than a pre-placed deal, with any non-call period dropped entirely for a 102/101 schedule. The sponsor does have to pay an underwriting fee, but it will save on the typical 2% to 2.5% fee paid for a pre-placed facility, sources explained.
Among the recent deals, Zentiva provides a case in point. Sponsor Advent International Corp. initially targeted a full syndication of the €275 million second lien tranche, but eventually pre-placed a €200 million chunk on the back of strong interest. If syndication progresses to plan then the sponsor will have landed a keenly priced deal with the tranche guided at Euribor plus 700 with a 0% floor, offered at 99 to 99.5. This suggests a yield of 7.28% to 7.36%, compared to a guided yield to maturity of 3.63% on the euro first lien tranche.

Even taking all these factors into consideration, sources said second lien loans are not about to push out bonds from the buyout market entirely. As investors clamor for paper, tranches in the billion-plus region could theoretically be achievable in Europe, said bankers, who added that the cheaper high-yield option is also more likely to win out once the debt requirement moves much beyond a couple of hundred million euros.
As such, with jumbo transactions in the pipeline — including Thomson Reuters Corp.'s sale of its financial and risk business to Blackstone Group LP and Akzo Nobel NV's sale of its specialty chemicals business to Carlyle Group LP and Singapore's sovereign wealth fund — there will still be plenty of bond buyout paper on offer for investors in the coming months.
