Second Lien Financing – Another way to acquire a company
By: Ali Mojdehi and Janet Gertz
When merger and acquisition options come up in conversation, the two most common choices discussed are either purchasing the stock of a company or, particularly if a company is in distress, its assets. An often overlooked – and underappreciated – option is using second lien financing as a means of acquiring a company.
What is Second Lien Financing
Acquisitions using second lien financing entails the buyer paying all or the bulk of the purchase price as a loan in second position secured by virtually all of the assets of the company and paying a nominal amount for equity. What this means is that the acquirer becomes not just an equity holder, but also a lender to the business. The purchaser’s bid will likely often have a valuation higher than other bids which seek to compromise liabilities. The bid is also attractive to old equity which at times are given an option or allowed to retain a small interest. If the company succeeds, the buyer reaps the rewards of financial success and the potential upside. At the same time, the buyer hedges against downside risk by retaining the protections of a secured lien in case of an eventual failure.
Second Lien Financing works well in many situations, but particularly when the need to act upon an opportunity is great and time constraints do not allow the level of due diligence that one would customarily perform before making a binding bid. Using second lien financing is also very effective in competitive bidding situations, by enabling the buyer to increase the value of their offer with the understanding that their downside risk is less than if they bought equity outright, which would evaporate if the business fails. Keep in mind that the loan is secured; meaning that the purchaser obtains priority over other existing unsecured creditors. In short, Second Lien Financing enhances odds for success in competitive bidding while providing the purchaser a decent safety net.
What Second Lien Financing Is Not
While such a strategy is extremely valuable to many opportunistic acquirers, it is by no means a magic elixir; the business being purchased must still have a reasonable chance of being successful to enable the board of the buyer to comfortably proceed. No creative financial structure will fix operational or market shortcomings on its own. One other situation where Second Lien Financing may not be a viable option is when the target company is severely overleveraged with no prospect of succeeding. In these instances, the board of the target may be reluctant to support a transaction which would result in certain failure.
One thing’s for sure; Second Lien Financing is an acquisition strategy that should at least be considered when an individual, business or investment group is considering purchasing a company in distress. The possibilities are significant enough to warrant discussion, certainly more so than what typically occurs.
About the Authors: Ali Mojdehi is a partner and Janet Gertz is an associate in the San Diego offices of global law firm Baker McKenzie. They are presenting at the ACG San Diego event on Distressed M&A Transactions, and can be reached at ali.mojdehi@bakermckenzie.com and janet.gertz@bakermckenzie.com.