Underwriting 1L vs 2L

Analyst 3+ in IB - CB

Can anyone explain the main differences in underwriting first lien vs second lien debt. Is there additional diligence is needed on the 2L side, or is it more just choosing where in the capital structure lies the best risk reward?

Comments (4)

  • Analyst 2 in PE - Other
Feb 18, 2020

There is 100% more diligence needed when looking at 2L paper, yes there is inherently more return but that doesn't come without risk with being subordinate in the capital structure and being second in line for recovery. Need to look at the business on a deeper level and understand the collateral package available + need to see how much is outstanding on the 1L + check all their credit docs to see what they have liens on / what they have perfected. In a downside case in the recovery waterfall, if the business were to liquidate how much would you have available as a 2L? All questions / concerns that need to be thought about

Feb 18, 2020

Makes sense, thanks. What are the key business diligence points that you would dig in on more comparatively? Would think cyclicality but that's pretty easily exhausted after analyzing prior performance, any changes since 09, and cost structure

  • Analyst 2 in PE - Other
Feb 18, 2020

Important to dig into cushions on 1L that dictate cushions on your 2L, look into cash flow generation of the business and understanding true operating cash flow (how much capex is there / how much is reccuring vs non recurring). As cash flow lenders, less concerned about overall assets, but being in a 2L position still good to note outstanding AR / inventory and how much that would cover you in a downside case. In a recessionary scenario yes it is important to look at the Company's past performance, but it is just as important to compare the Company's performance relative to the overall market / industry. Being a 2L lender in a highly project based business would give me pause regardless if it was a market leader, important to understand the business profile. Certain businesses I would do 2L / mezz paper all day - SaaS, licensing businesses, etc. The deeper you go in the cap structure the more equity like diligence it becomes

Apr 11, 2020
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