First Lien vs Second Lien
Definition
First lien and second lien debt are both secured by the same collateral, all or substantially all of the borrower's assets, and differ in the order they are paid from it. The first lien lender holds the first-priority security interest and is repaid in full from collateral proceeds before the second lien lender receives anything; the second lien lender holds a junior security interest and stands behind it. An intercreditor agreement sets the rules between them, including how long the second lien must wait before enforcing. The difference shows up in everything that follows: first lien term loans in leveraged buyouts have historically recovered on the order of 70 to 80 cents on the dollar in default, second lien loans roughly half that, and second lien pricing runs several hundred basis points wider to compensate.
Why it matters
Almost every private credit product an individual can buy, a BDC, an interval fund, a marketplace note, describes its loans by lien position, and the position is the single largest determinant of what the investor gets back when a borrower fails. Two loans to the same company with the same coupon are different investments if one is first lien and the other second: the first is likely to recover most of its principal, the second to lose most of it. The spread difference is the market's price for that gap, and whether it is enough depends on the leverage at which the second lien attaches. Reading a fund's portfolio by lien position and attachment point, rather than by yield, is the basic act of private credit diligence.
Common misconceptions
- •Second lien is not unsecured. It holds a real security interest in the same collateral; it simply ranks behind the first lien in the proceeds. Against trade creditors and unsecured bondholders it is senior.
- •First lien does not mean safe. A first lien loan attaching at 5.5 times EBITDA in a business worth 6 times is riskier than a second lien attaching at 4 times in a business worth 8 times. Position ranks the claim; loan-to-value sizes the risk.
- •The second lien lender cannot simply foreclose when the borrower defaults. The intercreditor standstill, typically 90 to 180 days, requires it to wait while the first lien decides how to enforce, and it has usually waived key bankruptcy objections in advance.
- •Recovery averages are not predictions. Published first lien recoveries in the 70s and second lien recoveries in the 30s to 40s are long-run averages across cycles and industries; a single deal's recovery depends on enterprise value at default and on how much debt is layered ahead.
Technical details
Side by side
Security: first lien, first-priority lien on all or substantially all assets; second lien, second-priority lien on the same assets.
Payment from collateral: first lien, first dollars until repaid in full; second lien, only what remains after the first lien is whole.
Typical leverage attachment (sponsored middle market): first lien from 0 to about 4 to 5 times EBITDA; second lien from there to about 6 to 7 times.
Typical pricing: first lien S plus roughly 350 to 550 basis points depending on market and borrower size; second lien several hundred basis points wider, often S plus 750 to 1,000, with higher upfront fees.
Call protection: first lien term loans, soft call of 101 for six to twelve months; second lien, hard call schedules such as 102 then 101, reflecting the lender's reliance on the coupon.
Amortization: first lien term loans, about 1 percent a year in broadly syndicated deals, more in middle-market deals; second lien, usually none, a bullet at maturity.
Maturity: second lien typically one year after the first lien, so it cannot come due first.
Covenants: both usually share the financial covenant package, with second lien levels set looser (for example 10 to 15 percent wider cushions) so the first lien trips first.
Long-run average ultimate recovery in US leveraged loan defaults: first lien term loans high 60s to about 80 percent; second lien 30s to mid-40s percent. Dispersion is wide.
Worked example: a default at different enterprise values
A company with $50 million of EBITDA is bought with $250 million of first lien (5.0x), $75 million of second lien (attaching at 5.0x, detaching at 6.5x) and $175 million of equity.
It defaults and is sold for 6.0 times a reduced EBITDA of $40 million, $240 million. First lien recovers $240 million of $250 million, 96 percent. Second lien recovers nothing. Equity recovers nothing.
If instead the sale fetches $300 million (7.5x of $40 million): first lien recovers 100 percent, second lien recovers $50 million of $75 million, 67 percent.
If the sale fetches $200 million: first lien recovers 80 percent, second lien zero. The second lien's outcome swings from zero to two-thirds across a range of values in which the first lien barely moves. That asymmetry is what the wider spread pays for.
The intercreditor agreement
Standstill: the second lien may not exercise remedies against the collateral for a set period after a default, commonly 90 to 180 days, during which the first lien controls enforcement.
Turnover: collateral proceeds received by the second lien before the first lien is paid in full must be handed over.
Bankruptcy waivers: the second lien typically agrees not to object to the first lien's DIP financing or use of cash collateral, not to seek adequate protection ahead of the first lien, and not to contest the first lien's liens. Some agreements go further and restrict plan voting.
Senior debt cap: the first lien agrees that the amount of debt secured ahead of the second lien is capped, usually the closing amount plus a cushion of 10 to 15 percent, so the second lien cannot be primed without limit.
Lien subordination only: unless the documents say otherwise, the second lien is subordinated as to collateral, not as to payment. It may receive its scheduled interest while the first lien is performing, unlike a payment-subordinated instrument.
Second lien versus subordinated and mezzanine debt
Second lien: secured, junior in the collateral, senior to unsecured claims, usually cash-pay, priced in the high single digits to low double digits over the base rate.
Mezzanine or subordinated notes: usually unsecured, contractually subordinated in right of payment to all senior debt, often with payment-in-kind interest and warrants, priced higher still.
In a liquidation the order is first lien, second lien, unsecured (including mezzanine), equity. In a going-concern restructuring the mezzanine lender's leverage comes from votes and negotiation rather than collateral.
Since the mid-2010s the unitranche has displaced much second lien issuance in the middle market; the first-out and last-out pieces inside a unitranche reproduce the first and second lien loss order through an agreement among lenders the borrower is not party to.
Reading a fund's portfolio by lien position
BDC and interval fund schedules of investments label each loan first lien, second lien, unitranche (often first lien) or subordinated, and report the share of the portfolio in each. A book that is 90 percent first lien with weighted average leverage of 5 times at close is a different risk from one that is 60 percent first lien at the same yield.
The attachment point matters more than the label: ask for, or compute, net debt through the fund's tranche divided by borrower EBITDA. Funds increasingly disclose weighted average loan-to-value or interest coverage; the lien mix without those figures is half the picture.
In retail note platforms that sell participations in a single loan, the offering document states the lien position and the intercreditor terms; a second lien participation sold at a first lien yield is the mispricing to look for.
Frequently asked questions
- What is the difference between first lien and second lien debt?
- Both are secured by the same assets. First lien debt is paid first from collateral proceeds; second lien debt is paid only after the first lien is repaid in full. The second lien lender takes more loss in a default and is paid a wider spread for it, and an intercreditor agreement limits when it may enforce.
- Is second lien debt the same as subordinated debt?
- No. Second lien debt is secured and ranks behind the first lien only as to the collateral; against unsecured creditors it is senior. Subordinated or mezzanine debt is usually unsecured and contractually subordinated in right of payment, so it ranks behind all senior debt, secured or not. Second lien sits between first lien and mezzanine in the capital structure.
- How much more does second lien debt pay?
- Typically several hundred basis points over the same borrower's first lien. In sponsored middle-market deals a first lien term loan at S plus 450 to 550 might sit beside a second lien at S plus 800 to 1,000, with the second lien also carrying higher upfront fees and call protection. The gap widens in stressed markets and narrows when second lien supply is scarce.
- What are typical recovery rates for first lien and second lien loans?
- Long-run agency studies of defaulted US leveraged loans put average ultimate recoveries for first lien term loans in the high 60s to around 80 percent and for second lien loans in the 30s to mid-40s, with wide dispersion by industry and by how much first lien debt sits ahead. Loan-to-value at issuance, not the label, drives the outcome in any single case.
- What does an intercreditor agreement do?
- It governs the relationship between the lien classes: the second lien agrees to a standstill, commonly 90 to 180 days, before enforcing on collateral; to waive or limit certain bankruptcy rights such as objecting to the first lien's DIP financing or adequate protection; and to turn over any collateral proceeds it receives out of order. The first lien in return agrees to caps on how much senior debt can be layered ahead.
- Where does leverage attach for each?
- In a typical sponsored structure the first lien covers from zero up to about 4 to 5 times EBITDA and the second lien from there to about 6 to 7 times, with equity below. Those attachment points, not the coupons, determine each lender's loss in a downside case.
- How does a unitranche compare?
- A unitranche replaces the first and second lien with one loan at a blended rate; the lenders then split it privately into first-out and last-out pieces under an agreement among lenders. The borrower sees one facility; the economics and the loss order inside it look much like first and second lien.