First Lien / Second Lien Priority
Definition
Lien priority determines the order in which creditors recover from collateral upon borrower default and liquidation. First lien lenders have senior security interest in all collateral—they receive 100% of liquidation proceeds until fully repaid before junior creditors receive anything. Second lien lenders have subordinated security interest—they only recover after first lien fully satisfied. Example: $150M enterprise value, $100M first lien, $50M second lien. Upon liquidation: First lien receives $100M (full recovery), second lien receives $50M (full recovery). If enterprise value falls to $120M: First lien receives $100M (full recovery), second lien receives $20M (40% recovery). Lien priority is established through UCC filings and intercreditor agreements.
Why it matters
Lien priority directly determines recovery rates and pricing. First lien loans historically recover 70% in default (Moody's data), while second lien recovers 30%—reflecting priority economics. This recovery differential justifies pricing: first lien at L+400-500, second lien at L+700-900. During 2008-2009, actual recoveries confirmed theory—first lien averaged 65% recovery, second lien 25%. Understanding lien mechanics explains why seemingly similar credits trade at vastly different spreads—the priority cushion is worth 300-400 bps in pricing and 40 points in recovery.
Common misconceptions
- •Second lien doesn't mean 'second in line after first lien'—it means last in secured creditor stack. Unsecured creditors rank below second lien, and equity below unsecured. Proper hierarchy: First lien → Second lien → Senior unsecured → Subordinated unsecured → Equity.
- •Intercreditor agreements aren't optional—they're required to establish relative rights between first and second lien lenders. Without intercreditor, conflicts arise over foreclosure timing, amendment rights, and workout negotiations.
- •Recovery rates aren't guarantees—70% first lien and 30% second lien are historical averages. Individual recoveries range from 0-100% depending on asset quality, timing, and workout strategy.
Technical details
Security interest mechanics and perfection
UCC filing requirements: Lenders perfect security interests by filing UCC-1 financing statements with state authorities (typically Secretary of State). Filing establishes public record of lien, date-stamps priority (earlier filings generally senior), and provides constructive notice to other creditors. UCC-1 must describe collateral (all assets, equipment, inventory, receivables) and identify secured party and debtor.
Collateral description and scope: First lien typically covers 'all assets'—equipment, inventory, receivables, intellectual property, cash, securities, general intangibles. Second lien covers same collateral but subordinated via intercreditor. Both liens attach to same assets; priority determines recovery order not asset allocation.
First-to-file priority rule: Under UCC Article 9, earlier-filed security interests generally have priority over later filings ('first in time, first in right'). Exception: Purchase money security interests (PMSI) can prime earlier liens if proper notice given. This creates risk—existing first lien could be primed by PMSI lender if borrower purchases equipment with PMSI financing.
Intercreditor agreement provisions: Defines first lien/second lien relative rights. Standard terms: (1) Second lien cannot take enforcement action without first lien consent, (2) Second lien agrees to standstill (no acceleration) during first lien workout, (3) Second lien votes subordinated to first lien in bankruptcy, (4) Second lien waives certain claims against first lien. Heavily negotiated document.
Recovery waterfall and priority mechanics
Liquidation proceeds allocation: Upon default and collateral sale, proceeds flow: (1) Pay foreclosure costs and expenses, (2) Pay first lien principal, interest, fees until 100% recovery, (3) Pay second lien principal, interest, fees with remaining proceeds, (4) Residual to equity (if any). Each tier must be fully satisfied before next tier receives anything.
Recovery scenarios by enterprise value: Assuming $100M first lien, $40M second lien. If EV = $200M: First lien 100%, second lien 100%, equity receives $60M. If EV = $140M: First lien 100%, second lien 100%, equity receives $0. If EV = $120M: First lien 100%, second lien 50% ($20M recovery), equity $0. If EV = $90M: First lien 90% ($90M recovery), second lien 0%, equity $0.
Cross-default and cross-acceleration: First lien default typically triggers second lien default through cross-default provisions. However, second lien cannot accelerate or enforce without first lien consent per intercreditor. This creates power imbalance—first lien controls timing of enforcement, workout strategy, and bankruptcy filing decision.
Make-whole provisions in bankruptcy: If first lien made whole in bankruptcy (receives full recovery via plan, DIP financing, or asset sale), second lien regains rights and can vote on plan. If first lien not fully recovered, second lien remains subordinated and votes controlled by first lien. Incentivizes first lien to accept reasonable recoveries rather than maximize their recovery at second lien's expense.
Pricing and structural considerations
First lien pricing: L+400-500 in middle market (2024), L+350-450 in large corporate. Pricing reflects 70% expected recovery, low default probability (2-3% annual), and senior claim. Lower pricing available for super-senior or unitranche structures with higher recovery assumptions.
Second lien pricing: L+700-900 typical (300-400 bps premium over first lien). Reflects 30% expected recovery, subordinated enforcement rights, and higher loss severity. During 2020-2021 market tightness, spread compressed to L+600-700; 2008-2009 widened to L+1000-1200.
Structural alternatives: Some borrowers use 'first-out/last-out' structures within single facility instead of first/second lien. First-out portion (75% of facility) has priority recovery, last-out (25%) subordinated. Economically similar to first/second lien but single documentation, potentially simpler bankruptcy treatment.
Unitranche positioning: Unitranche loans blend first and second lien risk in single facility. Lender holds both positions, eliminating intercreditor conflicts. Pricing (L+550-650) reflects weighted average of first/second lien economics. Particularly efficient for middle-market transactions where single lender providing full debt stack.
Workout and bankruptcy dynamics
First lien control in workouts: Intercreditor agreements give first lien control over restructuring decisions. Second lien cannot force acceleration, file involuntary bankruptcy, or pursue independent remedies. Creates tension—first lien may accept amendment preserving their recovery while impairing second lien, but second lien cannot block.
Standstill periods: Second lien typically agrees to 90-180 day standstill following first lien default declaration—prohibiting enforcement while first lien negotiates workout. If first lien cannot achieve workout, second lien rights unblock after standstill expires. However, by then borrower often in bankruptcy, rendering second lien rights moot.
DIP financing and priming: In bankruptcy, first lien lenders often provide DIP financing with super-priority. This 'primes' pre-petition first lien (DIP becomes most senior), pushing second lien further down capital structure. Combined with adequate protection liens for first lien, second lien often recovers 10-20% less in bankruptcy vs out-of-court workout.
Section 363 sales and credit bidding: First lien can credit bid (bid their debt amount) at Section 363 sales, effectively acquiring assets at discount. Second lien cannot credit bid without first lien consent. Result: First lien often acquires assets for their debt amount ($100M bid for $150M asset), realizes immediate gain, while second lien receives residual proceeds (often zero). Asymmetric outcomes favor senior creditors dramatically.