7 Steps to Structure Second-Lien Loans Behind Senior Facilities for PE Sponsors

Second-Lien Loans: Structure, Intercreditor, Execution

Second-lien debt is a secured loan that shares collateral with first-lien facilities but sits behind them in lien priority. It is not mezzanine or payment-subordinated paper; it is secured at the operating company with guarantees that match the first-lien. For sponsors, it is a way to add leverage, finance add-ons or liquidity events, and refinance junior capital while keeping equity control.

This guide shows how to build a durable second-lien that fits behind senior facilities without restricting flexibility when the cycle turns. The payoff is practical: clear feasibility checks, bankable structures, stress-proof intercreditor terms, and a clean path to exit.

When a second-lien fits and what it solves

Use second-lien capital when collateral coverage is solid and the intercreditor can be negotiated to preserve operating and liability management flexibility. The aim is to raise junior secured capital that survives volatility and does not force you into early, value-destructive refinancings. In practice, it can fund add-ons, dividend recaps, or refinancings without surrendering control or covenants to a new senior counterparty.

Step 1: Feasibility and kill tests

Start by reading the senior documents. Review the negative pledge, incremental and ratio-debt baskets, pari versus junior secured conditions, and any provision requiring the second-lien intercreditor to follow a specified form. Many agreements state “reasonably acceptable to the first-lien agent” and point to LSTA or LMA models; treat that as a real constraint with timing impact.

Size day-one capacity using the best basket stack you can meet. Ratio debt typically keys off secured net leverage, sometimes paired with fixed charge coverage, hard caps for acquisitions, and starter baskets. If an ABL sits in the structure, confirm whether it allows a second lien on ABL collateral; some do not, and many require tight standstills and blocked accounts favoring the ABL.

Map structural subordination. If meaningful EBITDA or assets sit in foreign, non-wholly owned, or unrestricted subsidiaries outside the guarantor net, recoveries shrink. In Europe, financial assistance, corporate benefit, and thin-cap rules can restrict upstream guarantees. If coverage falls below a defensible threshold, pause and revisit the plan.

Screen intercreditor terms for usability. Watch for mandatory blockage of all voluntary prepayments while first-lien amortization remains, long enforcement standstills, turnover of all proceeds including avoidance actions, and limited collateral information rights. If these cannot be moved, consider holdco PIK or a unitranche loans structure with a first-out and second-out split that delivers a cleaner path.

Decide funding timing with intent. If the senior facilities have an incremental with an MFN, a delayed-draw second-lien can be cleaner add-on currency. On buy-and-builds, pre-clear designated acquisitions, pro forma EBITDA adjustments, and delayed-draw mechanics to lower execution risk.

Step 2: Product selection, governing law, and market

Pick your market. A syndicated second-lien can offer lighter call protection and flexible prepayment, but it needs a receptive window. A private credit second-lien comes with higher original issue discount and stronger covenants, plus faster certainty and limited syndication risk. Price, certainty, and flexibility trade off differently across these routes.

Match governing law to the senior stack unless there is a specific reason not to. In the United States, New York law typically governs the credit, security, and intercreditor documents, and Article 9 of the UCC governs perfection and priority. In the UK and EU, run English law documents with LMA-style intercreditor provisions and an all-assets debenture, plus local security where needed.

Keep the borrower and guarantor group aligned with the first-lien. Parallel debt or a security trustee in Europe lets you accommodate multiple lender groups cleanly. Avoid holdco second-lien unless you intentionally accept structural subordination for looser terms or tax positioning. Lock agency mechanics early and decide whether to share a collateral agent or use separate agents with crisp turnover terms.

Define currency, rate mechanics, and interactions precisely. If the group is multicurrency, test whether senior documents constrain non-base currency secured debt. Hedge requirements typically live at first-lien; second-lien lenders will want alignment on hedge priority and subordination of termination payments.

Step 3: Collateral, guarantees, and perfection

Replicate the first-lien package, subject to priority. In the United States, file UCC-1s for personal property, obtain control of deposit and securities accounts, record IP security, and put mortgages on material real estate. In the UK and EU, use an all-assets debenture and share charges, and register at Companies House and local registries on time.

Mirror guarantor scope and definitions. Carve-outs for foreign subsidiaries may be necessary due to tax or local law limits; ensure the intercreditor and security recognize those limits and handle automatic releases on disposals. Use after-acquired property and future guarantor joinders that cascade to the second-lien through equal-and-ratable and accession mechanics.

Set cash control rules clearly. If the first-lien gains cash dominion upon availability triggers or defaults, second-lien lenders accept sweeps to first-lien during the period. Secure read-only access to bank statements and sweep reports to monitor collateral flows. Visibility shortens reaction time when it matters.

Audit liens and fix gaps before funding. Run lien and litigation searches across jurisdictions. Identify PMSIs, equipment leases, tax liens, and vendor liens with priority and address them through baskets or releases. Confirm IP chain-of-title and intercompany licenses, since non-assignability can create enforcement friction.

Address ABL priority assets directly. If an ABL is present, receivables, inventory, and cash generally sit first to the ABL and second to the term loan. The second-lien may be third or excluded. Spell out whether the second-lien has any lien on ABL collateral and how mixed-collateral proceeds flow.

Step 4: Intercreditor terms that hold under stress

Treat the intercreditor agreement as the operating manual. Nail lien priority, payment blockage, standstill periods, waterfall, turnover, purchase options, and amendment rights. Draft with an eye to uptiering, open market purchases, and unrestricted subsidiary transfers that have challenged junior recoveries in recent years. For more depth on market mechanics, see this overview of intercreditor agreements and lien subordination.

Payment provisions should be plain. Allow second-lien interest payments while the first-lien is not accelerated and no payment or bankruptcy default exists. Prepayments before first-lien paydown are typically blocked, with carve-outs for proceeds not required to prepay first-lien and a negotiated non-loan proceeds basket.

Standstill terms should balance value and flexibility. In the United States, 90 to 180 days after first-lien election of enforcement is market; second-lien may act sooner if the first-lien fails to protect collateral. In Europe, control of enforcement sits with senior secured creditors until discharge, with consultation rights for juniors.

Turnover and release mechanics must avoid traps. All enforcement proceeds should flow to the collateral agent and waterfall to first-lien, then second-lien. Releases authorized by requisite first-lien lenders should bind the second-lien for bona fide dispositions; resist broad discretionary releases unlinked to real transactions.

Guard against creditor-on-creditor mischief. Restrict open market purchase baskets that could create super-priority tranches without second-lien consent. Make lien priority, collateral scope, turnover, and waterfall sacred rights requiring each affected lienholder’s consent. Add anti-drop-down protections by tying transfers to unrestricted subsidiaries to leverage or cap-based limits mirrored across the stacks.

Preserve restructuring options ahead of time. Permit junior DIP priming the second-lien only with adequate protection, and set protocols for 363 sales and credit bids. Provide for post-petition accruals within insolvency law limits and draft stipulations to be bankruptcy-robust.

Step 5: Economics, covenants, and documents

Price risk, not appetite. Second-lien spreads sit above first-lien, often with higher OID. Private credit versions add call protection and unused fees on delayed draws. Budget agent and counsel fees; they are cash costs even when OID nets at closing. If you want a quick primer on break costs, see this guide to call protection and OID.

Model it cleanly and document flexibility. Example: 200 million at SOFR + 700 bps with 2 percent OID and 1 percent upfront is roughly 19 million of cash interest in year one at a 5 percent SOFR, plus about 6 million of OID amortization over five years if straight-line. Include call premiums in sources and uses and preserve optionality to take it out with high yield or unitranche loans.

Align covenants with the senior while preserving junior control. Maintenance covenants usually reside at the RCF or first-lien; second-lien relies on incurrence tests and defaults. Match EBITDA definitions, add-backs, and synergy caps to prevent arbitrage. Secure information, inspection, and auditor access co-extensive with the first-lien.

Run the document checklist. You need the second-lien credit agreement, security joinders or separate second-lien security, the intercreditor, guarantees, fee letter, perfection deliverables, officer’s and solvency certificates, legal opinions, and lien searches. Borrower’s counsel drafts the debt and security; first-lien agent’s counsel usually leads the intercreditor with second-lien counsel focused on collateral and sacred rights. Closing hinges on senior agent consent, perfected liens, and clean representations.

Address accounting classification early. Under US GAAP, carry at amortized cost with OID under the effective interest method; issuance costs reduce the liability and accrete to interest expense. Under IFRS, expect amortized cost unless designated at fair value. Disclose terms and maturities with a clear liquidity view.

Step 6: Diligence, closing, and timeline

Plan on four to eight weeks from mandate to money. Weeks 1 to 2: capacity checks, term sheets to the first-lien agent and second-lien lenders, collateral diligence, counsel instructed. Weeks 3 to 4: intercreditor framework settled, collateral exceptions agreed, lien searches complete, drafts in play. Weeks 5 to 6: conditions precedent finalized, deliverables and opinions in, lender calls done, sign and fund upon CP satisfaction and senior consent.

Assign owners and decisions. The sponsor drives economics and intercreditor outcomes. Management delivers diligence and projections. Borrower’s counsel drafts; second-lien counsel pushes on intercreditor; first-lien agent’s counsel protects baseline terms. Collateral and admin agents run filings and post-closing; auditors support comfort and going-concern calls when needed.

If you will syndicate broadly, plan ratings and disclosure. Agencies assess priority, collateral coverage, and covenants; recovery views set pricing guardrails. Keep the lender deck candid. For US placements, respect securities law exemptions and non-reliance language.

KYC, AML, and sanctions are gating items. Lenders request beneficial ownership and sanctions certifications. US companies formed after January 1, 2024 must file beneficial ownership reports with FinCEN on schedule and keep them current. European lenders will mirror UK and EU sanctions undertakings.

Step 7: Operating discipline and exit plan

Monitor with intention. Maintain a combined debt and covenant model for both liens. Track headroom for baskets, ratio debt, restricted payments, investments, MFN sunsets, add-back caps, and call schedules. Early warning beats emergency waivers.

Control amendments with governance. Pre-clear uses of baskets shared with first-lien. Record every consent given to the first-lien so protections do not erode by accident. Know your sacred rights and the thresholds to move them.

Prepare for stress in calm times. Build playbooks for waivers, liquidity bridges, and liability management. Align with second-lien lenders on DIP protocols and whether they will support credit bids or 363 sales when value-maximizing. Adequate protection terms should be drafted and supported by data.

Plan the take-out. Usual exits include high-yield refinancing, upsizing the first-lien after deleveraging, or pivoting to a US vs Europe unitranche loans solution once synergies land. Bake in prepayment mechanics that let you refinance the second-lien without reopening the first-lien, within intercreditor rules.

Jurisdictional notes for US and Europe

US deals use New York law credit and intercreditor documents with UCC-governed security and local mortgages. Perfect deposit and securities accounts by control; consider certificating LLC equity for perfection by possession where helpful. Ensure the intercreditor’s lien subordination and turnover hold in bankruptcy under Section 510 and relevant case law; waivers of marshaling and equitable subordination are standard.

UK and EU deals use English law senior and intercreditor documents with an all-assets debenture and floating or fixed charges. Register at Companies House and local registries on time to lock priority. Expect financial assistance, corporate benefit, and thin-cap limitations and use whitewash or targeted upstream limits where necessary. For region-specific fit and pricing, see when second-lien loans fit European sponsor-backed mid-market deals and US vs Europe second-lien loans.

In cross-border groups, coordinate local opinions, parallel debt or security trust structures, and insolvency regime alignment. Define “Discharged” of senior liabilities to include contingent and hedge claims but add materiality qualifiers or long-stop mechanisms so immaterial residues do not block releases indefinitely.

Economics and fee stack

Costs include cash interest, OID, upfront fees, call protection, ticking or unused fees on delayed draws, and agent or admin fees. Private credit second-liens often add commitment fees on undrawn tranches and make-wholes in year one. Syndicated loans can have lighter call protection but add flex and market OID variability. Confirm collateral agent fee sharing is pro rata across lien tranches and not skewed to the junior.

Tax, accounting, and regulatory considerations

US groups face Section 163(j) limits on interest deductions; high-coupon second-lien can hit the cap with carryforwards. PIK or deep-discount features can trigger AHYDO limits on deductibility; model the worst case. With non-US lenders, test portfolio interest exemption eligibility or rely on treaties, and set up registered notes mechanics if needed.

UK groups navigate Corporate Interest Restriction; use group ratio elections and ensure the interest counts as tax-interest. Watch EU anti-hybrid and anti-avoidance rules; avoid hybrids that create mismatches. Under US GAAP or IFRS, significant modifications or exchanges can trigger extinguishment accounting with gains or losses; plan for disclosure and a clear liquidity narrative.

Regulatory compliance includes KYC, AML, sanctions, and beneficial ownership reporting. Sanctions covenants should bind all subsidiaries and cover use of proceeds and screening.

Risk focus and mitigation

Rigid intercreditor: Excessive payment blockage or long standstills can cripple liability management. Negotiate reasonable carve-outs and acceleration triggers.
Leakage channels: Open-market purchases or uptiering without sacred right consent can subordinate recoveries. Hardwire consent rights and baskets.
Structural subordination: Non-guarantors or unrestricted subsidiaries holding core assets reduce recovery. Expand guarantees or adjust sizing.
Perfection gaps: Missed filings or account control failures render junior liens ineffective. Run comprehensive searches and checklists.
ABL dominion: Tight cash dominion in stress can drain liquidity without visibility. Secure reporting rights and cure pathways.
Cross-border friction: Misaligned insolvency regimes slow recoveries. Align security trusts and enforcement routes in advance.

Comparisons and alternatives

A unitranche loans solution with first-out and second-out tranches can be faster with fewer moving parts since waterfall and economics sit in an agreement among lenders. Holdco PIK avoids senior interference and often allows distributions, at the cost of price and recovery. Mezzanine or subordinated notes document quickly but usually carry heavier coupons and call protection. Preferred equity preserves covenants but dilutes returns and can be tax-inefficient. Choose second-lien when collateral, intercreditor, and execution combine to deliver flexibility and value.

Implementation checklist

Capacity checks: Sponsor deal team and borrower CFO with counsel test baskets, ratios, and negative pledge.
Term sheet path: Sponsor sets economics; borrower’s and agents’ counsel align on intercreditor framework and sacred rights.
Collateral diligence: Treasury, legal, collateral agent, and local counsel verify filings, control, and real estate.
Document drafting: Borrower’s counsel drafts; lenders’ counsel mark up; agents coordinate deliverables and CPs.
Compliance suite: KYC, AML, sanctions, and beneficial ownership filings sequenced with closing.
Closing pack: Lien searches, UCC filings, mortgages, officer and solvency certificates, opinions, fee letters, and insurance.

Common pitfalls and fast exits

Fixed intercreditor form: Senior documents permit junior liens only on a fixed form and the first-lien agent will not budge. Refinance the first-lien or drop the second-lien.
ABL exclusions: ABL blocks junior liens on working capital assets that are the only meaningful pool. Consider holdco or unsecured junior.
Thin guarantor net: Guarantor coverage under 70 percent of EBITDA due to foreign or non-wholly owned subsidiaries. Recut the guarantor group or pick another instrument.
MFN blowback: First-lien MFN or step-ups triggered by second-lien consents wipe out equity returns. Reprice or reconsider.
Tax drag: Section 163(j) or AHYDO modeling wipes out after-tax benefit. Adjust price or structure.
Standstill choke: Payment blockage and long standstills remove your ability to steer a restructuring. Escalate terms or walk.

What second-lien is not

It is not mezzanine with payment subordination. It is not a unitranche, even if collateral is shared. It is not a shortcut around senior covenants. Its value comes from precise intercreditor terms and disciplined collateral coverage, not a big headline coupon.

Records and retention

Archive the full document set and negotiation history. Index versions, Q&A, user access, and audit logs. Hash artifacts and set retention schedules. On exit or refinance, obtain vendor deletion and destruction certificates. Legal holds, if issued, override deletion until lifted. In leveraged finance, you get what you negotiate and what you can prove you negotiated.

Bankability barometer: quick signals your deal will clear

Aligned packages: Second-lien collateral and guarantees mirror first-lien with clean accession mechanics.
Usable intercreditor: Payment carve-outs, 90 to 180 day standstill, and sacred rights on priority and waterfall.
Solid coverage: Guarantor net captures 80 percent plus of EBITDA and assets, with minimal unrestricted leakage.
Basket roadmap: Day-one capacity mapped to ratio debt and starter baskets with MFN risks neutralized.
Exit clarity: Refinancing paths to high yield or second-lien loans take-out alternatives are documented in prepayment mechanics.

Conclusion

A well-structured second-lien adds flexible, durable capital behind your senior stack. The formula is simple but unforgiving: solid collateral coverage, clean perfection, a usable intercreditor, and economics you can live with in downside cases. Execute those pieces, and the instrument will support add-ons, liquidity, and orderly exits across cycles.