Second-lien loans are junior secured term loans that share the same collateral as a first-lien facility but sit behind it in lien priority. They are lien-subordinated, so second-lien lenders get paid from collateral proceeds only after the first lien is made whole. However, outside an enforcement, second lien is not junior in scheduled payment terms. This blend of security and subordination makes second lien a useful, but delicate, tool in leveraged finance.
This guide explains what second lien is, where it fits in the capital stack, how to price it, and the documentation terms that protect or erode value. It also offers practical underwriting checklists and a simple decision rule to improve outcomes.
Second lien defined and where it differs
Second lien is a junior secured claim on the operating company’s collateral package. A single collateral agent or trustee typically holds both liens, and a negotiated intercreditor agreement sets the rules. In split-lien ABL structures, second lien may be second on ABL collateral like receivables and inventory but first on term-loan collateral like equipment and intellectual property. Therefore, investors should specify which collateral pools the second lien sits behind to avoid priority confusion.
Second lien differs from mezzanine debt, which is usually unsecured or structurally subordinated and often carries equity-like features such as warrants. It also differs from holdco PIK, which has no direct claim on operating assets. These distinctions matter because remedies, control, and recoveries diverge across these instruments.
Why sponsors and lenders use it
Sponsors turn to second lien when a first-lien facility or a single-tranche solution will not satisfy leverage, timing, or covenant goals. Lenders offer second lien to earn a higher spread while remaining secured by the same assets as the senior. Borrowers often prefer second lien to unsecured notes because it closes faster, in a more private process, and can be tailored with bespoke terms. A typical execution takes four to eight weeks from term sheet to funding.
Position in the stack shapes outcomes. Common stacks include a first-lien term loan followed by second lien, or an ABL first-out, then a first-lien term loan, then second lien. In clubs using a single credit agreement, a last-out tranche can substitute for standalone second lien. When underwriting, anchor your view to the senior facility’s behavior because covenants, amendment flexibility, and liability management capacity at the top of the stack determine second-lien recoveries.
When comparing structures, many sponsors weigh second lien against unitranche loans. In some markets, what second lien would cover is provided through a last-out tranche that aligns control within one agreement, which can improve enforcement coordination at the cost of lower spread. For deeper context on deal design, see sponsor-backed unitranche structuring and US vs Europe unitranche terms.
Market pricing and return math
Private credit yields climbed with base rates. As of late 2024, many middle market floating-rate portfolios earned low double-digit yields. Second lien generally prices 200 to 300 basis points above comparable first-lien or single-tranche loans. The premium widens when documents are loose or volatility rises. Discounts to par and call protection are common and can drive a meaningful portion of return.
Consider an illustration. A 150 million second lien sits behind a 300 million first-lien term loan. The second lien pays SOFR plus 9.50 percent with a 1.00 percent floor, issued at 97 with a 1 percent call in year two. With base SOFR at 5.25 percent, the cash coupon is 10.50 percent. The 3 percent original issue discount, amortized over three years, adds roughly 100 basis points to the effective yield, landing near 11.5 to 12 percent before fees. A comparable first lien at SOFR plus 6.25 percent with a 1 percent OID often lands near 8 to 9 percent. The gap is the price of lower control and lower expected recovery.
A fresh lens: control-adjusted yield
Investors should evaluate control-adjusted yield, a simple metric that scales nominal yield by the probability that junior lenders can enforce or influence a timely solution. As a rule of thumb, subtract 200 to 400 basis points from headline yield if documents allow priming, loose collateral releases, or long standstills, then compare to last-out unitranche alternatives. This quick haircut aligns pricing with the real ability to turn yield into cash.
Recovery expectations and what drives them
History is not kind to junior secured recoveries. Second-lien recoveries tend to trail first lien by a wide margin and rank low across the secured spectrum. The reasons are straightforward. First-lien lenders control enforcement, they dictate collateral release mechanics, and they often have priming capacity in loose documents. In practice, price to loss severity rather than to headline spread. For many sectors, stress-band recoveries can slip to the low teens to sub 30 percent if documents permit uptiering or value leakage.
Intercreditor architecture that protects value
Most US deals run on New York law and European deals on English law. A single security agent or trustee holds both liens. The intercreditor agreement governs standstill periods, lien priority, proceeds waterfalls, collateral releases, and turnover obligations. LMA precedents shape European forms, while US deals are negotiated case by case using LSTA concepts as a reference. Small deviations in release and enforcement provisions can move expected recoveries by double digits. For a practical overview, see this guide to intercreditor agreements and lien subordination.
Standstill periods of 90 to 180 days are common in sponsor-backed transactions, with longer periods in Europe and more prescriptive steps for account and share pledge enforcement. Second-lien documents should include springing rights if the first lien does not begin meaningful enforcement during the standstill or waives defaults while value deteriorates. Payment blockages for second-lien cash interest during a default should be capped and modeled.
Collateral, guarantees, and ring-fencing
Second-lien lenders typically share a perfected lien on substantially all domestic assets and receive guarantees from material domestic subsidiaries. Foreign subsidiaries often sit outside the collateral net or carry limited pledges because of tax and legal frictions. In split-lien ABL deals, the ABL controls working capital assets through borrowing base and cash dominion. Term lenders focus on fixed assets and IP. Investors should track leakage routes such as unrestricted subsidiaries, loose permitted investment baskets, and incremental or sidecar capacity, which can move value outside the collateral net.
Mechanics and flow of funds
Second-lien proceeds fund leveraged buyouts, refinancings, add-on acquisitions, and capex. Absent a payment blockage, the loan pays cash interest current. In enforcement or bankruptcy, the waterfall is simple: costs, first lien in full, then second lien, then junior debt and equity. Intercreditor turnover provisions can require junior lenders to remit proceeds received in conflict with the waterfall, so agree tight exceptions for recoveries that second-lien lenders fund or initiate.
Documentation map and covenant alignment
Core documents include the second-lien credit agreement, the intercreditor agreement, security and guarantees, perfection steps such as UCC and IP filings, and the fee letter. Side letters often cover information rights, most favored nation protection on later second-lien tranches, and transfer exceptions for affiliates and CLOs. Second-lien covenants usually align with first-lien covenants to avoid conflict and include cross-default, while maintenance covenants often exist only at the first lien with a cushion at the second lien.
Pricing terms float over SOFR, SONIA, or EURIBOR with floors that set a minimum base rate. OID is usually higher than first lien, reflecting placement effort and thinner liquidity. Call protection is common, often stepping down over two years, and some deals carry a make-whole in year one. For background on these economics, see this explainer on call protection and OID.
Tax, accounting, and regulatory quick hits
Withholding can be mitigated with the portfolio interest exemption and treaty planning, subject to limitation-on-benefits tests. OID accrues for tax even without cash payments, which affects lender income timing and borrower deductions. Interest deduction limits under US IRC section 163(j) and EU ATAD can cap deductibility, which sponsors should model. Some jurisdictions impose stamp or registration taxes on security, adding closing friction.
Private credit funds often mark to fair value. Others elect fair value or carry loans at amortized cost with CECL. Borrowers carry second-lien debt at amortized cost using the effective interest method and apply modification accounting for repricings. US advisers remain subject to the Advisers Act. The Fifth Circuit vacated the SEC’s 2023 private fund adviser rules, but scrutiny of disclosures and conflicts continues, and Form PF reporting was increased for some advisers. The US Corporate Transparency Act now requires beneficial ownership reporting for many entities.
Liability management and failure modes to avoid
Second-lien lenders rely on first-lien control, and priming risk is real if senior documents allow uptiering, non pro rata exchanges, or broad open market purchase definitions. Courts continue to treat syndicated term loans as loans rather than securities, which narrows securities-law claims and places protections back into the contract. Respond with tight sacred rights, narrow open market purchase definitions, anti-uptier language, and alignment of critical terms across first and second lien.
Intercreditor failure modes checklist
- Broad releases: Collateral release rights that allow value transfer on a low-price sale.
- Excess standstill: Long standstills in a fast-melting collateral base without springing rights.
- Turnover traps: Turnover provisions that require junior lenders to hand over recoveries they funded.
- Senior capacity: Large senior incremental or sidecar capacity without MFN and pricing protections.
- ABL drain: Cash dominion and inventory control that starves term-loan collateral realization.
Alternatives and when second lien wins
Second lien competes with several instruments. A last-out tranche in a single agreement can deliver lower yield but better enforcement alignment. Mezzanine debt is unsecured or structurally junior and offers a higher coupon with flexible covenants, which suits light-collateral stories. Holdco PIK and preferred equity trade remedies for flexibility and sponsor control. For a primer that contrasts these options, see mezzanine financing.
Second lien earns its place when speed, custom terms, and collateral coverage matter, and when first-lien documents already curb priming and leakage. It often loses to last-out unitranche if alignment and control outweigh the extra spread, and it loses to mezzanine when collateral is thin and flexibility commands a premium.
Execution timeline and a 30 second underwriting checklist
A typical sponsor-backed second lien runs in four to eight weeks. Week 0 to 1 covers the term sheet, an intercreditor term sheet with the first-lien agent, and a diligence plan. Week 1 to 3 includes first drafts, initial intercreditor turn, collateral diligence, and model finalization. Week 3 to 5 focuses on negotiating the intercreditor, finalizing collateral schedules and perfection, and legal opinions. Week 5 to 6 closes internal approvals, conditions precedent, and funding mechanics. Gating items include an executed intercreditor, senior consents, lien searches, and account control agreements.
Your 30 second underwriting checklist
- Priority map: Identify each collateral pool and confirm where second lien sits in ABL split-lien structures.
- Control levers: Review standstill length, springing rights, collateral release votes, and turnover exceptions.
- Priming risk: Scrub senior incremental, open market purchase definitions, uptier blocks, and MFN.
- Leakage paths: Quantify unrestricted subsidiaries, permitted investments, and sidecar capacity.
- Cash coverage: Test free cash flow to cash interest, including modeled blockage periods.
- Exit math: Size call protection and OID versus expected maturity or amend-to-extend probability.
Monitoring, pitfalls, and quick kill tests
Match first-lien reporting, including monthly KPIs when relevant. Require notice of defaults and waivers, the right to attend lender meetings when senior changes affect collateral or priority, and access to management updates. Track collateral leakage, incremental capacity usage, and senior covenant changes that raise volatility for junior tranches.
Quick kill tests include senior documents that allow more than 1.0 times EBITDA incremental debt without hard MFN and anti-priming protections, collateral that sits mostly in foreign subsidiaries without pledges, an ABL with springing dominion that drains liquidity, a first-lien maintenance covenant already near breach, and weak sponsor alignment combined with restrictive second-lien transfer rights.
Pricing and structuring playbook
Price to loss, not to comps. Use sector recovery data as the anchor. Build returns with OID, call protection, and ticking fees, not just coupon, because cash coverage matters in stress. Protect priority with anti-uptier language in both documents, narrow open market purchase definitions, and sacred rights over releases and cross-subordination. Anchor enforcement with a short standstill and springing rights tied to clear milestones and value tests. Ensure information symmetry and audit rights and require concurrent senior notices.
Transfer and liquidity considerations
Liquidity in second lien is thinner than first lien. A white list of major CLOs and private credit buyers increases exit options. Allow affiliate and managed-fund transfers without consent to support portfolio management. Include MFN on future second-lien tranches to protect early lenders if later debt prices tighter. These mechanics lift close certainty and reduce hold risk.
Jurisdictional notes that affect execution
In the US, New York law governs, UCC filings perfect security interests, and account control agreements over deposit accounts matter. Recent cases confirm syndicated term loans are not securities, which streamlines distribution and narrows certain litigation angles, but it pushes protections into contract. In Europe, English-law intercreditors under LMA norms drive structure, with debentures over shares and assets plus local-law pieces. Enforcement often runs through share pledges and court-sanctioned schemes or restructuring plans. AIFMD II raises the bar on loan origination fund guardrails and reporting.
Risk governance and exit strategies
Set valuation policies that calibrate to origination and include scenario work that assumes aggressive senior tactics. Cap exposure by sector and sponsor and monitor double exposure when holding both liens across vehicles. Establish a second-lien steering group for amendments. Where you hold both tranches, implement conflict protocols, wall teams, and separate counsel as needed.
Base case exit is a refinance or sale call. Secondary exits require a documented white list and flexible consent terms. Amend-to-extend at first lien can force a second-lien roll, so price the roll and negotiate fees early. If a sale is likely, secure consultation rights and tie release provisions to transparent value processes, not just majority votes, to reduce value leakage at exit.
Borrower-side implications
Borrowers face added reporting, tax planning, and covenant tracking. Interest deductibility limits may drive a mix of cash-pay and PIK or preferred. Treasury teams should harmonize baskets and covenants across first and second lien to reduce administrative friction. Clean intercreditor and aligned covenants simplify operations and lower amendment costs.
Outlook
Higher base rates and uneven corporate performance support a durable premium for junior secured risk. Expect continued tightening of anti-priming and enforcement mechanics as liability management tactics evolve. Regulators will keep probing disclosures and conflicts even without new prescriptive rules. Second lien remains a targeted tool. It works when documentation discipline turns headline yield into real, recoverable value.
Conclusion
Second lien is not a pure yield trade. It is a control and recovery trade wrapped in a yield. Price the legal architecture, protect the collateral net, and align with the senior facility’s behavior. If you do that, the premium can compensate for junior position. If you do not, headline spread is only a placeholder for loss severity.