When Second Lien Loans Fit European Sponsor-Backed Mid-Market Deals

Second-Lien Loans: When They Work and How to Structure

A second-lien loan is a junior-ranking, secured, cash-pay term loan that shares collateral with the first lien but sits behind the super-senior revolving credit facility and the first-lien term debt in enforcement and payment priority. Its subordination sits in a negotiated intercreditor agreement, not in weaker collateral. It is not mezzanine, not unsecured PIK, and not the last-out in a first-out/last-out unitranche, even if the risk and recovery profile can rhyme with those instruments. When used with discipline, second-lien loans can unlock capacity, preserve speed, and improve certainty at an acceptable price.

The payoff for sponsors and lenders is control plus visibility. Second lien becomes a poor fit when the security package is patchy or the intercreditor structure makes junior control too remote. In lending, you earn the spread for risk you can size and manage; second lien works best when that spread comes from structure, not hope.

Where Second Lien Works Best

Add-on leverage: When a sponsor needs extra capacity for an acquisition, first-lien headroom is tight, and repricing the senior stack is costly, a second lien stapled to a modest first-lien add-on preserves speed and price discipline. The impact is a faster close with lower friction cost and tighter certainty.
Amend-and-extend gaps: If incumbents agree to push maturities but will not add exposure, a second-lien strip plugs the refinancing gap without reopening the full senior package. The impact is a bridge to a later takeout while preserving senior economics. For context on timelines and fees, see Amend-and-Extend in Private Credit.
Inside-perimeter rescue: When super-senior expansion is unavailable or contentious, second lien delivers capital inside the collateral perimeter without priming seniors. The impact is faster execution, lower litigation risk, and cleaner optics.
Recaps with durability: In steady cash generators with controlled leakage, second lien can be cheaper than holdco PIK and less dilutive than preferred. The impact is a lower blended cost of capital while keeping a deleveraging path intact.
Step toward unitranche: In mixed bank and direct-lender clubs, a second lien can bridge to a later unitranche takeout when market depth improves or regulation limits unitranche at signing. The impact is optionality and a path to simplification. For a broader comparison, review unitranche loans.

When the Second-Lien Case Weakens

Thin collateral: Insufficient collateral or weak guarantor coverage leaves value outside shared security. The impact is recovery slippage.
Hard blocks: First-lien documents hard-block junior secured incurrence or require consents that will not arrive on the timetable. The impact is execution risk.
Cash-pay strain: Volatility or business model uncertainty calls for longer covenant runways better handled with holdco PIK or equity. The impact is stress on cash-pay debt service.
Slow venues: Jurisdictions with slow enforcement pull junior recoveries toward equity outcomes. The impact is timing drag.
Priming risk: Likely restructuring routes that rely on super-senior new money will dilute second-lien recoveries. The impact is junior dilution.

Core Mechanics and Control Terms

Incurrence scope: Second lien typically sits at the borrower or midco within the secured perimeter and funds acquisitions, refinancings, or distributions. Keep structures simple to preserve speed.
Waterfall order: Super-senior is first-out on enforcement proceeds, then first lien, then second lien. Junior payments after a trigger are turned over to seniors. The impact is a predictable recovery order.
Payment blocks: On an event of default, junior payments are blocked per the intercreditor agreement. A 90 to 180 day standstill is common before juniors can act, which shapes value drift risk.
Enforcement control: First-lien creditors direct enforcement and security releases, while juniors consult and may step in after the standstill ends. The impact is strategy control with defined guardrails.
Consent rights: Juniors hold vetoes on ranking, security, guarantees, and intercreditor protections, plus material collateral releases outside enforcement. The impact is protection against drift. For deeper mechanics, consult guidance on intercreditor agreements.

Jurisdictional Nuances That Change Outcomes

Germany basics: Upstream guarantees need corporate benefit analysis and may be capped. Financial assistance and capital maintenance rules limit share pledges and cash pooling. Parallel debt often centralizes claims. The impact is constrained guarantee scope.
France pace: Corporate interest and proportionality tests apply to upstream and cross-stream guarantees. Security reform improved tools, but enforcement still tends to be slower than in England. The impact is timing.
Italy and Spain: Corporate benefit, financial assistance, and clawback risk drive caps and exclusions. Pledge enforcement may involve court steps or auctions. The impact is predictability.
Netherlands and Luxembourg: Favorable for holding structures with flexible pledge enforcement, tax neutrality, and parallel debt mechanics, especially in Luxembourg. The impact is execution efficiency.

Building the Security Package

Expect share pledges at the topco and key operating companies, bank account pledges with cash controls, receivables and IP assignments, and real estate or equipment where value warrants. Guarantees run through material entities, subject to local law limits and tax thresholds. The impact is broader collateral capture with careful attention to perfection and leakage risks.

Documentation You Will Need

Second-lien agreement: Mirror key definitions and baskets from first lien where feasible. Embed MFN, incurrence tests, restricted payment controls, and transfer terms for alignment and discipline.
Intercreditor agreement: Typically LMA-based with private-credit edits. Set ranking, waterfall, turnover, standstills, enforcement control, voting, and amendment scope as the rulebook.
Security and guarantees: Local-law governed, held via a security agent or parallel-debt structure to ensure perfection and integrity.
Hedging and super-senior: Document separately and designate as super-senior to preserve priority clarity.
Side letters: Include information rights, transfer limits, MFN on future junior secured, and equity cure usage for transparency and flexibility.

Pricing, Fees, and Investor Economics

Second-lien margins in Europe generally sit 150 to 300 bps over first-lien term debt, with higher OID where documents are loose or enforcement is slower. Soft call at 101 for 6 to 12 months is common; stressed deals may add short hard call periods. More flexibility usually means more yield, so price to real standstills, enforcement costs, and the actual waterfall, not the slides.

Fee stack: OID 1 to 3%; arrangement or underwriting 50 to 150 bps; amendment and consent fees as needed; occasional monitoring fees for added reporting. The impact is higher all-in yield.
Illustrative construct: Behind a 350 million euro first lien and a 60 million euro super-senior RCF, a 150 million euro second lien at EURIBOR plus 700 bps with 2% OID, 12-month 101 soft call, and MFN of 50 to 100 bps for 12 to 18 months. Add a springing leverage covenant if RCF is more than 35 to 40% drawn or upon default, a minimum liquidity covenant in stress, and incremental capacity via ratio tests and baskets with caps on pari junior secured. The impact is defined guardrails with clear economics.

Accounting and Reporting Basics

Under IFRS, borrowers typically book second-lien debt at amortized cost under IFRS 9, with OID and fees amortized via the effective interest rate. If proceeds refinance first-lien facilities, analyze modification versus extinguishment for profit and loss. Disclosures under IFRS 7 should cover maturity profiles, effective rates, covenants, and liquidity sensitivities. PIK features create non-cash interest, so align covenant definitions on PIK add-backs, exceptional items, and acquisition adjustments early. Funds mark positions at Level 2 or 3 under IFRS 13 or ASC 820 using yield curves, spreads, and recovery models calibrated against observable trades and likely intercreditor outcomes.

Tax Considerations That Move Net Yield

Interest limitation: ATAD Article 4 and UK Corporate Interest Restriction cap net interest deductions at 30% of tax EBITDA, usually with carryforwards. The impact is reduced after-tax yield if headroom is tight.
Withholding tax: UK loan interest can carry 20% withholding unless an exemption applies; the UK QPP regime can help for qualifying private placements. Luxembourg generally has no withholding on arm’s-length interest; the Netherlands applies conditional withholding to payments to low-tax jurisdictions. The impact is cash leakage if unmitigated.
Hybrid mismatches: ATAD 2 can deny deductions or include income where structures misalign entities or instruments across borders. The impact is tax certainty risk.
Transfer pricing: Expect arm’s-length pricing for debt and guarantees, plus clear policies for security sharing and guarantee fees. The impact is defendability in audits.
Intercompany flows: Cash sweeps and upstream loans must pass legal and tax benefit tests in civil-law jurisdictions. The impact is distribution certainty.

Regulatory and Compliance Checklist

Most second-lien lenders are AIFs under AIFMD with marketing, leverage, and reporting duties at the manager level. KYC or AML and sanctions checks must cover the borrower group and principals. Cross-border lending can trigger licensing, so structure within permitted regimes. Enforcement via share appropriations may attract FDI or national security review in sensitive sectors, which can affect timing and transferability.

Key Risks to Underwrite Upfront

Priming creep: Super-senior upsizes and generous hedging designations can crowd the waterfall. Hard caps and consent rights protect junior recoveries.
Structural subordination: Non-guarantor silos, pension traps, or regulated entities outside security dilute outcomes. Police leakage with hard caps and scope tests.
Portability and transfers: Portability and unrestricted subsidiary transfers can change ownership or move assets outside collateral. Tight RP and investment controls maintain alignment.
Enforcement friction: Jurisdictional delays and standstills can erode value. Model realistic timelines, fees, and currency or rate mechanics.
Definition drift: If junior covenants import senior definitions wholesale, later senior looseners can leak into junior terms unless definitions are frozen. Lock the dictionary.
Rate mechanics: EURIBOR or SONIA mismatches, rate floors, and fallbacks affect economics and hedging. Align documentation across tranches.

Alternatives and How They Compare

Unitranche FOLO: Simpler and often faster when a single lender can write the full ticket. It loses ground where banks want to keep the RCF or regulatory limits apply. Explore differences in US vs Europe unitranche and a sponsor-backed unitranche guide.
Senior stretch: A larger first lien wins when banks are open and the credit is strong. Second lien helps when bank capacity or concentration limits block the size.
Holdco PIK: Maximum flexibility with faster document work and no cash-pay strain, but with higher coupon and full structural subordination.
Mezzanine or preferred: Quick for small tickets and avoids intercreditor negotiation, but equity-like terms and dilution can be a hurdle.
ABL plus second lien: Efficient for working-capital heavy credits, but requires ABL-specific intercreditor terms and borrowing-base recognition.

Execution Timeline and Deal Owners

Week 0 to 1: Align with the first-lien agent on baskets and intercreditor access. Run a fast collateral coverage check to greenlight or reroute.
Week 1 to 3: Draft second-lien commitments, intercreditor joinders or amendments, and alignment schedules. Start KYC and local-law mapping.
Week 3 to 5: Converge documents; prepare perfection steps, corporate approvals, solvency and benefit statements. Confirm value attribution for intercreditor voting.
Week 5 to 7: Clear CPs; map funds flows; finalize agency and cash-control documents. Align auditors on classification.
Week 7 to 8: Sign and fund, and chase post-closing perfection steps where permitted.

Owners typically include the sponsor CFO or treasury for the model and liquidity, sponsor counsel for definition control, second-lien counsel for junior protections, first-lien agent counsel for senior control, local counsels for security and enforcement, security and facility agents for perfection and registers, tax advisors for interest limits and withholding, and a valuation advisor where needed.

Fast Screens to Save Time

Coverage shortfall: Security coverage below roughly 70 to 80% of EBITDA-generating entities with no viable fix.
Veto gridlock: Intercreditor vetoes that require unanimous senior consent for any junior incurrence on an unworkable timeline.
Super-senior drift: Headroom that can be upsized without junior consent and hedging designations that overrun the cap.
Capacity consumed: Debt capacity already used by builder baskets or designations.
Fragile cash flow: Unproven add-backs, customer concentration, or project-like risk under a cash-pay structure.
Slow enforcement: Paths likely to run beyond 12 months with disputed valuations and limited self-help.
Tax leakage: Withholding or 30% interest caps without relief, and hybrid risk that cannot be mitigated via QPP, treaty, or structure.

Negotiation Playbook

For sponsors: Offer a narrow, time-limited MFN with carve-outs for super-senior and essential baskets. Freeze junior definitions so later senior looseners do not flow down automatically. Ring-fence acquisition capacity with sub-limits and ratio retests. If portability is needed, trade it for tighter leakage controls and better information rights. Keep liquidity and equity cures workable.
For lenders: Underwrite to the intercreditor you have, not the one you wish for. Cap super-senior and hedging designations. Secure consent rights for new-money priming in restructurings or neutral economics. Police structural subordination and guarantor coverage with hard caps on non-guarantor debt. Lock robust information rights and price for portability, leakage, and covenant looseners.

When to Walk Away

Unequal security: Equal security and guarantees cannot cover a majority of enterprise value.
Unilateral senior power: Seniors demand unilateral power to upsize super-senior or release core collateral outside enforcement.
Stretchy plan: The business plan leans on debt-funded growth with thin cushions and aggressive, unverified EBITDA adjustments.
Hard venues: Enforcement would center on venues with long timelines and limited remedies.
Tax or regulatory fog: Frictions make net yield uncertain and unhedgeable.

Practical Takeaways

Second lien is a focused tool. It earns its keep when collateral is available, senior capacity is tight, and intercreditor access is clean on a fast timeline. Pick it when structure gives you a margin of safety; pick unitranche in sponsor-backed settings or holdco PIK when volatility or timing call for a different trade.

Data Points to Track Every Time

Interest caps: Interest limitation headroom under ATAD or UK CIR at the 30% cap.
Withholding status: UK withholding if any UK payers are in scope, with QPP or treaty mechanics confirmed at term sheet.
Dutch conditional WHT: Exposure for low-tax counterparties if relevant to payments.
Market context: Default backdrop and market depth, noting that low single-digit default expectations support availability but not outcomes.
Intercreditor baselines: LMA and ELFA baselines and any priced deviations.

Final Screen

If you cannot summarize on one page the collateral and guarantor coverage, intercreditor control, standstill timing, enforcement route by jurisdiction, and tax posture on interest and withholding, the second lien is not ready. Move to unitranche, holdco PIK, or revisit the senior. The week you spend getting the intercreditor right is cheaper than owning junior-secured paper that behaves like equity. For a broader market lens, see Private Credit Market Outlook.

Key Takeaway

Use a second lien when collateral and documentation give you control and visibility, your intercreditor terms are tight, and pricing compensates for real-world standstills and enforcement friction. Avoid it when capacity, control, or jurisdictional realities push you toward equity-like risk without equity-like return.