First Lien vs Second Lien: Key Differences and Risks Explained

Understanding the distinctions between first lien and second lien loans is critical for investors, lenders, and borrowers. These financial instruments shape the risk profile and return potential of debt investments, influencing everything from interest rates to recovery outcomes during defaults.

This article explores the key differences between these two types of liens and their implications within debt financing.

Priority in the Debt Structure

In debt financing, priority is fundamental. First lien loans occupy the highest rank, granting them precedence over other claims on a borrower’s assets. This seniority is established by legal frameworks, such as the Uniform Commercial Code (UCC) in the United States, which ensures first lien creditors have the primary claim on collateral during liquidation. This secure position often translates into lower interest rates due to reduced risk.

The capital structure reinforces the priority of first lien loans. These loans are repaid before subordinate debt, such as second lien loans, mezzanine financing, and equity. In bankruptcy, first lien creditors typically negotiate restructuring terms first, leveraging their seniority to recover a larger share of their investment.

Second lien loans, while still secured, are subordinate to first liens and carry a higher risk profile. This increased risk is reflected in higher interest rates. Intercreditor agreements define the rights and responsibilities of first and second lien creditors, often limiting the latter’s ability to take enforcement actions without the consent of the former.

Collateral Rights

Collateral rights are a central aspect of the relationship between first and second lien loans. Collateral secures loans, granting lenders a claim on specific assets if the borrower defaults. The rights to this collateral are clearly prioritized.

First lien holders have primary claims on collateral, enabling them to recover their investment first during liquidation. The type of collateral—ranging from tangible assets like real estate to intangible ones like patents—affects recovery potential.

Second lien holders, while secured, only have claims after the first lien obligations are satisfied. Due diligence is critical for second lien lenders, as they must assess the residual value of collateral, factoring in depreciation, market conditions, and existing encumbrances.

Intercreditor agreements govern the enforcement of collateral rights, specifying when and how each party may act. For instance, second lien creditors may be restricted from initiating foreclosure without first lien holders’ consent, ensuring orderly management of claims.

Loan Covenants

Loan covenants define the terms borrowers must follow throughout the loan. They protect lenders by promoting financial stability and responsibility and are categorized as affirmative, negative, or financial.

Affirmative covenants require borrowers to take proactive steps, such as maintaining insurance or providing financial statements. For example, a borrower might need to submit quarterly financial statements audited under Generally Accepted Accounting Principles (GAAP).

Negative covenants restrict activities that could harm the borrower’s financial position, such as incurring excessive debt or selling key assets. For instance, a borrower may be prohibited from taking on new debt beyond a specified leverage ratio.

Financial covenants set measurable benchmarks, like minimum interest coverage or maximum leverage ratios, to monitor financial health. A typical agreement might require an interest coverage ratio of at least 2.5x.

Interest Rate Differences

Interest rates distinguish first and second lien loans, reflecting their respective risk profiles. First lien loans generally have lower interest rates due to their priority and security. For example, a company with stable cash flows might secure a first lien loan at a rate tied to the London Interbank Offered Rate (LIBOR) or the Secured Overnight Financing Rate (SOFR), plus a small margin.

Second lien loans, with their subordinate position and higher risk, demand higher interest rates. These loans often include larger spreads over LIBOR or SOFR or may feature fixed rates to mitigate fluctuations.

Default Procedures

Default procedures differ significantly between first and second lien loans because of their positions in the debt hierarchy and contractual agreements. Legal frameworks, such as the U.S. Bankruptcy Code, and intercreditor agreements dictate these processes.

First lien lenders benefit from a structured recovery process. Their seniority allows them to take enforcement actions, like foreclosing on collateral or initiating bankruptcy proceedings, without requiring consent from subordinate lenders. In Chapter 11 cases, first lien creditors often lead negotiations for debtor-in-possession (DIP) financing or restructuring plans.

Second lien lenders face more constraints during defaults. Intercreditor agreements often require them to wait until first lien claims are fully resolved before acting, reducing their chances of recovery if collateral values fall short. To protect their interests, second lien lenders may negotiate provisions in intercreditor agreements, such as the right to share in collateral proceeds under specific conditions or participate in restructuring discussions.