Second-lien lending rides a gusher.

• Author: Marshall, Jeffrey
• Position: Cover story

With nearly 4,000 employees and 11 locations around the globe, ICON Health & Fitness Inc. is one of the largest manufacturers and marketers of fitness equipment in the world. It owns some of the best-known brands in the fitness industry--including NordicTrack, FreeMotion, ProForm, EPIC, HealthRider, Weider, Image and Weslo--and licenses Reebok and Gold's Gym brands.

But the Logan, Utah-based firm, privately held but with some public debt, found itself in something of a "cash-strapped position" last year, says CFO Fred Beck. The company, with $900 million in 2005 revenues, elected to enter into a sizable financing, led by Bank of America Business Capital, that included a $40 million second-lien loan from Back Bay Capital Funding LLC, a Boston firm working with the Bank of America unit.

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ICON's five-year second-lien loan is, in effect, a secondary piece of a larger, traditional asset-based revolving loan the company took out with a first lien; that loan, led by Bank of America, totaled $250 million spread among seven lenders. Beck says the collateral for the second-lien loan includes all of the company assets, including fixed equipment and intangibles like trademarks. The lenders "did an analysis of the cash flows and became comfortable with those values," he says.

Beck concedes that at six points over the prime rate, "this wasn't the cheapest piece of paper in the world." But the financing includes some prepayment incentives if the company's business improves and ICON can pay down some of the debt early, he notes.

The finance chief adds that the company just couldn't make the numbers work with a traditional revolver. "We've spent a lot on trademarks and debt, and on fixed equipment, and we saw this [second-lien loan] as a way to get money into the operating part of the business."

Once a minor product targeted for truly hard-up borrowers, second-lien loans have literally exploded in popularity in the past few years, especially as investment vehicles like hedge funds troll for higher yields and lenders direct assets into collateralized loan obligation (CLO) vehicles to offload balance sheet risk.

From just over $3 billion in volume in 2003, second-lien totals swelled to $12.0 billion in 2004 and $16.3 billion in 2005, according to Standard & Poor's (S & P). Representing just 1 percent of total institutional lending volume in the years 1997-2002, the percentages jumped to 3 percent in 2003, 8 percent in 2004 and 9 percent last year.

And the numbers just keep going skyward. S & P data for this year's first half show volume at $12.9 billion and the number of deals, 92, also at a record. Volume in both the first and second quarters topped $6 billion for the first time ever.

But, as with any type of financing whose growth seems almost nuclear-powered, concerns have been raised about whether things are going too far, too fast. That's particularly true in that hedge funds and distressed-asset lenders are prime forces in this type of lending, and may not have the stomach or the expertise to stay the course if things go south (see sidebar, "How Second Liens Complicate a Workout," on page 43).

Technically, a second-lien loan is a secured bank loan where the second-lien lenders share in the same collateral as the first-lien lenders. In return for agreeing with the first-lien lenders that they won't receive any proceeds of the collateral until the first-lien group is paid in full, second-lien lenders receive a higher spread.

Second-lien loans, despite their loftier spreads, are...