Issuers and investors have flocked to the second lien loan market over the past year-and-a-half, sparking U.S. second lien volume of at least $12 billion in 2004 alone - the most on record. This heightened popularity of the often yieldy debt product has caused arrangers, especially those in the asset-based middle market area - to source collateral for second lien credits in more creative ways than ever before. One particularly creative method is with intellectual property, which is known as a "soft" source of collateral.
To be sure, IP collateral has become more accepted, as second lien lenders are now more acute to a company's enterprise value. "We prefer lending on IP because it's the asset that is unique to the trade name," said Colin Cross, a managing director with Back Bay Capital. And some lenders are drawn to IP-type assets because their value is not directly linked to the strength of the stock market or economic cycles, further noted David Pullman, CEO of The Pullman Group LLC.
Another benefit of IP-backed second liens is that they net a strong return for the lender, typically priced at about 800 basis points over Libor for middle market companies and about 600 basis points over Libor for larger companies, Cross said.
This makes IP-secured second liens especially attractive to yield-hungry investors, such as hedge funds, said Sean Dougherty, a director in the collateralized debt obligation ratings group at Standard & Poor's. "A hedge fund wants a higher return," Dougherty said, explaining that Libor plus 200 basis points to 300 basis points returns - which may be attractive to some investors - are not attractive to hedge fund investors, as they prefer wider spreads.
"As spreads are very tight in the first lien, investors are starting to look for more investments that offer additional spread," Dougherty said. As a result, investors who are looking to second-lien loans as an avenue to increase spreads are beginning to go further into the capital structure.
Fierce competition for deal mandates has also caused arrangers to look toward unconventional collateral structures such as IP structures. "Over the last several months, in talking to different classes of investors...I've noticed second lien lenders talking more about IP," said Marc Lucier, a director at ICMB Ocean Tomo. "As the space is getting more competitive, people have gotten more aggressive [and] have started to think about unconventional aspects of collateral packages." And while bank loan lenders have not historically focused on IP, nor have they been comfortable assigning value to it, Lucier said that the rise of aggressive deals in the market has caused lenders to become more open to accessing such unconventional forms of collateral.
To be sure, the increasing interest in IP collateral amongst second lien lenders is mostly in the institutional middle market, sources said. However, this is not to say that larger borrowers - such as Levi Strauss & Co., for example - haven't assigned market value to their trade names as well. In 2003, Levi Strauss completed a $500 million trademark-backed term loan, $200 million of which was priced with a hefty 10% interest rate through lead arranger Banc of America Securities.
Specifically, IP collateral appears to be especially feasible for middle market asset-based credits because in many instances it gives second lien lenders a first priority lien on "soft," IP collateral and a second priority lien on hard assets (in which the ABL lender has a first lien). This makes the collateral position a lot more attractive to the second lien lender, said Andrew Hettinger, a director at Houlihan Lokey Howard & Zukin. He noted, however, that this structure doesn't work for every situation.
An improved risk position is a main reason second lien players like the idea of a first lien on IP collateral. "It changes the risk situation for the second lien lender if there's a real exit strategy," Hettinger said, noting that Houlihan Lokey looks at this structure as a possibility for any deal that has a strong trade name.
Improvements in valuation further support the advent of IP as second lien collateral. That's because establishing a market value for IP and other intangible assets is more accurate today than it was three or four years ago, thanks to better technology, better methodology and more sophisticated databases, said Weston Anson, chairman and senior partner with CONSOR Asset Management, an intellectual asset management firm. There is also a more active market for these assets, which makes their value easier to predict, he said. And lenders themselves are more sophisticated. "Ten years ago, when I'd go to a lender and say we're valuing the IP of a company and we're valuing the licensing agreements of a company, I would basically get a blank stare," he said.
That said, the notion of assigning collateral value to brand names or trademarks is not necessarily a new one. For example, middle market lending firm Monroe Capital has used IP collateral to back its loans and investments for about five years, said Ted Koenig, the firm's president and CEO. However, the interest of second lien lenders in IP is a newer phenomenon, Koenig said, starting around the time the second lien market began to intensify in 2003.
Such interest in IP collateral has escalated largely because, in the past, primary lenders felt traditional collateral was sufficient to provide liquidity, Koenig explained. However, as the market has become more flush and lenders - especially second lien ones - have tried to differentiate themselves, they have begun to look for more nontraditional assets to create value. "[And] a place where a lot of second lien lenders have been able to create value is IP," he said.
And even more lenders will seek to create value in IP in the future, predicts Keith Bergelt, CEO of IP Innovations Financial Services, a specialty financial services firm that guarantees loans made by banks that are collateralized by IP. "There's a palpable sense that something is happening, but it is not quantifiable. Once [lenders] see a reasonable amount of [IP] deals, you'll see a recalibration on the part of ABL shops, traditional banks with ABL groups, hedge funds and insurance companies," he said.
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