First Lien Term Loan: A Closer Look

A first lien term loan is one of the more standard debt structures. First lien term loans are senior secured debt that maintain first right on collateral and first payout position. This debt structure is offered by a broad range of capital providers, and can be paired with numerous other debt types. 

Quick Breakdown

Capital Type: First Lien Term Loan, Term Loan A (when provided by banks), or Term Loan B (when provided by non-bank institutions such as CLOs)
Typical Use: Finance growth, mergers and acquisitions and dividends
Funding Mechanism: Typically, fully funded at the close of the transaction. Delayed draw features may be available under certain circumstances
Security: Senior secured first priority lien
Collateral: Typically, all assets of the company and pledge of equity. In certain circumstances, personal guarantee from the owner of the business may be required
Payment Priority: Usually the first to be repaid from the proceeds of liquidation of its collateral. When paired with another debt facility with a first lien on the same collateral, will be repaid in equal proportion, or ratably, with other first lien debt

Who Should Consider a First Lien Term Loan?

First lien term loans should be considered by borrowers with the following attributes: 

1. For cash flow or EV structures, businesses with EBITDA greater than $7MM – $10MM, and ideally above $15MM
2. For most banks, the difference between the term loan amount and the value of the assets, known as the ‘airball’, typically needs to be less than 20% of the loan amount. Banks make an exception to this rule for highly profitable borrowers backed by private equity firms with a great track record.
3. Stable, largely predictive cash flows and a demonstrable track record of consistent financial performance.
4. Senior debt to EBITDA ratio less than 3.0x, and total debt to EBITDA ratio less than 4.0x, if the term loan is to be provided by banks. Depending on the ownership, transaction type and enterprise value, direct lenders can fund term loans upwards of 6.0x total debt to EBITDA ratio. 
5. For borrowers with a meaningful amount of fixed assets, first lien term loans can also be structured based on appraised value of the underlying collateral. This structure would function quite similarly to an ABL.

Advantages of a First Lien Term Loan

Borrowers of first lien term loans enjoy the following benefits: 

• Relatively low cost–when provided by a bank, first lien term loans are among  the most economical debt financing options
• Low maintenance–reporting obligations limited to financials and covenant compliance certificates
• Competitive market–one of the most common debt products offered by bank and non-bank entities alike, leading to a better choice and efficient pricing for capital seekers. When credit quality is not suitable for banks, credit funds can provide this capital at a higher cost and with almost no amortization requirements 
• Simpler lender group –typically, the same lenders that provide a cash flow line of credit also provide a first lien term loan, resulting in fewer documentation requirements

Drawbacks of a First Lien Term Loan   

There are prominent considerations that borrowers of a first lien term loan should take into account:

• Banks expect additional business such as cash management, in return for providing this relatively cheap form of capital
• Relationship focused–regular and somewhat frequent contact from bank relationship managers is required
• Mandatory amortization is required by banks, creating meaningful cash outflow (reducing what can be spent for other corporate purposes)
• If provided by non-bank institutions, cost of capital will be relatively high
• Periodic appraisal of collateral may be required for asset-backed structures

Underwriting Process for a First Lien Term Loan

Capital Providers: Banks, certain non-bank credit funds and Business Development Companies (“BDCs”)

Underwriting Thesis:  

1. Recovery through ongoing cash flow generation of Capital Seeker or through refinancing. In distressed situations, recovery through sale of Capital seeker as an ongoing business.
2. For asset-backed structures, recovery through liquidation of collateral in a distressed situation.
3. For recurring revenues based structure, recovery through collection of ongoing contractual payments

Underwriting Focus:  

1. Confirmation of business’ ability to generate cash flow and repay debt, ability of owner or sponsor to inject additional equity and liquidity.
2. For asset backed structures, liquidity and value of the collateral.
3. For businesses with recurring revenues, e.g. software companies, validation of the company’s ability to generate recurring revenues and maintain healthy contract renewal rates.

Underwriting Process:

1. Typical credit underwriting process focuses on the ability of the business to generate consistent cash flow and risks that may disrupt consistent cash flow generation. Underwriting involves analysis of business model, competitive dynamics, customer base and commercial terms, ownership history, historical financial performance as well as financial projections, operations and background of key stakeholders, including key executives.
2. Quality of earnings report produced by an accounting firm to validate the EBITDA of the business as well as any adjustments and an industry study to validate the company’s competitive position, size of the market, customer feedback, etc.
3. Some banks may want to conduct a collateral exam to review and analyze accounts receivable performance, inventory records and record keeping systems.
4. Analysis of owner’s personal financial condition may be required when personal guaranty from the principal owner(s) of certain smaller businesses is supporting the credit
5. For asset backed loans, appraisal of collateral by a certified appraiser to establish Net Orderly Liquidation Value (“NOLV”), which will govern the amount of capital that can be borrowed against such assets.

Amortization: Banks typically require mandatory repayment of 2% – 10% of the original loan amount on an annual basis. Non-bank institutions typically require a very small amount of amortization or none at all.

Financial Covenants:  

1. Most commonly, leverage ratios (senior debt to EBITDA and total debt to EBITDA) and fixed charge coverage ratio. Less frequently, minimum net worth requirement, maximum capital expenditures and interest coverage.
2. Covenants related to appraised value of the collateral for asset backed structures.
3. Total debt to recurring revenues ratio for structures focused on recurring revenues.  

Ongoing Reporting:   

1. Company prepared unaudited monthly financials, audited annual financials, annual financial projections
2. Periodic appraisals of collateral for asset backed structures  

If you’re interested in obtaining a first lien term loan, and you would like to discover the benefits of expanding your lender outreach to ensure the lowest cost of capital, please click the button below to speak with one of our debt experts.