PicoBlog

Welcome to the 64th Pari Passu newsletter.

Today, we are learning more about a technical concept that is often underappreciated: FILO and FOLO Loans. It has been several editions since we had the chance to dive into a technical topic, so I am excited for today’s edition.

Let’s dive into today’s post.

When thinking about a company's capital structure, many know the common types of debt: ABL/Cash revolvers, term loan A/B/Cs, senior/subordinated notes, high yield bonds, preferred debt, convertible debt, and equity. However, many are unaware of other types of loans available to companies: First-in, Last-out (FILO), and First-out Last-out (FOLO) loans.

First-in, Last-out, or FILO loans are senior secured loans with a first priority lien on all assets. These loans are typically issued in packages with first lien debt. The difference between first lien loans and FILO loans is in the name. FILO loans are last-out, meaning that in the first lien debt tranche, standard first lien loans are paid out first, and FILO loans receive the leftover proceeds of the collateral. An analogy can be drawn to senior and subordinated notes to understand the structure better. Typically, notes are treated pari passu, meaning that under liquidation, the creditors would receive pro rata(equal) recoveries depending on the percentage of debt they contribute to the capital structure. However, senior/subordinated notes are created via intercreditor agreements that bypass the pari passu treatment. This is the same logic with the FILO loans and first lien debt: an intercreditor agreement is formed that treats the FILO and first lien debt as two different tranches. 

These loans have historically been used to finance growth, M&A activity, and assist companies in dividend issuances. Recently, FILO loans are increasingly used in distressed financing transactions to provide liquidity to the debtors. As previously stated, these loans have liens on substantial assets in most scenarios. However, in some instances, the collateral can be limited to specific assets like PP&E, intangible assets, or current assets [1]. 

Typically, FILO loans have stringent requirements for borrowers to qualify because they are used in these distressed exchanges. Borrowers often meet some or all of the following characteristics:

• Stable cash flows with a long record of financial success

• Strong liquidity metrics, like interest coverage ratios (EBITDA/Interest Expense)

• A maximum of ~1.5x EBITDA (variable based off market conditions) of first lien debt already outstanding

As with any debt structure, FILO loans have many advantages and disadvantages. One of the benefits of FILO loans is that they tend to provide more debt capital than a standard first lien loan. This is because when FILO loans are issued, they are bundled with first lien loans. As will be discussed further below, FILO loans are often used in distressed exchanges, providing capital to companies who cannot otherwise finance their operations. These transactions involve the issuance of new first lien debt to benefit the creditor but to entice the debtor, FILO loans are also provided.

Unlike first lien loans, however, FILO loans are

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