A variety of factors have fed the rapid growth in the market for unitranche loans during the last few years. These structures — a hybrid of a traditional single lien and a first lien/second lien facility – began in the lower middle-market and are now commonly found in loan transactions exceeding $100 million.
In this first in a series of posts addressing this quickly developing market, I discuss below the basic structure of unitranche facilities. In later posts I will address certain of the intercreditor issues that necessarily arise when negotiating unitranche loans and the complexities that may be presented by the unitranche structure in a market downturn.
In years past, a unitranche loan might have been structured as a secured facility with a tranche of unsecured mezzanine debt. As sponsors gained leverage in the market following the credit crisis, the mezzanine tranche often morphed into a second lien term loan, subject to an intercreditor agreement between the senior lenders. The newly secured status of the junior portion allowed borrowers significantly better pricing. In recent years, the leverage in favor of sponsors and borrowers continues to shift, evidenced by further degradation of covenants and tightening of restrictions on transferability, among other things. This enhanced leverage has much to do with competition from lenders holding massive amounts of available capital. With this shift, many of those second lien loans have found their way into a “last out” tranche of the senior facility. Public business development companies (or BDCs) and other private lenders have been at the front of this rapid move in the loan market toward unitranche facilities. Traditional lenders are now trying to catch up, recognizing that they must be nimble to compete with private lenders in certain niches (including healthcare finance, for e.g.).
Sponsors and borrowers find unitranche facilities extremely attractive. They face a single facility, having one set of payment obligations (i.e., a uniform interest rate), and a common suite of covenants and defaults, for ease of loan administration. Rather than negotiating loan documents with agents for groups of senior and junior lenders, which later have to be harmonized and coordinated, unitranche loan documents are negotiated with a single agent and its counsel. For these and other reasons, unitranche financings typically move quickly and are also infrequently subject to syndication, allowing a borrower to close a material financing within weeks of commencing discussions with its lenders. The complex relationship between the various lender groups is left to an “agreement among lenders” or “AAL” into which the borrower often has little, if any, insight (and often is not a party to). The different tranches of debt are commonly categorized in the AAL as “first out” and “last out” obligations, with payments allocated by the administrative agent upon receipt from the borrower. A single interest payment made by the borrower is allocated to provide improved pricing to the last out lenders to compensate for their additional risk. Amortization and voluntary and mandatory prepayments are often allocated among lenders on a ratable basis, until a possible “waterfall trigger event” (e.g., a payment default or breach of certain financial covenants) after which the first out lenders get preference with respect to certain of the obligations. The intricacies of voting, buy-out rights and other complex intercreditor issues are beyond the primary loan documents that sit on the borrower’s CFO’s desk. Given the proximity of diverse lenders in a single lien facility, market participants often partner with others that they have worked with in prior transactions. These financings are often marketed as club deals, including first out and last out lenders that have worked well together and can commit to financing on an expedited basis.
Given the obvious benefits of the structure to sponsors and borrowers, it is reasonable to expect continued growth and acceptance in the finance markets until such time as lenders regain some leverage.