The rise of the unitranche loan has been a major feature of the private debt landscape in recent times, but the nature of it is arguably not well understood. Below, senior executives from Chicago-based mid-market lending firm NXT Capital address three key issues in the unitranche market as 2017 dawns.
Question 1: When making a unitranche loan, do you hold the entire loan or sell a first-out tranche to other lenders?
“Some managers will sell a low-levered first-out position at a lower spread than the underlying unitranche loan. These arrangements are generally documented as an agreement among lenders rather than a separate loan,” says John Finnerty, group head, corporate finance at NXT Capital. “So managers will generally describe their retained portion as a first lien senior secured loan despite the fact that another party has priority in terms of recovery if there’s a default.”
“’Skimming the first-out position lets managers generate a higher yield on the retained portion of the loan, but at the risk of a lower recovery in a default,” Finnerty explains. “That’s not necessarily bad. But investors who don’t ask about a manager’s hold position or typical inter-creditor terms can’t accurately evaluate the risk associated with a fund’s unitranche loans. Nor can they fully understand why one manager might have a higher yielding portfolio than another.”
Question 2: What types of companies are best suited for unitranche structures from a risk perspective?
“Lending to companies at a higher multiple of EBITDA equates to a higher loan to value. All other things being equal, this will increase the risk of loss in the event of a default. Our credit philosophy is to manage this risk by offering unitranche financing selectively,” says Joe Lazewski, group senior credit officer, NXT Capital. “We focus on companies that have demonstrated a very consistent and predictable level of cash flow to service their obligations over a cycle and can be expected to have lower than average risk of default.”
“Investor due diligence should reveal a higher bar for the fundamental credit attributes of companies financed with unitranche loans. If this isn’t evident, investors should expect and account for differences in credit losses among the products, particularly in an economic downturn, when they compare expected investment returns.”
Question 3: How does a manager price the additional risk associated with unitranche’s higher leverage?
“In the past, the incremental loan proceeds of a unitranche loan relative to a more traditional senior secured loan were priced in line with mezzanine loan pricing and offered to the borrower as one blended rate,” says Kelli O’Connell, head of asset management at NXT Capital. “As the market has evolved and more lenders are providing unitranche loans, the marginal pricing is closer to second-lien loans than mezzanine loans.”
“That may make sense if the attachment point in terms of leverage on a unitranche loan is considerably lower than a traditional mezzanine loan. At higher leverage, it’s fair for investors to expect a commensurate increase in unitranche transaction pricing.”