Friday letter: Favouring unitranche

The hybrid loan product possesses many characteristics that make it a clear favourite among borrowers. As for lenders, the downside has yet to be explored.

Unitranche debt is here to stay. At least, that’s what mid-market dealmakers and lenders at this week's Association for Corporate Growth’s Intergrowth 2014 conference in Las Vegas said.

Although more nuanced definitions exist, the term “unitranche” typically refers to the placement of senior and subordinated debt within a single instrument, with borrowers paying a single interest rate that falls within a range of what is normally paid on subordinated and senior notes.

Unsurprisingly, non-bank lenders that offer unitranche loans often claim that the consolidation of senior and subordinated debt under one facility eases the management of relationships for the borrower, and they don’t have to negotiate separate rates for each level of debt. It appears to be an easy sell for borrowers, which was echoed by a comment one private equity sponsor made in passing during a unitranche roundtable at the conference.

“I’d rather have a problem with a unitranche, as a borrower,” he said. “At least you know your partner.”

That very advantage seems key to what has driven recent activity. Although data on private mid-market unitranche issuance is spotty, Cowen and Company’s head of debt capital markets Len Sheer said that anecdotal evidence suggests the product has become a go-to preference for borrowers and sponsors.  

“There’s a big preference to go with guys who can underwrite a whole deal,” he said.

If Sheer is right, then this is a trend that in the US has coincided with a significant uptick in the number of registered business development companies, many of which include unitranche loans as a core component of their investment strategy (Two of the three firms nominated in this year’s Private Debt Investor Awards for Unitranche lender of the year function as or operate a BDC). The number of active US BDCs grew from four as of nine years ago to nearly 30 as of last year. At least two more – FS Investment Corporation and TPG Specialty Lending – have listed on stock exchanges in recent months.

BDCs' predilection for the unitranche product seems natural, as many do not pursue the loan-to-own strategies favoured by distressed-for-control specialists or some hedge funds – which in turn makes them attractive to mid-market business owners and sponsors seeking non-hostile lenders. Sheer went so far as to tell Private Debt Investor that BDCs have become a preferred lenders for mid-market managers.

At the very least, “I haven’t seen any on a ‘Do Not Call’ list,” he said.

Even so, as with any loan product, unitranche loans still carry a significant level of risk.  Because the borrower is paying a single interest rate across both subordinated and senior debt, it stands to reason that the subordinated portion of the facility is underpriced for the risk. Furthermore, a June 2013 Paul Hastings report points out that there has yet to be a bankruptcy in which a unitranche loan has played a part, so it is unclear as to how these structures will fare in the courts when the market turns. 

Until then, it’s unlikely the private debt world will see a decline in unitranche lending. When asked about what may cause the product to fall out of favour, Sheer demurred.

“You’re going to have to have some sort of event,” he said. “But I don’t see that happening.”