How low will unitranche go?

It has its critics, but that hasn’t stopped the instrument from becoming increasingly important in the European mid-market. If that popularity is to grow, unitranche lenders will again have to consider cutting pricing.

The number of unitranche financings rose to 111 in 2015, up from the 69 signed in 2014, according to AlixPartners’ European mid-market debt survey.

Those numbers appear to confirm what providers of the single tranche financing package claim – once sponsors try it, they use it again and again. Speed and simplicity combined with a leverage boost is winning over portfolio companies.

A fall in margins since 2014 is also likely to be helping sell the instrument. Rather than the 800bps-900bps that non-bank lenders used to demand, 700bps is more the norm with even lower interest rates for the largest and strongest borrowers.

Even banks are getting in on the act. Bank of Ireland, Lloyds and Macquarie are all open to providing unitranche debt if it helps win them the mandate.

That unitranche lenders are rarely as flexible as they claim and charge a significant premium for a small uplift in leverage of half to one full turn, as critics maintain, has not dented its growing popularity.

And senior debt, still dominant, is feeling the pressure. It accounted for 62 percent of total deals done last year, down from 70 percent in 2014, according to AlixPartners.

Banks still hold a majority of market share, at 67 percent of all deal participations in 2015, but that would have been close to 100 percent before the global financial crisis. Overall, bank deal share contracted marginally last year, with total deal count falling an average of 4 percent across the top seven lenders. That contrasted with the top six non-bank lenders increasing their average deal count by 36 percent, the study found.

Asked if they expect alternative lenders to continue growing their market share at that same rate this year, AlixPartners’ head of debt advisory Jacco Brouwer said that was the ‘$64,000 question’. High growth from a low base is difficult to sustain once the low base is left behind.

Brouwer’s colleague Tom Cox pointed out that the likely dynamic was even more intense competition in Europe as debt funds seek to penetrate regions with stronger bank markets, such as Benelux, Iberia and the Nordics.

Growth will be more challenging in the short-term, though, as the year has not got off to as busy a start as 2015. Brouwer said wider concerns, including stock market volatility, the slowdown in China and the UK’s Brexit vote, were feeding into an environment that was not conducive to investment.

And while the European Central Bank’s latest round of stimulus measures (announced 10 March) should go some way to boosting sentiment in Europe, the extension of its quantitative easing programme to investment grade corporate bonds is set to make life more difficult for lenders peddling unitranche.

There will be inevitable effects on pricing in sub-investment grade debt markets as the yields on debt issued by top corporates fall even further and investor cash flows elsewhere in search of yield.

This will leave unitranche providers facing a not unfamiliar quandary: cut pricing to compete and potentially drag down IRRs or fail to deploy and definitely underperform in IRR terms. Investors then, should be asking GPs: “How low can you go?”