Unitranche debt has been one of the big success stories of the post-financial crisis decade, with large amounts of investor capital flooding into the strategy’s funds. PDI’s recent New York Forum found unitranche was the second most popular structure among borrowers, just behind the first and second-lien combination.
This may make it seem like mezzanine debt is a thing of the past, superseded by this challenger debt product. But mezzanine fundraising is holding up well following its recovery from the 2008 crash and its lenders are confident that their product still has plenty of life left in it. The two strategies, rather than being rivals, seem to be co-existing quite happily.
François Decoeur, managing director of fund manager MV Credit, says mezzanine and unitranche tend to have rather different target markets for deal activity.
“At the smaller end of the market, unitranche is very popular as it’s much easier to implement and you don’t see mezzanine very often,” he explains.
“For deals with an EBITDA of €40 million or more, it’s rare to see competitive unitranche finance and you also have more sophisticated sponsors. Unitranche is a more expensive capital structure and it’s more cost effective for a sponsor to layer the debt.”
This could help explain the swift increase in unitranche in recent years. As private debt provision has become increasingly normalised and as banks have withdrawn from financing corporates due to balance sheet pressure, particularly at the lower end of the spectrum, more companies are seeking out an alternative. With its relatively simple, though expensive, structure, the unitranche loan is attractive for smaller firms.
“Unitranche is more commonly applied in smaller credits where there is more potential for complexity. Junior debt is used for the very best credits while more volatile businesses tend to opt for unitranche,” says Robin Doumar, founder and managing partner of Park Square Capital, which provides unitranche and mezzanine loans.
The headline cost of borrowing is certainly higher when using mezzanine compared to unitranche. While the former’s rates tend to sit in the low teens at around 13 percent, unitranche will often be substantially cheaper – in the high single digits, peaking at around 10 percent. However, over time unitranche will become more expensive than mezzanine.
“Mezzanine is more competitive over time as it offers a performing borrower the ability to prepay it, given it is the most expensive layer of the debt structure, unlike a traditional unitranche where the borrower would not benefit from this layering of the debt structure,” Decoeur explains.
This means that, when looking to finance a company over the long term, layering up junior capital can offer an advantage as you can reduce the overall cost of finance during the early years after leveraging a company, meaning that over an average five-year holding period, the cost of mezzanine can be cheaper. By contrast, a unitranche loan always costs the same amount throughout the lifetime of the debt, meaning that the company will need to be refinanced further down the road if it wants to reduce its debt repayment burden.
It’s also worth considering that mezzanine is an evolving product that offers wide variety to suit different financing needs.
Park Square’s Doumar says: “Junior debt itself, what is often collectively termed as mezzanine, has evolved. Lots of players are doing things a little differently, it’s a sophisticated market with lots of products available today.”
However, some market professionals believe the rise of other forms of junior capital has obscured the decline of pure mezzanine products, which have largely been usurped by unitranche and second lien instruments, according to IdInvest partner Eric Gallerne.
“At the larger end of the market, we’ve seen greater use of first lien/second lien structures, but second lien is supposed to be secured, it is not really mezzanine,” he says.
This tallies with data gathered at PDI’s New York Forum, which found first and second lien structures were the most in demand, while senior/mezzanine combinations were significantly less popular.
Gallerne adds that the relatively high cost of mezzanine in a low interest rate environment makes it off-putting for borrowers and the PIK component can erode the equity of a business during a downturn, which is also unattractive to businesses and sponsors.
However, Gallerne says mezzanine continues to be popular in certain market niches: “At the very small end, companies with less than €10 million of EBITDA, there is still a market for mezzanine, usually in combination with senior debt provided by a bank to make up the specific funding needs of very small companies.
“We’re also seeing a lot of mezzanine lenders shifting more towards the sponsorless market, focusing on less sophisticated and less mature companies where there is limited opportunity to access unitranche and other alternative sources of financing.”
While there is certainly a lot of demand for unitranche, there is also a burgeoning supply as an increasing number of private debt managers move into the space.
“Where we’ve seen the most fundraising activity recently is in direct lending, with a lot of that money being raised for unitranche. This puts a lot of price pressure on disintermediated deals with no sponsors,” says MV Credit’s chief executive officer, Frederic Nadal.
This is making unitranche more attractive for borrowers as they can access the product at more competitive rates, though there is potential for lenders to face increased risk in the event of a default as there is no mezzanine component to absorb the downside and no capacity to gain equity control when required.
“Currently unitranche is yielding lower than it has in the past at between 7 percent and 7.5 percent, but it is still more expensive than a mezzanine plus senior debt solution. However, it gives the borrower more flexibility,” explains Gallerne.
The key test for unitranche, and whether it can truly usurp mezzanine investment, may come during the next downturn, when the ability of unitranche lenders to manage risk in their portfolios and to handle companies in difficulty will be put to the test. Without the ability to take equity control of a business in trouble, unitranche lenders will be reliant on covenants and board positions to be able to step in and cope with any unforeseen circumstances.
The next economic crisis may also test whether forgoing the cushion of mezzanine is really a wise move. Unitranche lenders will be much more exposed than senior lenders will be in traditional layered capital structures and this will test their pricing and credit selection strategies to their limits. A failure to live up to expectations could also see unitranche risk repriced and a revival in interest in mezzanine as a way to meet funding requirements at a lower price.