Mezz is dead, long live mezz

As is so often the case with private debt, mystery surrounds the exact origins of unitranche. But most agree that the debt instrument really took off in the mid-market post-downturn. Unitranche has a few different guises now, with the latest version looking quite similar to the instrument it replaced – mezzanine, with a slice of senior debt on the side.

The bank syndicated mezzanine market, which so many private debt funds relied on, all but dried up post-crisis. Unitranche helped kickstart deal flow again. With some agreeing with investors to target lower returns (unitranche prices at Libor plus 650 basis points at the lower end versus mezzanine returns of 15 to 20 percent in the instrument’s heyday), funds found they could still serve debt-strapped borrowers. Indeed, unitranche has been a significant driving force behind the direct lending market we see today. The successful unitranche joint ventures between GE Capital and Ares Management are illustrative of this. 

Unitranche is a combination of senior and mezzanine debt packaged into one tranche provided by one lender to mid-cap borrowers, typically non-amortising and offering higher leverage than senior debt alone. In its basic form, it’s a senior secured stretched loan. Most unitranche in Europe looks like this and borrowers are predominantly private equity portfolio companies.

UNITRANCHE 2.0

Meanwhile in the US, a new iteration dubbed unitranche 2.0 is developing. This bifurcated structure, which involves slicing the loan for distribution amongst lenders, accounted for around 35 percent of the mid-market deals Proskauer’s US office looked at in 2014, up from around 3 percent in 2011, Bill Brady, partner at the law firm, tells PDI.

Near the end of 2014, Proskauer helped structure one of the first bifurcated unitranche deals in Europe. Faisal Ramzan, partner at Proskauer, says that he sees the market growing in Europe for some of the same reasons it’s grown in the US.

Here too, there is more capital chasing fewer deals and to remain competitive, lenders are turning to the bifurcated structure. 

Where one lender cannot provide the full quantum of debt required by a borrower, it can agree with a second lender to provide one package under a single intercreditor agreement. Behind the scenes, they will then draw up an agreement amongst lenders (AAL), which splits the unitranche into first-loss and second-loss pieces, to leave creditors in the same economic position they would have been had they initially provided senior and mezzanine.
The structure helps borrowers avoid the dual document process that the more traditional route of separate lending classes demands, Ramzan says. 

The first loss piece typically accounts for the first 55 to 60 percent of debt. “In a situation where things go wrong, the senior lender will always be repaid first. In return for being second ranking, unsurprisingly, the junior lender gets a higher interest rate to reflect its greater risk,” Ramzan says. 

There is the risk that the second loss piece could be placed significantly lower in the capital structure than fund investors realise though, below even where traditional mezzanine sits. Tim Atkinson, director at Meketa Investments, warns: “Lenders will need to be very careful of their attachment points when they are taking a ‘last out’ piece of a unitranche deal. They may not be getting paid adequately for the risks they are accepting if it goes too deep in the capital structure.”

UNTESTED

Without being tested through a downturn, unitranche retains an element of unknown risk. There is no easy-to-retrieve data on default or recovery rates. 

From an exit point of view, borrowers could face challenges finding a lender willing to refinance the whole deal. With two distinct classes of creditors there is more flexibility to refinance one or both tranches.

In bankruptcy situations, unitranche and AALs have been tested in a limited way. However, market sources say that insolvency provisions are consistent with the language seen in a two document market, already tested in a senior / secured mezzanine or first lien / second lien context. 

Atkinson cautions: “Both the first-out and last-out holders need to pay careful attention to the documentation between lenders to understand what they can and cannot do in downside scenarios.” 

Clearly, the traditional senior and mezzanine market we used to know is being resurrected in the unitranche market. This time however, the negotiations are veiled.