Direct Lending: Expert commentary from Churchill AM

As with all great capital market innovations, the unitranche structure seems obvious in hindsight. Having one lender provide a senior secured tranche that mimics a combined senior and subordinated debt structure solves several borrower issues.

Historically, banks dominated senior debt and private funds ruled mezzanine. Then, in 2007, GE Antares and Allied Capital (later Ares) developed the first unitranche fund – the Senior Secured Loan Program (SSLP).The SSLP offered one tranche to borrowers by synthetically blending pricing for a GE’s first-out tranche with Ares’ second-out tranche.

During the Great Recession, unitranche offered private equity sponsors certainty of execution. Since then unitranche has become an attractive one-stop credit solution. It avoided syndication risk and market flex; unitranche providers guarantee pricing and terms since they hold the entire loan.

Unitranche grew in popularity even when liquidity returned to the markets. The overhang of volatility compelled sponsors to continue seeking the safe haven of the one-stop, while the advent of the Fed’s leveraged lending guidance has left banks struggling to compete effectively with their syndicated product.

Thanks to the success of SSLP, and now its competitors, sponsors now have a wide range of one-stop options.

UNITRANCHE STRUCTURES

“Pre-crisis, unitranche was a single product with a simple five-page agreement among lenders [AAL],”William P Brady, a partner at Paul Hastings, notes. “Today, the unitranche has evolved from a single product to a platform that replicates an increasingly complex variety of debt structures.”

The simplest is a revolving credit facility and unitranche term loan. The provider lends through the total lever- age in the structure. A variant would be a term loan bifurcated into first-out and last-out. In this case, each tranche has separate treatment under the repayment waterfalls, along with separate voting rights, remedy standstills and so on – all governed by the AAL.

Another permutation is the inverted, or upside-down unitranche. This involves a much smaller low-leverage first-out and larger second-out. Because it’s well within even the discounted enterprise value, the first has few rights from a voting perspective. The last-out carries most of the risk so seeks to control the debt.

In whatever its form, each unitranche should offer roughly equal terms of all-in pricing and total available leverage to the issuer. That means balancing the different yield demands of each side of the deal.

The larger the second-out piece, for instance, the lower yield imposed on the first-out to maintain the same interest costs.

All this borrower optionality requires significant legal engineering. Unlike early unitranche agreements, building an AAL that defines buyout rights, application of proceeds in a bankruptcy and pricing no longer runs to only five pages.

AGREEMENT AMONG LENDERS

For some unitranche options, one debt provider alone mimics the leverage that would be offered by both first and second lien (or senior and subordinated) lenders at a blended pricing of the two debt layers.

The unitranche can also be bifurcated behind the scenes into first-out and second-out term loans with different lenders providing each piece. Unlike a multi-tranche financing with separate credit and security agreements, the relationship between unitranche lenders is governed by one document, the agreement among lenders.

The AAL is outside of the credit and security agreement between the unitranche provider and the borrower, and is negotiated by the lenders. The purpose of the AAL is to clearly outline intercreditor terms and conditions. Each tranche must be defined and distinguished in terms of rights and provisions relative to the others. Unitranche is a synthetic blend of first- out and second-out costs to the borrower – higher than the first-out and lower than the second-out typically receive alone.

Accordingly, the first-out lender must pass along a “skim” of the blended rate to the second-out lender. That skim depends on how leveraged the first-out is, thus how much risk is borne by that lender.

Consent of both first-out and second- out lenders is required to amend or waive the credit agreement. When the second- out is over-weighted relative to the first- out, that lender might have more favourable rights than the first-out. The same is true of buyout rights.

THE UNITRANCHE UNIVERSE

There are two kinds of unitranche providers. Both provide the entire financing to the borrower at a given spread across a single tranche.

But one type bifurcates the tranche into first-out and last-out term loans to different lenders.

The classic bifurcated provider was the SSLP. Others, such as NewStar/GSO, have adopted a similar approach. The non- bifurcated strategy is more common and is typified by Golub Capital.

There are some advantages to bifurcation. It offers natural alignment with each lender’s investment profile – lower leverage and moderate yields for the first- out, and higher yield and leverage for the second-out. A bank as first-out lender can also provide the revolving credit.

Regardless of who your lender is, unitranche players agree nothing is more important than knowing who you’re dealing with.

KEY CONCERNS

The critical question that always arises in discussions about unitranche is: ‘How will it fare in bankruptcy?’

With providers that do not bifurcate between first-out and second-out lenders, there are no intercreditor issues to con- sider. But for those that do, how second- outs are treated relative to first-outs is critical.

Leslie Plaskon, a partner with Paul Hastings, says enforceability is key: “That’s been helped with more AALs being acknowledged and signed by borrowers. So bankruptcy courts are more likely to view the AAL no different than ‘regular way’ intercreditor agreements.”

Whether bifurcated tranches receive single debt treatment is another worry. Bankruptcy judges may deem collateral value insufficient to cover both tranches collect post-petition interest and costs.

How workouts and restructurings play out will be interesting. First and second- out lenders seem tied at the hip on voting and assignment rights. It’s not uncommon to see pages of provisions dealing with issues like ROFOs (rights of first offer), ROFRs (rights of first refusal), cross-over voting restrictions, minimum holds and drag-alongs.

With exponentially more complicated inter-lender and assignment issues, bifurcated unitranche deals may stay more club-like during a workout. That means less of a secondary market available to lenders and sponsors alike which could impact liquidity.

Plaskon notes, however, if bifurcated unitranches migrate to the large-cap market, there may be pressure among lenders to standardise AALs and loosen restrictions on assignments. “That may make AALs less proprietary,” she says. “But having a secondary market might make the primary market more competitive.”

Randy Schwimmer is senior managing director, head of origination & capital markets for Churchill Asset Management, where he is widely credited with developing loan syndications for mid- market companies. Schwimmer is also the founder and publisher of The Lead Left, a weekly mid-market newsletter that reviews deals and trends in the capital markets with a unique focus on the mid- market space and is read by thousands of influential industry participants.

Churchill Asset Management is a leading provider of senior and unitranche debt financing to mid-market companies, primarily those owned by private equity investment firms. Churchill currently manages $1.1 billion in committed capital and is majority-owned by TIAA-CREF, one of the largest global asset managers across multiple asset classes.

This article is sponsored by Churchill Asset Management. It originally appeared in PDI's Direct Lending Special supplement, published in February 2016.