Unitranche loans have become an increasingly popular financing solution for mid-market buyouts. Virtually non-existent 10 years ago, US mid-market unitranche loans today offer private debt investors a compelling opportunity.
It is widely understood that unitranche loans generate higher yields than traditional senior debt, but it is equally important to understand they also add incremental risk to a portfolio. Although all unitranche loans share some fundamental characteristics, the product is far from standardised.
Unitranche loans are used in a wide variety of transactions and may have complex structures. They may include numerous lenders with varying rights, incentives and legal terms. Clearly, not all unitranche loans are created equal.
Making an informed investment in unitranche requires asking probing questions that help reveal a portfolio’s underlying risks and rewards.
Simply put, unitranche debt combines senior and junior debt (whether mezzanine or second lien) into one instrument or “tranche”. The borrower signs one set of documents and pays interest to one lender, with the cost of the loan a blend between that of a traditional senior loan and a subordinated loan.
Initially, unitranche loans were provided to smaller EBITDA companies by legacy mezzanine providers and held by a single lender. This eliminated the need to layer two separate debt securities into a company’s capital structure and provided greater certainty of execution.
Today, unitranche loans are far more common. They are offered by dozens of capital providers to borrowers with EBITDA ranging from less than $5 million to more than $50 million.
Bifurcated unitranche is one variation. The loan appears to the borrower as a single facility; but behind the scenes, it is divided into first-out and last-out pieces, and split among two or more lenders investing in the tranche that best suits their risk tolerance.
As a result, unitranche structures can be quite tailored, with complicated legal and economic terms negotiated among multiple lenders. Each lender’s rights to collateral and cash flows from the borrower are governed by an Agreement Among Lenders (AAL), which is essentially an intercreditor agreement among the unitranche lenders. The AAL not only governs cash flow applications that drive each lender’s ultimate yield and security rights, but also critical legal terms such as voting, enforcement and buyout rights.
DUE DILIGENCE FOR UNITRANCHE LOANS
Today, the phrase “unitranche loan” describes a variety of potentially complex structures and lender positions. Asking managers the following important questions about their strategy can help investors better understand the risks and rewards of unitranche loans in a fund.
1. When providing a unitranche solution, do you hold the entire loan or bifurcate and sell a first-out or last-out tranche to other lenders?
If a manager holds the entire loan, it is fair to call it a senior secured loan. If a manager sells the first-lien portion of a unitranche loan to other lenders and retains the last-out piece, the retained portion is actually a riskier junior loan.
Either could suit an investor’s risk appetite, but understanding the hold position is essential to accurately identify the risk profile of a fund’s unitranche loans.
2. To what types of companies do you provide unitranche financing?
Not every company is a good candidate for unitranche. Given the higher risk associated with increased leverage, unitranche loans tend to be better suited to companies with strong credit attributes and high free cash flow.
The best candidates for unitranche operate in less cyclical industries with business models that exhibit significant levels of recurring revenue, which is typically reflected in a well-diversified customer base, a wide array of products and low ticket prices for individual products.
If investors cannot find clear distinctions between the companies in a manager’s portfolio that are financed with more highly leveraged unitranche loans and those financed at lower leverage, further investigation is warranted.
3. Is the yield commensurate with the risk?
The additional risk associated with a unitranche loan due to higher leverage should correspond to a higher yield. But how much is enough? It is important to understand how this risk is priced and how a manager factors potential incremental loss factors into the yield.
Historically, the loan proceeds in excess of the amount a traditional senior loan would provide carries a coupon similar to a mezzanine loan. The unitranche pricing would approximate the weighted average of the straight senior and mezzanine loan pricing.
The recent push to deploy capital has created a new paradigm that has often driven the blended pricing down to reflect second-lien pricing on the incremental loan proceeds, rather than mezzanine pricing.
This may make sense if unitranche leverage is materially below that of a traditional mezzanine loan. But at higher leverage, especially if a lender holds a last-out position in the AAL, it is fair to expect transaction pricing closer to mezzanine given that the risk is comparable.
4. How do you compare loss and default rates on unitranche to straight senior loans?
Unitranche loans are still a fairly new product and their performance relative to traditional senior loans has not been fully evaluated through a credit cycle. Moreover, the more complicated terms now appearing in AALs have not been widely tested in bankruptcy or significant workout situations. Accordingly, default and loss expectations are more difficult to estimate.
As the number of lenders in a unitranche transaction increases, so does the potential for consensus risk and other alignment issues if a company runs into financial difficulties that require restructuring or liquidation. How will this play out? Only time will tell.
5. If you have multiple investment vehicles, do funds with different strategies invest in different parts of the same deal?
Here’s why this is important: Consider a unitranche loan consisting of a $50 million first-out loan that is allocated to one fund and a $30 million last-out loan that is allocated to another. If a workout occurs and the highest current committed settlement offer is for $50 million, the manager must decide to either accept the offer or reject it and continue the workout process. Accepting the offer would be to the detriment of the last-out loan holder, which would not receive any proceeds from the workout. Rejecting the offer introduces further uncertainty, because continuing the process could result in a higher or lower recovery.
Understanding this dynamic is critical to evaluating the potential for divergent outcomes in a workout situation.
Unitranche has proven to be a viable product with staying power. Its complexity has increased, but none of the issues identified here should dissuade investors from exploring unitranche as they consider opportunities in U.S. mid-market private credit.
Yet accepting at face value that all unitranche loans are created equal is inherently flawed. Successfully taking advantage of unitranche’s potential for greater yield requires actively exploring how the loans are structured, priced, documented and managed. Asking probing questions is the key to understanding the true risks and rewards of unitranche – and making an informed investment.
Kelli O’Connell leads NXT Capital’s Asset Management group and Joseph Lazewski is the senior credit officer for NXT’s Corporate Finance Group.
NXT Capital offers investors proprietary access to directly originated US mid-market first-lien senior secured and unitranche loans through a variety of separately managed accounts, funds and CLOs.
This article is sponsored by NXT Capital. It appeared in the May 2016 issue of Private Debt Investor.