Whether it’s upside-down or merely conventional, the seemingly infinite flexibility of the unitranche market adds a range of colours to the funding rainbow for private equity sponsors.
“Borrowers probably have a broader range of options, and with a wider availability than ever before, because of the growth of debt funds offering unitranche,” says Paul Bail, London-based managing director in European Investment Banking at Baird, the financial services firm. “You can almost determine whatever capital structure you want.”
And even over the past year or so, the range of unitranche financing alternatives provided by debt funds has grown.
Unitranche can be equally flexible from the point of view of the lender. “A few years ago there was a revolution in unitranche,” says Gary Creem, Boston-based partner at Proskauer, the law firm, referring to the US market. “Now it’s turning into an evolution, with the development of more strands and variations.”
He cites the exotically named “upside down Agreement Among Lenders” unitranche, where the last-out (broadly speaking, second-lien) lender, rather than the first-out (first-lien) lender, can enforce the terms of the deal.
Unitranche loans are term loan deals made directly with borrowers by debt funds rather than with the banks that used to dominate the market. In the US, where they originated in 2005, one fund usually signs a contract to make the entire loan at a single rate – putting the “uni” into “unitranche”.
However, in most cases it simultaneously signs a separate Agreement Among Lenders (AAL) with at least one other fund to take on some of the debt. It often does this by splitting the debt into a first-lien tranche with a lower rate than that agreed with the sponsor, and a second-lien tranche with a higher rate.
The AAL is a behind-the-scenes deal done between lenders, with no involvement by the borrower. Almost all deals are done alongside a revolving credit facility with a bank to provide working capital, which has a “super-senior” call on the debt, above the first-lien tranche. Unitranche deals are also more bespoke than other products such as senior loans, because the debt funds that offer them are more flexible.
In Europe, unitranche has gone down a different route, since most deals do not include an AAL. Instead, all the unitranche lenders sign a contract with the borrower. To complicate matters, last year about half of European unitranche deals involved two tranches, aside from the bank super-senior debt, according to David Parker, London-based partner at Marlborough Partners, the European debt advisory firm.
A unicycle has one wheel and a unicorn has one horn, but cynics argue that to call a unitranche loan with more than two tranches directly agreed with the borrower is stretching the definition too far – in other words, it is as unreal as the imaginary spiked animal of legend.
But that hasn’t stopped it becoming a common form of funding for private equity sponsors. After rapid growth since 2012, in the 12 months to July 2015 it accounted for 53 percent of primary mid-market deals in the UK funded by debt funds and 46 percent in the rest of Europe, according to Deloitte. In the US, Creem says that in the last fiscal year about 35 percent of all loan deals negotiated by Proskauer were unitranche.
Moreover, it is expanding beyond the mid-market on both sides of the Atlantic, as debt funds specialising in direct lending become both more numerous and bigger.
Parker, of Marlborough Partners, cites the French private equity firm Eurazeo’s November 2015 buyout of Fintrax, the Irish payment services company. It was partly funded by a €300 million unitranche commitment by Ares, a large direct lender in both the US and Europe – Europe’s largest bilateral unitranche commitment so far.
“Twelve months ago the sponsor wouldn’t have contemplated unitranche,” says Parker, who advised Eurazeo. “A bank would have underwritten it.”
As well as Ares, other large unitranche lenders include GSO and Apollo.
These direct lenders are able to put more money into each loan because they are not bound by the same capital rules as banks. In Europe, banks would probably not lend more than three times EBITDA for buyouts in the relatively risky retail sector, thinks Parker. Even for businesses in safer sectors “it’s unusual that banks will go above five times”.
Unitranche, on the other hand, might provide an extra turn and a half. In the US, “banks will lend up to four times EBITDA as a senior loan, but unitranche may go to five or five-and-a-half times or even higher”, says Creem. “Senior bank lenders will typically not go to this level on their own.”
Annette Kurdian, partner at Linklaters in London, says that as well as higher leverage, unitranche offers flexibility. This reflects the contrasting business models of the banks and direct lenders, she says. “Banks are often distribution-focused”, with an emphasis on earning fees rather than yield. “They’re underwriters, who want to sell the deal on as fast as they can” – and it may be harder to pass it on if it is more complex.
On the other hand, “the direct lending funds are extremely credit-focused. They want to maximise return during the life of the loan, rather than receive repayment of principal before the loan matures”.
Kurdian says that for this reason, they are often happy to agree the option of a payment-in-kind deal, where the interest is added to the principal and not paid off until the maturity of the loan – a godsend for private equity sponsors which are hungry for cash to expand sponsored companies through acquisitions, capital expenditure, store rollouts and so on.
Parker cites other examples of flexibility. Instead of the standard leverage covenants demanded by banks and tested by them on a quarterly basis, “last year we did unitranche deals with minimum cash balance or interest cover as the covenant”.
A typical example where a leverage covenant might not be logical is, he says, a retailer that has to increase working capital heavily to stock up for a particular season. Because of this flexibility, some borrowers rejected by the banks are still able to fund a buyout through unitranche.
Parker adds that agreeing a unitranche deal also tends to be speedier than borrowing from a bank, because of the absence of a credit committee. In December 2015 a Scandinavian mid-market client signed a full credit agreement with a fund on “day one – and we signed the full deal 10 days later”.
But despite all this flexibility, some general partners are sceptical that unitranche can make financial sense, because of the higher cost. Any comparison between the pricing of unitranche and bank loans quickly becomes bogged down in debates about the right methodology.
The preferred method of one managing director in the capital markets team of a large European general partner is to calculate the effective rate for the extra turn or turn and a half of capital that it could borrow through a unitranche, instead of relying on a senior loan. “We think this is usually priced in the mid-teens, and sometimes at up to 30 percent,” he says. “We find it inexplicably expensive. I have yet to come across a unitranche offer that comes even close to making economic sense for us.”
He also has qualms about the relative newness of the product, which is untested in European courts.
“There could be a nasty unravelling of first-loss/second-loss deals, where different lenders have different opinions about how to proceed if there’s a covenant breach or default. There’s every chance that the junior debt holder will say, ‘Let’s be a little more patient,’ and the senior debt holder will say, ‘I’m worried about my position right now,’” he warns.
Danelle Le Cren, partner at Linklaters in New York, has similar concerns about the US market. She cites a March 2015 case where a Delaware bankruptcy court implicitly recognised its ability to enforce two AALs involving loans made to RadioShack, the bankrupt electronics retailer. However, the ruling provided only limited clarity: “AALs have not really been tested in a bankruptcy scenario.”
These concerns are likely to be surmounted as precedents are established in the courts, but the high returns required by direct lenders mean that unitranche will never to be able to offer pricing as low as for bank loans, say leveraged loan experts.
For this reason, unitranche is unlikely ever to gain a clear upper hand over bank lending, they claim. “The pricing and other financial aspects will still drive a borrower’s decision for the most part. Though, in some cases, other requirements will be more important,” says Le Cren about the US – the sort of requirements that unitranche can meet.
As for Europe, Bail says: “Extremely strong credits tend to end up with senior bank rather than unitranche deals, because the banks are prepared to offer high leverage.”