How have you seen the unitranche market evolve, and what are the challenges in unitranche today?
The unitranche market in Europe really got going in 2012 with a handful of providers, despite defensive banks trying to ward off borrowers from using the instrument. It has evolved from a relatively rare, single-tranche instrument provided by one lender to replace a small club of banks, into a relatively standard marketplace offering, with different lenders taking different risk positions in the same ‘unitranche’.
The size of European deals has increased significantly during this period, and now we see them nearing €1 billion. The main challenge for unitranche is whether the incremental cost of capital versus a straight senior financing is worth the extra cost to the borrower, which will vary according to each business plan.
What benefits could an exposure to unitranche bring to investors?
Mid-market margin changes have been less dramatic than those seen in the ‘great repricing’ in the syndicated market over the past nine months. Unitranche pricing has remained reasonably consistent during this time at broadly between 650-700 basis points above a 75-100bps Euribor floor. This discipline has – so far – allowed managers to protect their investors’ targeted returns. Arrangement fees of between 300-350bps are also attractive versus the syndicated market, where they have been reduced to between 0-50bps.
Investors also get access to documentation that has been drafted by the manager in which they invest for a specific credit situation, rather than by an investment bank for the general market. Maintenance financial covenants still predominate, allowing earlier action in a problem situation – the more widely syndicated market is largely cov-lite or cov-loose, meaning value might have been lost to debt investors if an underlying borrower heads unfettered towards payment default.
Is there a problem with the definition of unitranche?
Unitranche structures today have different tranches and multiple lenders in a single deal. Broadly, they have offered one extra turn of leverage and priced 200bps wider than regular senior bank debt. Is the definition a misnomer in today’s market? It really depends on what story the borrower has been sold and what the documentation says in a default scenario.
As some direct lenders stretch for yield by stripping unitranches into a lowly levered first-out piece to sell to a bank or another fund and a higher-yielding first-loss piece to retain, future default situations may become more complicated. The other lender will probably just expect to be repaid at par immediately – or have substantial nuisance value. Documentation will vary deal by deal.
How big is the market opportunity?
Substantial. Some 50 percent of UK alternative lender deals were provided via unitranche in 2016, with 41 percent in continental Europe [according to Deloitte]. More than 18 of these deals were for unitranches above €90 million from a variety of different providers.
There is, however, a word of warning. The market has had a tendency to polarise between straight senior debt and unitranche, and the opportunity for stretched senior debt – priced and with leverage in between – has hitherto only been recognised by relatively few market players. Funds are now being raised to cater for this white space.
The risk is that in a hot market lenders provide unitranche leverage at stretched senior pricing, rather than interpolating leverage. Were this to happen, it would squeeze the returns of managers with fixed-liability costs and dampen returns for investors in pure unitranche funds.