Stretched senior (or senior stretch) is a term that is becoming increasingly common as private debt fund managers look to diversify their product range with innovative finance solutions
A typical senior debt loan is normally constrained in the amount it can lend, either vs EBITDA for corporate lending or loan-to-value (LTV) for real estate lending. While a senior loan may only extend to 4x EBITDA or 70 percent LTV, a stretched senior loan might be able to loan up to 6x EBITDA or 90 percent LTV.
So how is this done? The simple answer is by increasing the cost of the loan. As the lender is taking on more risk, they will want to be compensated for it. This increased cost can be quite substantial with one real estate lender quoting 750 basis points above one-month LIBOR, while a more typical senior loan would perhaps only be about 300 basis points above LIBOR.
The loans are very similar to a unitranche product and combine senior debt with subordinated debt into a single package, enabling borrowers to deal with a single lender which can meet their entire financing need. Typically, the debt is cheaper overall than a combined senior and mezzanine arrangement.
So what’s the difference between unitranche and stretched senior? The loan is structured as a senior debt facility which has the capacity to be expanded (stretched) into subordinated debt territory to cover additional borrowing needs as they arise. This might be to fund acquisitions or growth, or to fund refurbishment for a real estate deal.
For borrowers, the attraction of stretched senior is simplicity. The borrower can deal with a single lender rather than negotiating with two or more lenders to arrange both senior and subordinated debt tranches. This is not only more convenient but can be much faster as well, which can be crucial in private equity-backed auction processes, for example.
Simplifying the deal in this way also helps to streamline the documentation process, which can cut legal fees and compensate for some of the additional cost of the loan.
The biggest downside for the borrower is that the loan is more expensive over its total lifespan than it would be if they use separate lenders.
But while borrowers can see significant upsides, lenders face a lot of extra risk. Not only are they facing greater leverage risk as a result of increasing their exposure from 4x EBITDA under a regular senior loan to as much as 6.5x from stretched senior deals, but they also sit alone in the capital structure and will bear any losses in full, rather than being able to spread the loss among other lenders.
The major benefit for the lender is that they can charge a higher interest rate for the loan and, by having a sole relationship with the borrower, they are likely to have more control over documentation and terms than if they were involved in a club deal. Having some degree of oversight over how new money is deployed as the senior loan stretches out could also be useful in helping to manage the risks inherent in this type of loan and ensuring that potential problems can be recognised at an early stage.
While the increased cost of this type of lending can help to offset the risks involved, it may not be enough if a company gets into severe difficulties and lenders need to be sure that the company they are financing has strong and stable cashflow that is unlikely to be affected by cyclical market trends.