Why the small print may contain big risks

Not all first lien loans are created equal, and some investors may be surprised to find they can contain junior debt risk.

Unitranche loans may not be what they once were. Competition has eroded pricing, particularly in recent months, which may come as an unwelcome surprise for some investors newer to private credit.

Spreads on unitranche loans have compressed quickly, dropping almost 50 basis points in six months, falling from 6.61 percent last year to 6.05 percent in the second quarter, according to data from LPC BDC Collateral. The accelerated decline started between 2016 to 2017 when there was a drop of 25bps from 6.86 percent to 6.61 percent.

Limited partners should take note, since unitranche loans are classified in the ‘senior secured’ category.

Sophisticated investors are aware that not all first lien senior secured deals are created equal, says one market observer. Unitranche loans can carry more risk than a straight first lien senior secured term loan, depending on myriad factors, including the quality of both the underwriting and the credit.

However, not all investors know the ins and the outs of private credit the way seasoned LPs do, making it important to realise that there can be more to a loan than meets the eye.

It’s worth noting that spreads have started to stabilise. Near the end of the second quarter and at the beginning of the third, pricing began to move from more borrower-friendly terms to lender-friendly, says one credit manager that offers unitranche loans.

Still, it’s important investors have a clear idea of what senior secured means (or, should mean).

Unitranche loans can be a key component of meeting stated return goals for first lien strategies, multiple sources tell PDI, due to the higher return potential. The trade-off is that it goes deeper into the capital structure, more into the realm of junior debt sometimes, than a vanilla first lien loan.

“As a lender, if you’re going to take some of the junior debt risk, the more attractive way of taking that risk is incorporating it into a unitranche structure,” says Shahab Rashid, a partner and co-founder of the private credit group at Adams Street Partners.

“What an investor may need to look at is, does the manager have enough junior debt underwriting experience that they can underwrite that increased risk?”

The cost of debt for unitranche loans declined from the first quarter to the second quarter, from 9.16 percent to 8.85 percent, the LPC data show. Meanwhile, the cost of debt increased for other debt structures: notably non-bank lender-provided term loans with second lien and non-bank lender-provided term loans with mezzanine arrangements.

That makes unitranche a more compelling option for private equity sponsors, something LPs should be alive to.

The decline in unitranche spreads should not be viewed as an isolated incident as credit spreads have been on the decline for years across many products.

Private equity sponsors continue to choose unitranche because the attractive features of the product – fewer cooks in the kitchen, less execution risk, no intercreditor agreement – still make it attractive.

Unitranche has also come to be a solid alternative to the broadly syndicated loan market for upper mid-market businesses, two advisory sources say, offering private equity sponsors another reason to like the product.

While it’s no doubt unitranche is here to stay, LPs should be cognisant that a senior debt investment can include junior debt risk.

Contact the author at Andrew.h@peimedia.com.