Here’s the question for private equity firms: why worry about hashing out a credit agreement and an inter-creditor agreement? Ditch the first-lien/second-lien financing and go with the unitranche option, and you have a credit agreement only.

“If you’re a sponsor, and you’re seeing what is happening in the syndicated market on large middle-market credits, it makes more sense to go the direct lending route” in Q4, says Fran Beyers, head of mid-market loan analysis at Refinitiv. “Many are going to say, ‘I’m going to the direct lenders that have large hold sizes and I am going to take my execution and flex risk off the table.’”

The syndicated markets are flexing deals up while direct lenders are receiving renewed attention from large sponsors hungry for unitranche loans. The second quarter saw $9.2 billion of unitranche issuance. This surpassed the previous high in the third quarter of last year, when the figure was just under $9 billion, according to data from Refinitiv.

“Many sponsors like the ease of the unitranche execution, and lenders have told their LPs we’re going to do first lien,” Beyers says. “Unitranche has the spread to get the yield lenders need to meet return hurdles. The issuance stats are at record highs. [The third quarter] will be a new record.”

The pricing squeeze

The blended spreads on unitranche loans have become tighter too. From 2014-16, the spread for unitranche loans was more than 6.8 percent, according to data from the firm’s fourth-quarter Middle Market Lender Outlook survey. In 2017, that figure dropped by 20 basis points to 6.6 percent. In 2018, it fell to under 6 percent.

After volatility in the fourth quarter of 2018, which appears to have strengthened lenders’ hands in pricing negotiations, spreads in the first quarter of this year were around 6.1 percent. But spreads fell over the next two quarters as the market swung back to a more lender-friendly environment. In the third quarter, the unitranche spread reached its lowest level since 2014.

As the blended spreads have declined, so too has the minimum pricing threshold under which direct lenders will provide a unitranche loan. To do so, 65 percent of direct lenders said they would extend such a facility with 5.5 percent-5.75 percent pricing – up from 38 percent a year ago.

“I think LPs would be shocked if they knew how much of their portfolios are 6x-levered unitranches when they think they are 4x levered first-lien loans,” one direct lender said in the survey. The moment of candour brings to mind a question raised by an LP at our recent PDI New York Forum where an LP asked: “What does senior secured mean?”

However, one lower mid-market lender says this runs contrary to what his firm has experienced.

“I don’t think that the investing community is blind to the higher unitranche leverage [more than first-lien loans],” the source says. “LPs are looking at the asset-level leverage and the fund-level leverage. The depth of questioning continues to get finer and finer.”

Lenders are split on what recoveries to expect on unitranche, though more expect them to be on the lower side. A majority, 54 percent, anticipate recoveries being lower than 70 cents on the dollar.

Known unknowns

In fact, the level of recovery, at least for bifurcated unitranche loans, may depend on a largely unknown factor: the agreement among lenders provision. This bifurcates the loans into a first out/last out structure and governs things like interest rates and payment waterfalls.

A recent research note by Fitch Ratings said the AAL provision was still relatively untested in bankruptcy courts. The ratings agency said there was a “lack of precedent with respect to issues such as the bankruptcy court’s jurisdiction to interpret AALs; unitranche lender claims against the debtor; and the treatment of post-petition interest in relation to the first-out and last-out tranches”. It added that this “has created a level of uncertainty in unitranche lending that does not exist in other more typical financing structures.”

But while AALs may bring uncertainty, the rise of unitranche is not in question.