Unitranche on the up down under

Australia is beginning to follow the US and Europe in their embrace of the unitranche structure.

Australian private real estate fund managers are becoming more accustomed to unitranche structures, not only through M&A transactions but also through real estate debt financings.

In its market outlook for 2018 published early in January, Partners Group, the Switzerland-headquartered global private markets firm, said it had seen more demand for institutional unitranche debt in Australia over the past six months.

Brae Sokolski, chief investment officer at MaxCap Group, a real estate debt and investment firm headquartered in Melbourne, also tells PDI that unitranche structures have been seen recently in senior lending strategies.

“We recently lent A$100 million to residential developers in Melbourne through the unitranche structure with 75 percent loan to existing value of the project ratio,” Skolski tells PDI, adding that MaxCap had been mandated by an Australian superannuation fund to provide development finance through one of its real estate debt funds.

Around 60 percent of the request for debt facilities that he is receiving are now unitranche structures, according to Daniel Erez, a managing director at Newground Capital, the Brisbane-headquartered real estate investment manager with $385 million in projects under active management.

Having a single party at the negotiating table brings simplicity and with it an increase in the premium that borrowers are willing to pay for the facility, according to Erez.

The unitranche structure, a single facility that covers both senior and mezzanine tranches, is designed to have a blended risk-return profile of both senior debt and mezzanine debt, according to Hogan Lovells, a London and Washington DC-headquartered law firm.

“From the lenders’ perspective, given their nature, they typically don’t want the money back from quarterly instalments. They prefer a single drawdown and single repayment at maturity of the deal,” explains Richard Hayes, a Sydney-based partner at Hogan Lovells.

“From the borrowers’ perspective, they like not having an additional drain on their cash flows, which frees them up for investment in their business and other purposes, rather than paying back their debt,” Hayes adds, noting that having no loan repayments until maturity gives borrowers more flexibility.

He notes that when a borrower generates surplus cash flow, a portion of it will not be swept to repay the loan, but kept on the balance sheet under the unitranche structure.

As banks retreat from lending to developers amid tightening regulatory requirements, more institutional lending deals are being backed by non-bank lenders, which are not subject to leveraged loan guidelines.

For instance, Australian banks have been pulling back from lending to real estate developers since the Australian Prudential Regulation Authority (APRA), a regulator of the Australian financial services industry, took a stricter stance on cutting institutional lending in 2015.

APRA said on March 31, 2017 that the annual growth rate of investor lending, which includes lending activities from all authorised deposit-taking institutions in Australia, has remained below 10 percent since October 2015.

“The 10 percent growth benchmark continues to provide an appropriate constraint in the current environment, balancing the need to continue to moderate new investor lending with the increasing supply of newly completed construction which must be absorbed in the year ahead,” Wayne Byres, the chairman of APRA, said in a statement last year.

Erez explains that as recently as 18 months ago, developers could still access up to 80 percent of their development cost from the major banks, while now it is down to 50 or 60 percent, creating opportunities for private credit lenders to fill the gap.

In addition to local non-bank lenders, a number of global players including Barings, ICG, KKR Credit, Partners Group and Bain Capital have begun to look to replicate the success their European and US offices have had with unitranche, according to Hogan Lovells.

Explaining the reasons behind the growing appeal of unitranche structures, a report called Unitranche: On the up, down under, published on October 17, 2017 by the law firm – said that documentary flexibility is key, particularly in relation to covenants.

Edward Tong, a Singapore-based senior vice president and head of private debt in Asia-Pacific at Partners Group, says the firm has exposure to a value-add strategy in the form of a construction financing deal to build out an additional part of an existing shopping centre in Australia.

Partners Group is active in providing senior-secured financing for construction projects.

“The leverage level [of unitranche structures] is generally in excess of 4.5x EBITDA and pricing is north of L+500 bps,” Tong says, adding that he underwrites based on hard assets’ collateral as well as the cash-flowing income portion of buildings.

Unitranche is interesting because, given the same cost of capital, lenders can leverage more and add further capital to gain more profit, according to a Sydney-based real estate investment firm with over AS$5 billion in assets under management.

“For instance, within unitranche structures, it is possible to source capital with 80 to 85 percent less cost along with additional 10 percent leverage,” a managing director of the firm says, adding that the firm has provided unitranche debt to developers in the construction phase.

As Hogan Lovells points out in its report, unitranche structures are still in their infancy in the Australian market but are on the rise, with more institutions participating.

“We expect to see some of the successful mid-market private equity firms here in Australia begin to adopt the unitranche structure to finance their deals, which allow for higher levels of debt and less onerous covenants,” Hayes notes.

This rising usage is providing both borrowers and lenders with greater flexibility as their deals are not subject to regulatory scrutiny despite higher leverage levels.

However, non-bank private lenders, including real estate debt lenders, should be wary of this flexibility as it can sometimes undermine the quality of their loan books.

WHY THE DEBT OPTION MAKES SENSE

Developers are shifting their financing preference from equity to debt. Tim Johansen, managing director of Real Estate Finance at Qualitas, explains why. 

 

Tim Johansen

“Debt pricing is an important consideration for developers, however most developers understand the cost of debt is cheaper than the cost of equity, so it is in their financial interest to maximise (within reason) the level of debt in the capital structure. So if they can borrow senior debt or use a stretch-senior (unitranche) debt option, it is still a quite acceptable and credible cost of capital for them.

In the current market it is often difficult to get finance certainty from the banks. Also, many developers today want to diversify their equity across a number of projects, so they often are willing to put less equity into a particular project and get more of a structured debt solution to assist in financing the project.

For instance, if a developer is doing a project costing $100 million, they previously could borrow senior debt up to $75 million and would have to put in $25 million. Now they might want to put in only $15 million and borrow up to $85 million through a stretch-senior solution, or using a $10 million mezzanine finance top-up solution.

This enables them to be more strategic with their scarce capital. This example is even more pronounced if they can only borrow senior debt up to $65 million – which is more indicative of the current market.”