An introduction to the unitranche market

Experts from PwC outline why this form of lending is an attractive financing option for mid-market leveraged buyouts.

Unitranche lending involves a hybrid loan structure that combines senior debt and subordinated debt into one loan facility at a blended interest rate that falls between the rates of the two traditional types of debt, senior and mezzanine.

Debt funds offering unitranche debt entered the market to fill the funding gap left by banks after the credit crisis. This has proved an attractive alternative financing structure for mid-market leveraged buyouts (typically less than €150 million debt), with unitranche representing two-thirds of lending into the UK and Ireland in 2018 and continued expansion and acceptance of the product across continental Europe.

The biggest challenge for borrowers is knowing who to approach for a specific lending request given the large number of players now operating in a crowded market. The market continues to see new players, and established funds are raising ever-larger direct lending funds, with several multibillion euro funds closed in the past 12 months. As debt funds increase in size they are competing directly with banks at a size where previously the institutional term loan B or high-yield bond markets were the only viable options for borrowers. Recent deals saw single debt funds providing £1 billion-plus ($1.3 billion; €1.1 billion) loan packages.

A number of debt funds have also extended their offering into new lending products, such as asset-based lending. Raising debt from funds used to be the preserve of niche borrowers or those with unique or more challenging capital structures – this is no longer the case and unitranche is now an established financing solution in the private equity market.

Legal terms

Key features of unitranche debt contracts are:

–              No amortisation with maturity, thus reducing the regular cash burden on the borrower, leaving it free to grow the business through acquisitions or capital expenditure.

–              Tailored covenants specific to the borrower, with “covenant loose” commonplace and “covenant-lite” being seen more frequently.

–              Call protection, which generally includes a “make whole” provision, to guarantee the lender a minimum rate of return.

–              Higher leverage, which typically improves the internal rate of return of the private equity fund on a successful exit.

–              Higher interest rate payable compared with a bank senior facility given higher leverage and often looser controls over the borrower. Competition to deploy capital, as well as first-out/second-out structures, continue to push unitranche pricing down, with margins of 5.75- 6.5 percent seen on the best credits.

Flexible debt funds

The main appeal of unitranche lending is flexibility on terms and the circumstance-specific tailoring available compared with traditional bank debt providers. Debt funds have a more flexible model, particularly as they do not face the same capital adequacy requirements as regulated banks. Funds often have more latitude to price credit risk, whether on more challenging credit stories or offering higher leverage, although this comes at a price. Furthermore, the ability of debt funds to write large tickets provides financial firepower to support private equity buy-and-build growth strategies.

It is becoming more common to see debt fund lenders structuring solutions through the capital structure, from senior-secured debt through to quasi-equity (preference shares and even ordinary equity, providing real freedom in a novel way to borrowers and their majority backers.

Future credit cycle

Credit market conditions have been reasonably benign since the growth in popularity of unitranche debt so it will be interesting to see how providers react when the credit cycle turns or individual borrowers become distressed.

Most debt fund lenders are not set up to provide revolving credit facilities for borrower working capital purposes.  If an RCF is required by the borrower, debt funds typically partner with a clearing bank.  RCFs will often rank “super-senior” to the unitranche facility and the relationship between the two lenders will be governed by an intercreditor agreement.  The terms of such agreement can vary from deal to deal regarding the degree of control that the unitranche lender has in the event of an event of default, such as a covenant breach, or in an enforcement scenario.

Under a typical structure, the unitranche lender benefits from tighter financial covenants than the RCF lender and the former has initial control in an enforcement scenario. This means the lender benefits from a standstill period before the RCF lender takes enforcement action. However, these are points of negotiation and the relative size of the RCF versus the unitranche can affect the relative strength of the lender positions. These considerations can impinge on a debt fund’s freedom of action in a distressed situation.  The intercreditor agreement may give the unitranche lender the option to buy out the RCF lender at par in certain situations.  This allows them to take control of the borrower’s whole debt profile, which gives wide-ranging power and flexibility in a distressed situation.

Subject to transferability restrictions, the unitranche lender could decide to cut its exposure by selling its debt to another lender. However, examples of a debt fund “dumping” a distressed credit through a secondary sale are relatively rare. Not only would it be damaging to its relationship with a financial sponsor, debt funds appear to prefer supporting a borrower, thereby keeping any issues “under the radar”, reducing reputational damage which could harm both future fundraising and its ability to deploy capital.

Given Brexit uncertainty, as well as continuing US-China trade wars, there is a risk that the capital markets could become more volatile and less dependable. However, the risks of a future credit crisis appear to have reduced given the growth in debt fund liquidity, their flexibility around lending parameters and their incentive to lend since most typically receive management fees on deployed capital rather than on fund size. Whether this fee structure leads to poorer lending decisions remains to be seen.

Sophie Vann is a solicitor in PwC’s banking legal practice specialising in advising on leveraged finance transactions, syndicated lending and group restructurings of PE-backed businesses. David Godbee is a partner in PwC’s debt and capital advisory business, advising both PE and corporate borrowers on finance raising transactions. Tim Sydor is a solicitor in PwC’s London region private equity team, advising PE funds and portfolio company management teams on management buyouts.