The volume of middle market unitranche financings continues to rise in the US and European loan markets. Unitranche loans combine separate senior and subordinated debt financings into a single debt instrument. While unitranche financing is not new, the increased use of this type of financing, both domestically and abroad, creates new opportunities for middle market loan participants. However, unitranche financing also poses risks, and lenders who participate in unitranche financings must understand the related legal issues in order to adequately mitigate these risks.
This article provides an overview of traditional unitranche financing in the US and looks at recent developments in this area. Specifically, it:
- Explores the growth of unitranche loans in the US middle market.
- Describes the basic unitranche financing structure.
- Reviews the typical terms in an Agreement Among Lenders.
- Examines key bankruptcy-related risks that are unique to unitranche financing.
- Reviews recent US cases involving unitranche financing.
- Discusses the growing unitranche market in Europe.
UNITRANCHE LOANS IN THE US MIDDLE MARKET
In 2015, there were $142 billion of loans extended to middle market companies in the US (often defined as companies with annual revenues of less than $500 million and annual EBITDA of less than $100 million) (Thomson Reuters LPC, Leveraged Loan Monthly – Year-End 2015 Report). While there is not a lot of publicly available data on the volume of US unitranche financings, anecdotal evidence and tracking by regular market participants indicates a growing volume of activity in the middle market.
The principal amount of unitranche financings can vary depending on the needs of the borrower. However, $50 million to $100 million is a fairly common size. As unitranche financings have gained acceptance, deals far exceeding $100 million are not unusual now.
MIDDLE MARKET LENDING: MAIN ADVANTAGES
The middle market differs from the large corporate (or large cap) loan market in many ways. Certain characteristics associated with middle market lending have attracted a wide array of participants to the market, resulting in greater demand for middle market loans.
These characteristics include:
- Higher yield for lenders.
- Smaller lender groups, often involving club deals (two to three lenders) or smaller syndicates, giving lenders more control over documentation and decision-making.
- Greater variety of investment structures available.
- Less adherence to market terms and precedent.
- Growing market share of business development companies (BDCs), mezzanine investment funds, hedge funds, and other non-bank lenders.
- Growing private equity sponsor investment in middle market companies.
COMMON MIDDLE MARKET FINANCING STRUCTURES
There are two common middle market financing structures that involve both senior debt and a type of subordinated debt. They are:
- 1st/2nd lien financing. In a 1st/2nd lien financing, there are two separate groups of lenders who are separately granted liens on the same collateral. Pursuant to an intercreditor agreement, the two lender groups agree that the first lien lenders have a senior priority lien and therefore recover first on the value of the collateral following the exercise of remedies by the lenders against the borrower.
- Subordinated debt financing. In a subordinated debt financing, there are similarly two separate groups of lenders. In addition to the collateral arrangement of a 1st/2nd lien financing, the junior lenders contractually subordinate their loans and agree not to receive payment on their loans until the senior debt is repaid.
There are other traditional middle market financing structures which are beyond the scope of this article, including structurally subordinated financings and hybrid debt/equity structures.
Both of these common financing structures involve two sets of loan documents, which often contain different covenants. Each lender group is often represented by separate law firms, who also negotiate an intercreditor or subordination agreement to define the relative priority of the debt and shared liens. These agreements contain provisions restricting the lenders' rights to, among other things:
- Amend their respective loan documents.
- Bring remedies against the borrower or the collateral.
- Raise certain technical defenses or claims as part of the borrower's bankruptcy.
RISKS AND RETURNS IN MIDDLE MARKET LENDING
To understand any financing structure involving subordinated debt, market participants need to understand both the financial risks and returns should the borrower fail to repay its loans. Figure A is a simple illustration of basic risk and return characteristics of the two traditional middle market financing structures in the event of a liquidation of the borrower's assets.
BASIC UNITRANCHE FINANCING STRUCTURE
Unitranche financing is a unique debt structure that involves a single layer of senior secured debt, without a separate subordinated debt financing. Because unitranche financing combines multiple debt tranches into a single financing, a borrower with a simple capital structure would appear to have only one class of creditors.
Unlike the traditional senior/subordinated debt structures, a unitranche financing has a single credit agreement and security agreement, signed by all of the lenders and the borrower. In a classic unitranche structure, the single credit agreement provides for a single tranche of term loans with the borrower paying a single interest rate to all lenders.
FIGURE A: ILLUSTRATION OF RISKS AND RETURNS
The liquidation value of the borrower's assets flows through the inverted pyramid, and gets paid to the borrower's creditors, with any residual liquidation proceeds being paid last to the borrower's equity holders.
Senior Debt (1st Lien/Senior Debt):
- First lien lenders get priority on the borrower's assets.
- Lower risk of economic loss compared to subordinated debt and equity.
- Lower interest rate than subordinated debt.
Subordinated Debt (2nd Lien/Subordinated Debt):
- Intermediate economic level of a company's capital structure.
- Higher risk of economic loss than senior debt.
- Lower risk of economic loss than equity.
- Higher interest rate than senior debt.
The interest rate is a "blended" rate which is often higher than, or about the same as, the interest rate of traditional senior debt, but lower than the interest rate for traditional 2nd lien or subordinated debt. All lenders benefit from the same covenants and defaults and, as described further below, the voting provisions are similar to a non-unitranche credit agreement (that is, governed by the majority vote of the lenders with some amendments being subject to the vote of all lenders or all affected lenders).
Separate from the credit agreement, unitranche lenders agree among themselves to create "first out" and "last out" tranches (also known as "first out" and "second out" tranches) through an agreement typically known as an Agreement Among Lenders (AAL). Common terms of AALs are described below (see below Typical Terms in an AAL). The sizing of the first out and last out tranches changes by deal and is dependent on the attractiveness of the blended pricing that can be achieved and the lenders interested in any given deal at the proposed pricing and terms.
Unitranche structures are growing more complicated and some provide for multiple tranches of term loans and a revolving loan facility, and even multiple, separate unitranche facilities. For example, the revolving loan facility may be the first out tranche and the term loan may be the last out tranche or there may be a revolver with more than one term loan tranche, with layers of priorities among the term loan tranches.
In some unitranche deals with multiple tranches of term loans, the tranches represent the first out and last out tranches and include separate pricing for the tranches on the face of the credit agreement. Some of these multi-tranche deals also provide for voting rules by tranche on the face of the credit agreement. As described below, in a classic unitranche structure, pricing and voting arrangements among the lenders are dealt with in the AAL.
BENEFITS OF UNITRANCHE FINANCING
The volume of unitranche financings have increased as more borrowers have discovered the benefits of unitranche financing as compared to other middle market lending structures. The benefits include:
- Reduced closing and administrative costs. With only one credit agreement, the amount of required loan documentation is cut in half. In addition, there is only one administrative agent and one law firm representing all of the lenders.
- Speedier closings. Many unitranche lenders are willing to underwrite the full financing without pre-closing syndication. Combined with the faster documentation of one credit agreement, unitranche financing is particularly attractive in deals with multiple lenders competing to provide the financing and short timeframes to closing (such as in acquisitions).
- Less syndication risk. In deals with full underwriting and no pre-closing syndication, there is no risk that the lead bank arranging the financing will be unable to syndicate the loans and, therefore, not close the financing. Similarly, many unitranche deals do not have flex provisions allowing the lead bank arranging a syndicate to change pricing and other loan terms to match the demands of the syndication market.
- Greater amount of available senior debt. In many cases, the amount of senior debt available to a borrower in a unitranche financing is much higher than in a more traditional senior/subordinated financing structure.
- Lower debt service costs. Unitranche loan pricing can be attractive compared to other middle market financing structures. Depending on the borrower and the sizing of the first out and last out tranches, the blended interest rate and fees can be lower.
- Often no amortization or prepayment premiums. Many unitranche financing deals do not have amortization or prepayment premiums. This gives the borrower flexibility to refinance or pay down more expensive debt, which they may not have in a 1st/2nd lien or subordinated financing with a call premium. However, as unitranche structures have grown more complex, some multi-tranche unitranche deals have amortization or prepayment premiums in favor of the last out tranche.
- Easier compliance and administration. With only one set of covenants and one reporting package to prepare, unitranche financing is easier for the borrower to administer and comply with.
While unitranche financing started as a structure used mostly by specialty finance companies, its acceptance has grown. Banks, BDCs, fund lenders, and other types of lenders now regularly provide unitranche financing options to their customers.
TYPICAL TERMS IN AN AAL
The AAL synthetically creates the benefits and risks to the lenders found in a senior and subordinated financing by defining which lenders are first out and which are last out. The AAL provides that the lenders holding the first out tranche (the first out lenders) receive a lower return for their lower risk of repayment and the lenders holding the last out tranches (the last out lenders) receive a higher return for their higher risk. The AAL includes other terms similar to an intercreditor agreement. For example, in an AAL, the lenders agree that as part of the remedies against the collateral (or possibly the borrower), the last out lenders will turn over any remedial recoveries to the first out lenders.
AAL terms vary from deal to deal. There is not a standard market form and there is not yet an agreed-upon set of "market" terms to be included in an AAL. With that caveat, typical terms seen in AALs deal with:
- Payment waterfalls.
- Interest and fee skims.
- Remedial standstill.
The lack of standardization of AAL terms and forms has resulted in certain unitranche lenders working together more regularly based on a form of AAL that they have negotiated and generally use from deal to deal. As more lenders are entering the unitranche market, these pre-negotiated AAL forms are receiving more comments and changes.
Whether the borrower sees the AAL, or even acknowledges it (as it does with a typical 1st/2nd lien intercreditor agreement), varies by deal. In many deals, the borrower does not see the AAL and does not know how the tranches are split between the lenders. Recently, more unitranche borrowers are seeing AALs, especially with deals where some of the unitranche terms are included within the credit agreement. Private equity sponsors, who are now very active in the middle market, typically require a full understanding of the unitranche terms (including the terms in the AAL).
To win mandates from borrowers, many lenders who arrange unitranche deals are willing to underwrite and close the deal without pre-closing syndication. For an arranging lender who underwrites, having good partnerships with other unitranche lenders who regularly agree on AAL terms can help lessen the risk of not being able to assign the unitranche loans to other lenders post-closing. Some of these arranging lenders will also plan to hold all of the last out tranche under the belief that selling down the first out tranche may be easier, especially to banks who may be more interested in the first out tranche because many banks prefer the risk profile of the first out tranche.
The AAL creates the separate first out and last out tranches and sets out how much of each tranche a lender holds. This core structural feature of the AAL synthetically creates a structure similar to 1st/2nd lien and debt subordinated structures where one lender group has more risk and gets paid more of the economics in return. The mechanics of this risk and return in unitranche financing is described further below.
Most AALs introduce the concept of a "waterfall triggering event," (also sometimes known as a payment application event), which addresses how the two tranches share payments by the borrower under the credit agreement. While no waterfall triggering event exists, unitranche lenders usually share payments under the credit agreement pro rata (but subject to the interest and fee skims described below), without one group of lenders being paid first. In more complex unitranche structures, however, sharing of prepayments may be subject to a waterfall even in the absence of a waterfall triggering event.
Following a waterfall triggering event, the last out lenders are required to pay over any amounts received under the credit agreement (including all payments and proceeds of collateral enforcement) to the first out lenders until the first out lenders are paid in full.
The list of events that constitute a waterfall triggering event varies. It can include the occurrence of any event of default, although the market is moving away from this approach. Many AALs have a negotiated and limited list of waterfall triggering events. This list is becoming more complex and bespoke by deal or sponsor. The negotiated list, at a minimum, typically includes:
- Payment default.
- Bankruptcy/insolvency default.
- Financial covenant default.
- Exercise of remedies.
- Acceleration of the loans.
There are four noteworthy complications relating to payments:
- Payment-in-kind (PIK) interest is now common in many middle market deals, and is being included in unitranche deals. Payment waterfalls in unitranche deals with PIK interest need to address how and when PIK interest is paid.
- In deals with a revolver, the revolving lenders want to be the first out tranche. Some revolving lenders negotiate additional rights more akin to the "super senior" status that is typical in UK unitranche deals (see below The Unitranche Market in Europe).
- With banks being seen more in unitranche deals, particularly as first out lenders providing revolving loans, they typically seek to have any hedges or other bank products included as first out obligations. AALs need to address whether these obligations should be given priority and, if so, any applicable caps.
- In unitranche facilities where sponsors or their affiliates participate, AALs include complex provisions addressing the rights of these inside lenders.
INTEREST AND FEE SKIMS
While the borrower pays one interest rate to all lenders under the credit agreement, the first out lenders assume less risk than the last out lenders. To compensate the last out lenders for their increased risk, the AAL requires the first out lenders to pay over to the last out lenders a specified portion of the interest received from the borrower. The administrative agent under the credit agreement manages these payments after receipt of debt service payments from the borrower.
In addition, some AALs provide that the first out lenders similarly pay over to the last out lenders a portion of the commitment fees, facility fees, and other regularly accruing credit agreement fees.
Similar to a non-unitranche credit agreement, voting under a unitranche credit agreement on amendments, waivers, or remedies requires the consent of a majority of the lenders, with a few specified matters requiring the vote of all lenders or all affected lenders. Unitranche lenders in many AALs agree not to exercise these voting rights under the credit agreement unless the majority of both first out and last out lenders consent. This approach has resulted in practical difficulties for getting amendments passed, frustrating borrowers and sponsors. More complex voting arrangements are being seen in some AALs. Sometimes these voting arrangements become effective only after the occurrence of certain events of default, which are similar to the waterfall triggering events, or only if the tranche without a blocking position would be adversely impacted.
Other AALs specify just certain credit agreement provisions that require a voting arrangement different from the customary majority lender vote in the credit agreement, including pro rata sharing and payment application provisions. A further complication arises when a lender holds both first out and last out loans, which some AALs prohibit or limit.
As borrowers and sponsors face the practicalities of getting amendments and waivers passed in unitranche deals, different mechanisms are being used to limit the ability of lenders to block amendments and waivers and, instead, encourage lender support.
Some AALs grant both first out and last out lenders the right to buy out each other's loans at par in certain circumstances, including:
- If the other debt tranche does not consent to an amendment or waiver.
- Upon a payment default or the occurrence of any of the other waterfall triggering events.
- In some deals with complex voting provisions, permitting the buyout of the position of any lender blocking a desired vote.
AALs often have standstill provisions similar to 1st/2nd intercreditor agreements that, in a classic AAL, restrict the right of the last out lenders to bring remedies following an event of default and give the first out lenders the exclusive right to bring remedies. Restrictions relating to decisions during bankruptcy are also often included. In many deals, however, the first out tranche is significantly smaller, by dollar amount, than the last out tranche. Last out lenders with more leverage try to negotiate broader remedial rights as a way to ensure remedies are carried out in a way that generates maximum proceeds, sufficient to reach the last out tranche.
AALs, accordingly, have become more complex with respect to remedial arrangements. The AAL may provide that the last out lenders can control remedies following certain, or even all, events of default. Other AALs provide for:
- Remedies to be subject to the vote of the majority of both tranches.
- Exclusive remedies in favor of the first out tranche only for certain enumerated defaults.
Unitranche credit agreements usually have customary restrictions on assignments similar to a non-unitranche credit agreement. Those restrictions can include borrower or agent consent rights, with some exceptions for certain types of assignments, including assignments to affiliates or other lenders. Many AALs have additional assignment restrictions. This could include requiring consent of certain of the lenders, or requiring a selling lender to give the other lenders a right of first refusal or right of first offer before selling to a third party.
AALs also often have restrictions on lenders holding both first out and last out loans. While middle market and subordinated loans often have less liquidity than large cap loans, the bespoke nature of unitranche financing, including additional restrictions on assignments in some deals, can further limit the liquidity of unitranche loans.
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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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