Unitranche – debt funds and banks as new finance partners
February 2017 | PROFESSIONAL INSIGHT | BANKING & FINANCE
Financier Worldwide Magazine
The number and scope of unitranche financings has continually increased over the last few years. Unitranches are, to some extent, comparable with equity financing. Due to this, they were initially only offered by debt funds. However, several banks have expanded their business activities which has allowed them to supplement unitranche financing offerings from debt funds with revolving credit facilities, and in some cases to even replace part of debt funds' unitranches by offering a share in unitranches themselves. This increase in bank lending, alongside direct debt fund lending, has influenced the pricing and risk allocation structure among debt funds and banks. The trend has also meant that new contractual arrangements are required among these new financing partners.
Structure of unitranche financings
When funds entered the high yield debt market, in addition to their regular equity business, they developed the unitranche financing concept in order to open up new profit opportunities and to provide an instrument to diversify risks. Initially, the term unitranche described a credit facility which was granted by a single credit provider on the basis of uniform transaction documentation.
At first, unitranches were solely granted with high interest margins and, due to operational requirements of debt funds, only as term loans. Borrowers were, therefore, mainly either corporations with imminent liquidity issues or companies which needed term loans with covenant flexibility – since debt funds are generally able to accept less restrictive covenant levels (for example, higher leverage ratios and lower equity ratios) due to their lower risk adversity and less demanding regulatory requirements. In addition, debt funds can often ensure higher transaction speeds for borrowers and do not require a regular amortisation during the term of the loan. Further, despite their comparable level of restrictions and flexibility for borrowers, the pricing of unitranches is usually better than the average mezzanine financing.
Under current market conditions, the structure of unitranche financings has changed as debt funds have widened their product range beyond refinancings and dividend recapitalisations to acquisition financing. As a result, unitranche loans are often not solely provided by debt funds but rather as part of a financing package of different products and involving multiple lenders.
Is unitranche debt comparable with equity?
Unitranche debt has certain characteristics in common with equity financings as a result of certain contractual features typically included in unitranche facility agreements. Unitranche lenders assume a position which, in some respects, is comparable to shareholders, although this does depend on the negotiated terms of the unitranche facility agreement.
Comparable with shareholders, debt funds usually provide debt in unitranche financings with the purpose of extending capital for the long term without syndication. This has the advantage of efficient decisionmaking when negotiating the facility agreement, as well as during the term of the loan, as there are fewer parties involved than in normal syndicated loans. Additionally, there is no syndication risk for the borrower which can be a significant issue in ‘best effort’ syndications or can lead to increased interest costs as a result of market flex provisions.
Another similarity between unitranche debt and equity is that the unitranche providers often not only request pledges over the shares in the borrower and guarantors in order to gain control over these companies in an enforcement event, but they also have the right to send their own observers into the decision-making bodies of the obligor companies prior to an enforcement event. In such bodies, the debt funds’ observers act as advisers that provide further market knowledge on strategic and other corporate matters. In connection therewith, the borrower usually accepts more extensive information undertakings compared with other financing transactions (for example, shorter intervals for the delivery of management presentations).
Examining return and interest margins is crucial in order to compare unitranche debt and equity. Unitranche debt regularly carries interest margins of more than 6 percent per annum. This is not that dissimilar to conservative equity return margins with the added benefit, compared to equity, of not being subordinated to an obligor’s other debt in the event of insolvency. Unitranche facility agreements mostly provide, alongside a bullet repayment at the end of the facility’s term, for a liquidity-saving payment-in-kind margin, by which interest is not constantly paid but is accumulated and added to the loan’s principal amount. This means that borrowers can budget in a liquidity-saving manner over the entire term of the facility. This benefits borrowers, especially when financing capital expenditure or if they are in a distressed situation, as they are able to bridge a period of time until a (liquid) return is generated on their investments or the risk of insolvency passes.
Unitranche debt can also be structurally close to equity in terms of risk profile. Normally, debt funds accept a low and flexible level of covenants, relative to the borrower’s credit worthiness. Further, the minimum equity ratios for shareholders are often comparatively low so that the lenders and not the shareholders provide the greater part of the borrower’s financing. This gives the shareholders the option to either inject less equity initially into the company or to withdraw their equity injections at a later stage. For example, the unitranche instrument can be used in such a way that a private equity fund sells one of its portfolio companies to another fund within the same group and the acquisition is financed by way of a unitranche with more debt (and less equity) than was the case in the original acquisition by the selling fund.
New role of banks in unitranche financings
Recently, some banks have become active in the unitranche space (initially only occupied by debt funds). This is a result of interest margins dropping significantly in many of the banks’ regular lending transactions due to the monetary policies applied by central banks, most notably, quantitative easing.
Since debt funds mostly provide term loan facilities only, banks filled the gap and supplemented unitranches by providing revolving credit facilities. Debt funds and banks (officially or unofficially) now cooperate right from the start of a transaction in order to be able to offer complete financing packages. This can, for example, be attractive to bidders in M&A auctions. The contractual documentation in these financing packages is usually based on precedents of similar transactions to ensure a high transaction speed. It mostly depends on the parties involved whether the term loan facility of the debt fund is documented in the same agreement as the revolving credit facility or in separate agreements.
However, due to the introduction of banks in unitranche financings, the structure of such financings has become somewhat more complex and is no longer as uniform. Similar to the structure of high yield bonds, the term loan facility (senior) is usually subordinated to the revolving credit facility of the banks (super senior). This is mostly done by way of an intercreditor agreement with the borrower as party, or by way of an agreement among lenders behind the scenes, which does not include the borrower.
Such intercreditor agreements tend to deviate from one another with regard to voting rights on decisions in enforcement scenarios. However, certain market practices have already been developing in order to provide for a sufficient balance among creditors. For example, the lender whose commitments exceed two-thirds of the total commitments is often entitled to determine an enforcement event, even though the banks would receive the enforcement proceeds first due to their super senior position.
To ensure that the banks cannot be constantly overruled by the debt funds, they are provided with special enforcement rights in case of serious events of default (for example, non-payment or insolvency) if the debt funds do not exercise their enforcement right. However, the exercise of special enforcement rights requires that certain grace periods must have expired without any debt having been purchased by the debt fund from the respective bank and compliance with a pre-agreed enforcement procedure. These special rights are not only granted in relation to enforcement scenarios. Banks are granted veto rights on various types of decision on issues of special importance and in case of decisions which mainly or exclusively involve the revolving credit facility.
Until recently, banks only acted in unitranche financings as revolving credit facility providers, due to the unitranche’s riskier equity-like credit profile. Lately, banks have started providing part of the term loan unitranche market as well.
In such cases, the term loan facility is tranched into a bank loan (first out loan) and a term loan facility funded by a debt fund (last out loan). The bank loan is, like the revolving loan, made super senior toward the senior term loan funded by the debt fund. Due to the seniority of the bank tranche in the term facility, such tranches can be provided at a risk level acceptable to banks and with a lower interest margin compared to the subordinated debt fund tranches. Through this structure, borrowers can often reduce the average interest cost for all tranches and facilities since debt funds, in practice, have not tended to raise their pricing, despite the change in their risk profile. The introduction of the banks into the unitranche term loan market has significantly increased competition among debt funds.
This does not only change the pricing structure but also the risk structure for banks through their increase in commitments and for debt funds through the increase of the super senior bank commitments, as well as through changing voting mechanics. This has led to the review and amendment of intercreditor agreements between banks and debt funds. For example, debt funds might now require, due to their own risk profile, certain rights vis-à-vis the borrower, in case banks hold a blocking minority and remain inactive or object to the taking of certain measures, since ultimately the banks enjoy greater protection due to their seniority.
It remains to be seen whether the high yield product unitranche will grant banks an opportunity to increase the profitability of their credit business in the long run. Or whether banks, due to higher leverage and lower equity ratios, and against the background of potentially increased regulatory requirements resulting from Basel IV, will have to retreat from certain riskier market segments once more and leave such segments to more ‘traditional’ unitranche players, the debt funds.
Dr Michael Josenhans and Maximilian Lang are partners and Dr Max Danzmann is an associate at Freshfields Bruckhaus Deringer LLP. Dr Josenhans can be contacted on +49 69 27 30 80 or by email: firstname.lastname@example.org. Mr Lang can be contacted on +49 69 27 30 80 or by email: email@example.com. Dr Danzmann can be contacted on +49 69 27 30 80 or by email: firstname.lastname@example.org.
© Financier Worldwide
Dr Michael Josenhans, Maximilian Lang and Dr Max Danzmann
Freshfields Bruckhaus Deringer LLP