The harmonious relationship between ABL firms (revolver lenders) and credit fund/BDCs (term lenders) who have successfully partnered to provide split-lien unitranche structures is starting to
strain. A split-lien or split-collateral unitranche structure is one in which the revolver lender only has priority with respect to the revolver collateral (accounts receivable and inventory) and the term lender has priority over all other collateral, which typically entails general intangibles. The gray area is general intangibles, such as IP and customer lists, being in the middle of a tug of war over lien rights.
As lenders, these constituencies have made great friends over the years by partnering to provide a competing alternative to traditional subordinated debt/ mezzanine capital, but both are now fighting for claim over general intangibles.
The unitranche facility has proved to be formidable from both a corporate finance and a product perspective. The borrower enters into one credit agreement at an attractive blended rate and is often impervious to the intense lender-to-lender negotiations which arise in a straight senior and subordinated/second lien deal. The unitranche facility provides a single solution, speeds up time to closing and lowers the transaction costs. The borrower only deals with one agent should the need for an amendment or restructuring arise. The aforementioned items are meaningful drivers behind the growth of the public BDC industry, which is trading at a combined net asset value of more than $30 billion.
Despite the prolific growth, this symbiotic relationship is starting to fray over lien fighting. In a typical unitranche deal, the credit funds are usually putting up more than 50% of the capital and now they are starting to demand more lien rights. This is creating cracks in this market. Standard practice used to specify ABL firms got all the assets, so the revolver lender was first in the waterfall of payment and collateral, and the term lender was second. Recently, however, term lenders have started pushing for IP and general intangibles while carving out the A/R and inventory for the revolver lender.
This may sound innocuous, but it’s not. In response, ABL firms are starting to make this a sticking point in negotiations. Many are drawing a line in the sand and demanding both payment and collateral priority on revolving assets and general intangible assets. ABL lenders fear, among other things, a company could enter bankruptcy and the cash collateral could go towards preserving value for the general intangibles. This puts the ABL lenders at a disadvantage as they have to manage the process, tie up resources and burden infrastructure in addition to having their collateral used for the benefit of the term lender. This scenario will be played out for years to come given the billions of split-lien deals already completed.
The ABL firms also fear the credit fund or term lender are not sophisticated enough to negotiate the sale of the general intangibles. This would preclude the ABL from selling the company as a going concern and limit options. The ABL is left to liquidate and seriously risk a deterioration of collateral while the credit fund shrewdly uses this process to maximize its own value. Although few bad outcomes have resulted so far, it’s been enough to make ABL firms wary.
There is always a counter-argument. In this case, the credit fund or term lender will always be concerned the ABL will rush to pull the plug too soon if it has all the assets, leaving the credit fund with a reduced chance of recovery. The goal is parity, but striving to reach this point has become a tug of war with real strategy on each side.
These conversations never occurred a few years ago, but now they are constant because of experiences which have hardened the positions. Some ABLs won’t give up the intangibles as there is a true downside since they can’t control all the business value. To avoid doubt, they will continue to partner on a unitranche deal, but within the inter-creditor agreement they have a true first on the general intangibles to control their destinies. Agreements have become more sophisticated as capital alternatives have exponentially grown. Banks simply don’t have the leverage or control over this market given the proliferation of institutional capital chasing yield.
Splitting the Lien
This battle has been going on for much longer in the technology lending field as the intellectual property in some of these firms is extremely valuable, and the non-ABL lenders are terrified the ABL will liquidate before it can be monetized. The practice of splitting the lien is generally more accepted because the other half of the lien is really taking equity risk as opposed to a manufacturer or distributor. Most of these types of companies are never profitable, so the question is a matter of timing when there is no clear end in sight to a cash burn scenario.
The concept of split-lien deals is relatively new and resulted from the proliferation of credit funds and BDCs. These constituencies have aggressively raised capital to provide an alternative to traditional subordinated/mezzanine capital. A unitranche structure should be less expensive and dilutive than junior subordinated secured debt and unsecured debt. ABL firms are the natural partners of unitranche lenders to lower the cost of capital on a blended-basis and provide revolvers with traditional formulas and collateral monitoring. This partnership has proved formidable as evidenced by the growth of non-SBIC capital. Today there are more than 30 public BDCs and numerous private credit funds.
The credit funds are squarely going after the banks’ clients, and the clients are working with one lender for a total solution. Banks realized this early on and — as a way to hedge and offer another compelling product — created a partnership with this industry. The unitranche product was the result, in which one loan document is delivered to the client and the UCC-1 is split between the bank or ABL and the credit fund.
The bank and credit fund work to define their relationships within the credit agreement via a payment waterfall and lien splitting. If the split-lien is coming up in a unitranche product then the waterfall is being defined in the agreement among lenders (AAL). These deals also are being done in a truly split-lien fashion in which an inter-creditor agreement defines the waterfall. The flip side of these deals concerns allocation of proceeds if there is a going concern sale of the business.
The partnerships between banks and non-bank capital providers, like any relationship, is in constant flux. The two parties clearly need each other, but the parity is definitely changing as the non-bank credit world continues to expand and evolve. It remains to be seen how this game of tug of war will unfold, but as fellow secured lending participants we should all respect our partners’ positions as the ABLs do the hard day-to-day work in this country.