Historically, when a middle-market company sought to borrow money the approach was simple: Call the bank. If additional junior capital was needed, the bank might suggest a call to a traditional subordinated debt or other junior capital lender. Much has changed in the credit markets over the last several years as we went from easy credit standards and bountiful availability in the immediate pre-financial crisis days to almost no availability and painfully stringent standards during the height of the crisis to where we stand today facing the “new normal.”
This new normal has some similarity to the old normal as we’ve seen banks in the last two-plus years relax their underwriting standards, extend more credit as a multiple of EBITDA and become more flexible on terms. Bank credit offerings (i.e., working capital lines and term loans) remain substantially unchanged, and banks continue to offer ancillary services such as interest rate hedging, trust services and cash management, etc., which are factored into their pricing/profitability algorithms. But the credit market for middle-market companies is now also populated with a newer group of lenders — non-bank direct lenders with a heritage in bond trading and private equity and with a different type of credit offering: unitranche loans.
Unitranche lending involves one tranche of debt as opposed to the typical two-tiered senior debt/subordinated debt and first lien/second lien structures familiar to most borrowers, as well as a single credit agreement for long-term capital. Instead of separate notes and security agreements for two classes of debt with an intercreditor agreement harmonizing the two sets of documents, unitranche transactions are governed by a single document typically called the Agreement Among Lenders (AAL).
The AAL addresses intercreditor rights and obligations and allocates interest and principal payments disproportionately among the “first-out” and “last-out” lenders, thus creating a multitranche transaction through the operation of the AAL. It is worth noting that the borrower is not a party to the AAL. If a single lender is providing all the debt in a unitranche transaction, there may not be need for an AAL. Single-lender unitranche deals are most common in lower middle-market transactions for companies with annual revenues ranging from approximately $10 million to $50 million.
The principle benefits to borrowers of a unitranche deal are straightforward and fairly obvious: only having to pay a single blended interest rate, lower legal expenses, fewer parties with which to negotiate pricing and terms, a single administrative or collateral agent, and, oftentimes, a quicker closing. Additional benefits of unitranche lending can include covenant-light documentation, light amortization requirements in the first few years of the term, and a single suite of financial and operational reports to lenders. It is worth noting, however, that many bank lenders are experienced in developing intercreditor agreements between a bank and a subordinated lender, often having standardized agreements in place with some subordinated debt providers. These standardized intercreditor agreements can remove any potential complexity and reduce legal fees.
One benefit a unitranche lender may not be able to deliver to a borrower is a lower cost of capital. When historically low interest rates on bank loans are combined with the higher cost of subordinated debt, the blended cost of capital to a borrower in the current rate environment is comparable to and often less than rates offered on unitranche loans. Unitranche lenders’ pursuit of higher returns in the current low interest rate environment has caused a proliferation of unitranche lenders — credit opportunity funds, business development companies and hedge funds — within the middle market. There is understandable uncertainty regarding the long-term commitment of these lenders to the middle market once interest rates rise and other sectors appear relatively more attractive. Commercial banks and subordinated debt providers, too, are seeking the best returns available on every loan they make, but they do not move from market to market in pursuit of the best rates; they are rooted in and committed to the middle market.
Split Collateral Intercreditor Agreements
Unitranche lenders normally do not provide working capital financing for companies, a key distinction for many borrowers. Most unitranche lenders are not equipped to administer such a dynamic credit facility, one which virtually all banks offer and routinely administer. Thus, if a company requires a line of credit, it must arrange it outside the unitranche structure requiring an intercreditor agreement between the bank providing the line of credit and the unitranche lender. It is at this point that the relative ease of a unitranche transaction starts to unravel since the documentation simplicity is diminished.
Collateral security needs to be split between the bank and the unitranche lender. These “split collateral” intercreditor agreements can be challenging if the unitranche lender will not allow payment blockage or they do not wish to divide up the collateral. Some unitranche lenders do offer lines of credit within the unitranche structure, but since they lack the administrative staff and systems to actually manage a revolving credit facility, they “participate” the revolver out to a bank of their choosing, not that of the borrower. While this approach does deliver the simplicity offered by unitranche, it exposes the underbelly of the unitranche approach: The borrower knows the named unitranche lender but they may not know or even influence the selection of the other lenders funding the various credit components. Bankers have long applied the underwriting saying, “Know your borrower,” and borrowers should apply the corollary to that: “Know your lender.”
Since they are not typically local to their borrowers, unitranche lenders generally do not develop as deep and broad a relationship with their borrowers as a traditional bank lender, thus, are more transactionally-focused than relationship-focused. With a bank lender the company may have more access to its lending officer and more opportunities to develop a relationship that can translate into more consideration, trust and potentially less severe consequences if the company hits a bump in the road. The unitranche structure concentrates a tremendous amount of leverage over the borrower into the hands of the lenders, even more so in single-lender unitranche transactions.
Furthermore, unitranche lenders may display a higher propensity to exercise rights and accelerate debt in a negative situation as opposed to a senior lender/subordinated lender arrangement in which the bank lender remains fully collateralized in a downturn and the subordinated debt lender is forced to take no action for some period of time. Additionally, subordinated debt lenders tend to have fewer companies in their portfolios than do unitranche providers, allowing them to spend more time understanding the companies and working out problem situations.
Bankruptcy Court View
Ultimately, the potential challenges to a borrower from its involvement in a unitranche transaction are really a derivative of the potential problems that the lenders themselves face. If the lenders in a unitranche transaction experience problems, those problems will invariably trickle down to the borrower in some form. The potential lender problems are less clear and, largely, still to be determined since there is little legal precedence surrounding this form of financing under adverse circumstances.
What appears to be clear, though not tested in court, are the rights and obligations of the borrower. However, it’s uncertain how courts will view the relationships among the various lenders and how potential disputes among those lenders will affect borrowers. Bankruptcy courts may deem AALs as substantially the same as intercreditor agreements and affirm the rights of the first-out and last-out lenders, but they could view disputes among the lenders as intracreditor disputes that need to be resolved outside of bankruptcy court since the borrower was not a party to the AAL and did not agree to its terms. Of course, intercreditor issues inside a unitranche deal would not be a factor in a single-lender unitranche transaction.
When management of a middle-market company contemplates borrowing, it needs to assess exactly what it is seeking beyond just the capital. Is it seeking a partner, linked through a multifaceted relationship, or does it simply want a one-dimensional provider of capital? Does it want advice at the onset of the borrowing relationship and throughout the life of the loan, or will it seek its own counsel? Does the company only want/need a single tier of debt that encompasses what would traditionally be a term loan and subordinated debt, or does it also need a revolving credit facility for liquidity or other purposes? Does a lender have the capacity to fully meet the capital needs of the company, or will it need to arrange a syndicate to meet the current and future borrowing needs of the company? Does the company want to know the lenders, their operating style and track record in good times and bad, as well as their capacity to grow with the company?
If a financing involving senior term debt and subordinated debt — whether in a unitranche structure or as two distinct tiers of capital — can be thought of as a discrete event without consideration to other credit products or banking services or to an overall relationship or to future capacity of the lender, then the decision is clear, and the only consideration should rightly be pricing and terms. If, however, the company needs a broader array of credit and non-credit banking products, along with the need to know, understand and develop a relationship with its lenders, then the decision algorithm is quite different.
Marc A. Reich is president of Ironwood Capital, a private equity firm based in Avon, CT. He can be contacted at (860) 409-2101 and firstname.lastname@example.org.