With the market for commercial lending opening up, middle-market companies looking to finance growth, acquisitions, or recapitalization have a number of choices.
Among the most recent of these is unitranche financing, so called because it encompasses two traditional types of loans—senior and subordinated debt—into a single, blended product. Rit Amin, Co-Head of Corporate and Leveraged Finance at Regions Securities, LLC, indicates that unitranche has become a frequently utilized form of financing over the last several years as the alternative credit markets (non-bank capital) have continued to replace banks in middle market leveraged finance. His business unit maintains relationships with numerous alternative credit investors and he has perspective in where banks and alternative capital investors are best suited to provide a solution. Here’s a closer look at unitranche funding and what it can be used for based on feedback from some of those investors.
What are unitranche loans?
Unitranche loans first appeared in 2005, but they grew more popular during the financial crisis and ensuing credit crunch. Each unitranche loan is divided into distinct first and second lien components analogous to a senior bank loan and junior mezzanine financing. The resulting instrument has a single interest rate and term, which is typically five to seven years. Unitranche loans are primarily offered by business development companies (BDCs) that specialize in acquisition finance and middle-market lending. BDCs have become the dominant institutional investor class in the alternative credit markets.
Who uses unitranche loans?
As a general rule, unitranche loans are used primarily by middle-market borrowers with annual EBITDA of less than $50 million and sales under $500 million. While they vary in size, a typical loan would run about $100 million. This type of financing is often seen as an alternative for companies that might have difficulty securing a traditional bank loan.
What are unitranche loans used for?
Charles McCusker, managing partner of the Patriot Capital Group, a private equity firm based in Baltimore, notes that unitranche loans are primarily used to fund leveraged buyouts, whether private equity-backed acquisitions or management-led buyouts. “It’s very rarely used for growth capital or for a company that does not have a financial equity sponsor,” he says. “I have not really seen family owned businesses or individually owned businesses use a unitranche product.” Unitranche financing may also fund dividend recapitalizations in which company owners take a cash dividend out of the business.
Why unitranche?
One of the advantages that unitranche loans offer is simplicity. “Borrowers are willing to pay a premium because they didn’t have to go through two approvals,” says Ken Jones, managing partner of Philadelphia-based Boathouse Capital. “They only have to go through one approval process and prepare a single set of financial and operational reports for the lenders.” Another attraction is the low, fixed amortization (typically one to five percent annually) required in the early years of the loan. Such notes may nonetheless include a cash-flow recapture feature that requires a certain percentage of free cash flow to pay down the loan principal at the end of the borrower’s fiscal year. “But if you have a poor year, all you really owe the lender is the one to five percent amortization plus interest,” Jones points out. Dealing with a single lender can also be an advantage in a time-sensitive transaction, and borrowers may be able to negotiate additional flexibility in terms of prepayment penalties, amortization rates, equity cures, or covenant documentation.
What to look out for
Convenience comes at a price, of course. Rates for unitranche loans typically run 0.5 to 1.5 points higher than the weighted average of the two components that comprise them. Besides cost, there are other considerations as well. Unitranche lenders are typically transaction-focused, unlike banks, which generally develop long-term, multifaceted relationships with their customers. Because of this transactional approach, unitranche lenders may display a higher propensity to accelerate debt should your company hit a bump in the road. What’s more, rates are typically not fixed, so a unitranche loan could become more costly to maintain should interest rates rise.
Clearly, unitranche loans are not for everyone. But if your midsize company is seeking a leveraged buyout or looking to provide its owners with a cash payout, they can offer simplicity, speed, and convenience.
