Commercial Insights
What is unitranche financing?

Article

An increasingly popular financing option for middle-market companies looking to finance growth, acquisitions and recapitalizations.

Years after the number of private equity–owned companies surpassed the total number of publicly owned companies, the alternative credit market (i.e., non-bank capital) continues to expand. Middle-market companies and private equity firms can now take advantage of a variety of mature vehicles for financing debt, one of which is unitranche financing.

What Is Unitranche Financing?

Unitranche financing combines two or more loans, known as senior and subordinated debt, into a single, blended product. This financing product first appeared in the first decade of the 21st century and gained popularity after the 2007–2008 financial crisis and the ensuing credit crunch. The role of alternative credit investors has grown in middle-market-leveraged finance, and as a result, unitranche financing has become an increasingly popular means of increasing borrower capacity. One key factor that has driven the growth is that unitranche loans can be set up within relatively tight time frames, if necessary.

Tom Archie, Capital Marketing Lead at Regions Bank, says that unitranche financing’s behind-the-scenes complexity can bring traditional banks and alternative capital investors together to provide a streamlined solution for a borrower. “Many banks will participate directly in a unitranche loan, particularly when it involves companies in industries where the bank has extensive experience,” he says. “They can also provide traditional banking services in addition to these loans. But the demand for loans by middle-market companies far outstrips the capacity of most banks’ risk appetite, so institutional investors have stepped up to embrace unitranche lending and private credit in general.”

Initially, business development companies (BDCs) that specialized in acquisition finance and middle-market lending provided most unitranche loans. But as the product has matured, lenders have created different approaches, says Archie. “In addition to consolidation, many large BDCs have built massive private credit platforms with investment vehicles much larger than their core BDC funds. We’ve seen an inflow of capital into private credit over the last several years. Now, some of the largest private equity groups are also some of the largest players in private credit.” In fact, the private credit market now has estimated assets under management of about $1.5 trillion.

How Unitranche Financing Works

In many instances, the unitranche loan is divided into distinct first and second lien components similar to a senior bank loan and junior mezzanine financing. However, one unitranche investor may provide all the capital and use their own credit facility to create the structure. In either case, the resulting instrument has a single interest rate and term, which is often five to seven years.

Typically, the lenders advance capital under conditions that reflect their risk tolerance. For instance, a commercial bank may extend capital at a relatively low interest rate because the agreement stipulates this debt will be retired first, thus reducing risk. A BDC could then provide a larger last-out loan with a higher interest rate with little or no amortization because it is willing to assume greater risk. The blended cost of capital and amortization would be what the borrower sees.

The terms between the lenders are settled in an agreement among lenders (AAL), which remains in the background. So the borrower has a credit agreement with a single set of terms. The AAL also governs how the loan will be repaid and what rights the senior and subordinate lenders have. Commercial banks may also provide basic services that non-bank lenders typically do not provide, such as banking and checking needs.

Which Borrowers Might Consider Unitranche Financing?

Unitranche loans are typically attractive to 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–$200 million. This type of financing is often seen as an alternative for companies that might have difficulty securing a traditional bank loan or are looking to secure funding on an accelerated schedule.

“Most banks will not extend a cash flow loan to small companies. That means those with less than $10 million to $15 million in EBITDA,” Archie says. “Typically, small companies borrow from banks based on their assets via an advanced rate. But a unitranche lender might provide a cash flow–based loan to a company of this size.”

While the purposes of these loans vary, unitranche loans often fund leveraged buyouts and recapitalizations, whether private equity–backed acquisitions or management-led buyouts. They may also facilitate acquisition activity and dividend recapitalizations in which company owners take a cash dividend out of the business. As the unitranche market has grown, Archie says, more borrowers are using these loans to secure growth capital, even in cases where they don’t have a private equity sponsor.

What Are the Advantages of Unitranche Financing?

Unitranche loans can benefit borrowers whose funding needs are time-sensitive and who are willing to pay a premium for a single approval process. Borrowers also can save time by having to prepare a single set of financial and operational reports. “Typically, these deals are done faster, have more flexibility and often result in borrowers securing more leverage,” Archie says. The amortization rates are fixed and low—often 1% annually—and require interfacing with only a single lender team.

The loans may 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 the borrower has a poor year, they will owe only the amortization, plus interest. Borrowers also may have more flexibility in covenant documentation and the ability to make acquisitions or investments.

Other Considerations

Unitranche loans can provide borrowers with speed and convenience, but the trade-off comes in higher rates: Historically, these ran 50 to 150 basis points higher than the weighted average of the two components that comprise the loan. But Archie says that here, too, standardization has changed the landscape. “Given the growth and acceptance of unitranche loans, now the blend of senior and subordinate rates is often at parity with the average, or maybe 25 basis points higher.” Changes in interest rates may affect the cost of maintaining the loan, since rates typically are not fixed.

While alternative lenders used to take a more transactional approach with borrowers, the massive increase in middle-market lending has led many to cultivate a more relationship-focused stance. “Almost all direct lenders are building their business around relationships with private equity firms who are driving this trend,” Archie says. “Unitranche lenders aren’t going to provide the traditional services of a commercial bank. But most take a more relationship-focused approach since private equity firms provide repeat business.”