As most entrepreneurs know, running a small business can be tough work. Whether it’s aligning the company’s vision on a unified goal or onboarding new staff, it can be a struggle to keep new enterprises aloft.
Traditional financing institutions’ hesitance to lend to small business owners doesn’t make it any easier. Unitranche lending is, however, one of many forms of alternative financing available to small to medium-sized enterprises (SMEs), who have seen federal regulation — instituted in the wake of the 2008-09 financial crisis — limit banks’ ability to lend to such businesses.
Banks have declined loan requests for such reasons as inconsistent cash flow, poor collateral, unfavorable debt-to-income ratios, and insufficient credit. But sources ranging from hedge funds to private equity funds, wealthy financiers, and business development companies (BDCs) have filled the gap, irrevocably shifting the US lending market.
In particular, BDCs, which are designed to support small and middle-market businesses, have led the charge in providing unitranche financing options. By offering flexible debt-financing terms, unitranche lending provides small businesses the opportunity to fully tap into their growth potential.
The availability of lending opportunities for SMEs has been striking. As of 2018, a full 40 percent of private credit managers were actively lending to companies with EBITDAs lower than $25 million.
But what exactly is unitranche debt? In this article, we’ll walk through what unitranche financing is, how it works, and everything business owners need to know.
What is Unitranche Debt?
Unitranche debt refers to a mixed loan structure that combines the benefits of senior debt with subordinated debt into a single loan package. The concatenation of highest-priority debt and lower-ranking debt, or first- and second-lien loans, allows unitranche debt to be offered at a mid-range interest rate.
In contrast with traditional loans, unitranche debt allows funds to be drawn from multiple parties, resulting in decreased costs comparative to the impact of sourcing from unaffiliated issuances.
So, what does this mean? Greater fundraising at subsidized costs in a single financing round combined with a faster acquisition under buyout.
In lieu of separate credit agreements, borrowers are governed under a harmonized set of documents outlining senior debt, subordinated debt, and long-term credit. The agreement is managed in the Agreement Among Lenders (AAL), which spells out inter-creditor obligations between the lenders. Importantly, the buyer isn’t party to the AAL document.
Offered at a blended interest rate, unitranche loans are provided at a higher interest rate than senior debt but at a rate that is lower than or equal to second-lien debt.
Unitranche lending first kicked off in 2005 in the U.S. market, later gaining traction in the European leveraged loan market by 2012. European investors were attracted by the opportunity to realize attractive yields at low levels of risk.
Since its inception, unitranche lending agreements incurred low default levels averaging 2 percent. Yet with due diligence on the part of the investor, the annual default rate runs at near-zero. The result? A mutually beneficial arrangement between promising companies seeking capital and savvy lenders.
Though leveraged loans slowed in 2016, unitranche lending upticked significantly in volume by the fourth quarter of 2018 and continued to trend through the second quarter of 2019, where it achieved a record high of $9.2 billion.
Even in periods of market volatility and economic downturn, unitranche financing has remained appealing to both lenders and borrowers, owing to its simplicity of execution and low overhead. For that reason, banks have found themselves less able to compete with non-bank lending sources when it comes to middle-market lending.
How Does Unitranche Debt Work?
As one of the most flexible financing options, unitranche debt can be uniquely structured to best suit the needs of the borrower. The level of risk, and thus the interest rates, vary by how the debt is structured.
When organizing the deal, the borrower must agree to staggered priority levels for repayment if a default occurs. However, the borrower doesn’t have to keep track of disparate repayments; instead, the average cost of debt is issued when the deal is closed.
Unitranche debt is divvied up into separate vehicles dubbed as tranches, which each receive their own class designation. Underwriters help to carefully document and determine the terms, detailing the pay periods, interest rates, seniority, and duration of the agreement.
Lenders identify each tranche through a name determined by the year issued and a letter, making it easier for investors that want to hop on a particular vehicle. While seniority determines how tranches are subdivided, additional provisions, such as call rights, repayment at the principal, and floating versus fixed interest rates can be tagged onto tranches.
Inside a tranche, investors are often divided into two classes: first-out and last-out. The AAL governs the relationship between both categories, outlining the rights of the two sub-tranches and allocating repayments.
Similar to an inter-creditor agreement, the AAL increases the flexibility of debt financing by offering distinct terms for investors in a unified document.
Borrowers should know that there are two primary types of unitranche loans: straight and bifurcated. The first is a senior stretch loan that provides five to six turns of leverage, which describes the borrower’s debt-to-EBITDA leverage ratio.
By contrast, bifurcated loans are sliced into the first-out and last-out loans like those described above, which are more popular in the U.S. Despite their apparent complexity on the lender-side, bifurcated unitranche appears as a single debt vehicle to the borrower.
For more clarity, imagine a hypothetical network of healthcare clinics seeking to expand its influence over the US market. The company may seek unitranche funding to support its acquisition of a competitor clinical care company, thereby effectively supporting a buy-and-build growth strategy. Since unitranche funding is both flexible and extensible, it would aid the company in further solidifying its dominance over the North American market through a unified financing round.
As popular as unitranche financing was pre-2020, the COVID-19 pandemic has further consolidated its outsized influence on the lending market. In the wake of economic fallout, small and mid-sized enterprises were left scrambling for flexible financing options.
As the capital market grows more opaque, it has become untenable for small businesses to leverage already stressed time and resources into coalescing on a financing strategy. First-lien loans are transforming into unitranches that not only offer a higher certainty of closure, but also decrease the burden of juggling disparate investors.
The Advantage of Unitranche Loans for Borrowers
The borrower benefits of unitranche financing are central to its structure.
First and foremost, unitranche lending provides small and mid-sized operations access to capital that simply can’t be organized through traditional lending sources. It’s worthwhile to reiterate that banks are reluctant to lend to new businesses, owing to increased federal regulation after the ’08 financial crisis.
Among other benefits, unitranche financing reinvigorates the stilted debt market, boosts market liquidity, and provides investors with novel investment opportunities. Alternative lenders, such as business development companies (BDCs), are able to offer the high degree of flexibility that borrowers are hungry for.
Since their inception, unitranche loans have only grown in size to fund more extensive buyouts. Greater simplicity and speed of execution have caused a surge in the lending system, which reached a record volume size of $10.7 billion in the last quarter.
For borrowers, unitranche loans are very simple: Since multiple loans are combined into one, the borrower only directly deals with a single lender. The loan is backed by a single set of collateral documents that reduce the number of restrictions the borrower needs to adhere to, in sharp contrast with traditional leveraged financing options.
The amount of legal reports the borrower needs to prepare is paired down too, helping the transaction to close much more quickly. Borrowers are better able to fight for friendly amortization rates, repayment terms, and covenant documentation.
Since a single underwriter authorizes the agreement, the borrower incurs decreased administrative overhead and associated costs. The company won’t have to adhere to the restrictive regulations imposed by traditional financing institutions.
Interested borrowers should note that the interest rate for a unitranche loan tends to be higher than a first-lien loan, yet could result in savings down the line.
Imagine this: a single set of documents, a single lender, and a decreased cost of capital due to the amortization of debt over time. Since the debt is combined into a hybrid loan agreement, more capital is available to the borrower (again, this is in contrast with disparate debt instruments).
Accessing capital doesn’t have to be arduous. Nor does it have to silo company owners into complex agreements with unfavorable stipulations attached. Mid-sized and distressed companies can now break into a borrower-friendly capital market through unitranche lending. And in the age of COVID, securing single-instrument loans has become one vital way for companies to get back on track.
Final Thoughts
During an economic downturn, unitranche financing remains one of the most popular ways that small and middle-market businesses access alternative financing markets. They’ve proven incredibly resilient to market stress, and empower borrowers with some of the most flexible terms in the industry.
In addition, compared to other financing options, unitranche debt offers one of the easiest, speediest, and least regulation-bloated ways for companies to grow. Owing to its simplicity and low overhead, unitranche lending provides long-term savings and less paperwork so business owners can focus on what they do best: running and growing their businesses.