For years, the market has enjoyed low interest rates. Capital has been very cheap, which has been good for loan-making banks. It’s also prompted nonbank financial institutions — credit and hedge funds, business development companies — to enter the lending game.
Shielded by the regulations that govern banks, nonbank financial institutions are bolstering debt multiples for companies looking to go all-in on transformational purchases through a product called unitranche debt. This solution links lenders behind the scenes to offer borrowers a single loan rather than multiple loans within a capital structure. It’s targeting the middle market, giving companies in this class a lot more capital to put to work, but only when the situation calls for it.
“Unitranche is not a solution for every borrower or every situation,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank. “It’s on the spectrum of solutions for middle-market borrowers.”
Smart Business spoke with Altman about unitranche debt — what it is, when it’s used and what to look for from a lender.
How does unitranche debt work?
In a unitranche structure, there are senior lenders, often a bank, and subordinate junior lenders, usually nonbank financial institutions, that partner together in a capital structure. The bank provides the working capital solution while the nonbank or bank provides the necessary term debt (senior and junior combination). The multiple capital providers are unified in a debt arrangement with a borrower under one credit agreement, one payment schedule and one interest rate, but can offer many times the debt of a single provider.
While the structure provides more leverage than borrowers can get with a bank alone, it also gives borrowers the same protections they get when borrowing from a bank. And speed of transaction is improved because the structure inherently reduces the number of decision-makers in the process.
How is unitranche debt used?
It has been and remains an attractive and prevalent financial structure within the middle market. As the managers of early unitranche funds have shown that they can effectively manage a middle-market credit portfolio, their funds are getting larger and moving upmarket — whereas unitranche loans had been commonly sized at $25 million to $50 million, it’s now common to find structures of $50 million to $100 million plus.
Unitranche debt is often used for large acquisitions for which maximum leverage is required. These are typically transformative acquisitions that require the acquirer to put forth the highest possible bid.
What should borrowers know about unitranche debt before taking it on?
In a unitranche structure, borrowers have credit documents with a single lender, but they don’t necessarily know what’s going on with the subordinate lenders behind the scenes. There is the risk that the unitranche will close on its entire capital structure and break into pieces without the borrower having any insight. Also, one of the lenders in the unitranche could get bought or decide it doesn’t want to lend in that industry, which might disrupt the agreement. It’s important to have good counsel in place to help mitigate risk in a unitranche deal.
Also, while banks are relationship lenders, unitranche debt arrangements are primarily credit driven, so any considerations that might be made based on a long-standing relationship and the good faith it’s created between the lender and borrower typically doesn’t carry much weight.
It’s prudent to note that it remains to be seen how unitranche structures perform in a distressed credit market. There’s limited precedent for these scenarios.
Otherwise, credit issues are credit issues, regardless of the structure. Failure to make payments and covenant violations will disrupt a unitranche borrowing agreement like it would any lending agreement.
What should borrowers look for in a lender?
The starting point to determine the best debt product for the situation is with a banker. Businesses should discuss their plans and work with their banker to determine the best options. If unitranche debt is the right fit, it’s the banker who will find the best nonbank partners to help with the deal.
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