Overview
Unitranche financing is an alternative financing structure to the traditional senior/subordinate debt financing arrangement. It has gained broader recognition in small and middle-sized loan markets in both the U.S and the Europe. The basic idea of unitranche financing is to combine senior and subordinate debts within a single debt instrument with one single blended interest rate. By doing so, unitranche financing increases the flexibility of debt financing terms, thereby increasing access to capital for companies and stimulating growth in small and middle-sized loan markets. Lenders are increasingly recognizing the potential benefits to this unique financing structure. Unitranche financing may, among other things, increase market liquidity, bring new energy to a rather conservative debt market, and satisfy lenders' appetite for new investment opportunities.
Unitranche financing is not, however, without risk. Although it can make lending more efficient, unitranche financing has created new problems in dealing with the agreements among lenders. It likewise creates potential issues if the borrower files for bankruptcy. This article will introduce the mechanism of unitranche financing and the terms of an agreement among lenders, which makes the unitranche financing possible. This article will also discuss the benefits of unitranche financing, as well as why it is growing in popularity in small and middle-sized loan markets. Finally, this article will analyze the potential problems that emerge from the unitranche financing structure, using two bankruptcy cases as examples.
Basic Structure of a Unitranche Deal
Unitranche financing changes a company's debt financing structure. With a traditional senior/subordinate debt structure, a company has several tranches of debt and corresponding creditors. Each tranche holds its own credit agreement with the company. Covenants in those agreements can be dramatically different. Creditors from different tranches may enter into different intercreditor agreements with each other. These intercreditor agreements govern a variety of issues among the creditor classes, including when and how subordinate creditors may recover shared collateral.
Unitranche financing simplifies this multi-tranche, multi-agreement structure. In a unitranche financing structure, the company/borrower will have only one tranche of creditors. The rights of various creditors and the company are set forth in a single debt instrument. The instrument will define the amount of the loan, the interest rate, and other covenants applicable to all creditors in that single tranche of debt.
Inside this single tranche, creditors can be further divided into two classes: a first-out tranche, and last-out tranche. The relationship between the first-out tranche and the last out tranche is governed by an agreement called "Agreement Among Lenders" (AAL). The company/borrower may not even know the terms or the existence of an AAL. The AAL allocates repayments between the two tranches of creditors disproportionately and determines respective rights of the two tranches. As unitranche financing is growing more sophisticated, there could be more than two tranches under an AAL, and the allocation will be further complicated.
Terms in an Agreement Among Lenders
An AAL is similar to an intercreditor agreement used under senior/subordinate debt financing structure. Although its terms can be flexible and dramatically different, a typical AAL will most likely address the following issues:
- Payments allocation
- This term decides the recipient, the order, and the amount of repayments. Most AALs will address events that trigger the waterfall payment among different tranches of creditors. "Waterfall triggering events" are similar to default events, such as a bankruptcy filing, deferring of payment, or violation of a covenant. Absent a waterfall triggering event, lenders from both the first-out tranche and the last-out tranche will share the payments pro rata, according to the different yields that different tranches agreed upon. Usually the first-out tranche shares the payments at a yield lower than the blended rate offered to the company/borrower, and the last-out tranche gets the payment with a yield higher than the blended rate. Upon a waterfall triggering event, the first-out tranche has the priority to recover from all of the collateral and other remedies, and the last-out tranche will not be able to recover from the same collateral and remedies until the first-out tranche is paid in full.
- Voting rights
- Lenders will have the right to vote on whether to amend the credit agreement and on other issues regarding the covenants of the creditor agreements. They will also have the right to appoint and direct the administrative and collateral agents. An AAL may allow certain last-out tranche creditors to vote on how to execute remedies against the company/borrower to protect the interests of the last-out tranche creditors upon a default event. However, there is no standard term for how to allocate voting rights among different tranches of creditors.
- Buy-out option
- An AAL may also contain a buy-out option. This is generally offered to the last-out tranche for the purpose of giving some control to the last-out tranche over recovery of the collateral. If a buy-out option is triggered, the lender could buy out all interests of the creditors in the first-out tranche. The events that could trigger the option are similar to the events that trigger the waterfall payment.
- Right of first refusal
- The identity of the parties to the AAL is important. In most situations, consistency in the identity of the members will mitigate demands to amend or change the terms of either the credit agreement or the AAL. Therefore, in an AAL, the lenders from both tranches may agree under the right of first refusal term that the lender who wants to transfer or sell its interest under AAL must offer its interests to the members within the unitranche deal before offering it to a third party. This term is also common in an AAL.
Benefits of Unitranche Financing
Two main reasons are frequently cited to explain the growing popularity of unitranche financing in small and middle-sized loan markets, despite the fact that the blended rate is usually higher than the interest rates of a traditional senior lien.1 First, it reduces the administrative and transaction costs for both the company/borrower and the lenders. Second, it satisfies the needs of the lenders in small and middle-sized loan markets. A unitranche deal is very flexible in terms of both the credit agreement with the company/borrower and the AAL.
- Cost-efficient structure
- Unitranche financing simplifies the negotiation and the documentation procedure, thereby reducing the transaction cost for both the company/borrower and the lenders. The traditional senior debt/subordinate debt structure requires the company to negotiate separately with its senior creditors and junior creditors regarding their respective covenants. Senior creditors will worry that the company may give a better deal to a new tranche of creditors while junior creditors will demand better protection against senior creditors when things go sour. There will be different covenants in those indentures, and the company has to make sure that it does not promise something to one tranche that it already gave to another tranche.
- With unitranche financing, the company only needs to negotiate a single set of terms and covenants. The company will spend less time and effort closing a deal and will make more streamlined decisions because it does not have to worry about the conflicts among different tranches of creditors. The company will also save time looking for new lenders. Additionally, the company will have a lower administrative cost because there will be only one administrative agent and collateral agent in administering the instrument.
- Satisfy the needs of small and middle loan markets
- A company in a small or middle-sized loan market can have trouble getting senior loans from a bank because its financial situation is not as stable as that of large companies. This is especially the case after the 2008 financial crisis. Restrictive regulations tie the hands of loan banks in their underwriting policies. Unitranche financing can increase the chances for a company to secure a debt financing that may not be possible under a traditional multi-tranche financing structure. Smaller lenders and private equity groups are the main participants in small or middle loan markets. They have different needs and are less concerned about the "market standard" of a deal. Unitranche financing gathers these lenders together to negotiate and come up with an arm's-length deal without being restricted to some customary practice. Those lenders together could offer a large amount of senior loan to a company. This will increase the creativity and flexibility of the deal and better meet the needs of those lenders.
Bankruptcy Issues Related to Unitranche Financing
Because many unitranche financing structures are increasing in complexity, the consequences of a borrower's bankruptcy filing are somewhat uncertain. Each tranche of creditors under the unitranche structure will have to figure out its relationship with the administrative agent, with the debtor, and with each other. For example, should the creditors in the last-out tranche be treated like unsecured creditors or secured creditors? How should unitranche creditors file proof of claims? Is the AAL admissible and enforceable in the bankruptcy case?
As previously noted, the company/borrower in a unitranche deal, which would be the bankruptcy filer, is not a party of the AAL. It can be unclear whether the company/borrower has an interest in the AAL. That raises the question of whether a bankruptcy court should enforce an agreement merely among those creditors. Section 510(a) of the Bankruptcy Code addresses the court's ability to enforce a subordination agreement, but it does not mention whether the debtor should be a party to that agreement. Also, as the court explained inIn re American Roads LLC, bankruptcy courts have upheld inter-creditor agreements in prior cases, but different considerations may come into focus with an AAL.2 Moreover, in In re RadioShack Corp. No. 15-10197 (Bankr. D. Del.), the Delaware Bankruptcy Court faced the issue of whether to enforce the AAL in resolving a dispute regarding the term loan AAL and the asset-based loan AAL in the context of an asset sale under section 363 of the bankruptcy code. After a four-day hearing, the court actually construed and enforced the AAL provisions and approved the sale.3 Although the two cases suggest that courts may be willing to uphold an AAL, creditors should still consider the possible complications when entering into a unitranche deal.
Conclusion
Unitranche financing is earning a wider acceptance. In the future, there will likely be more companies entering into a unitranche deal. Corporate counsel would benefit from keeping track of developments in unitranche financing methods, the pricing of such deals, and best practices in drafting the related agreements. It is also important to be aware of how a bankruptcy court may handle a Chapter 11 bankruptcy case that involves a unitranche deal.