What is Unitranche Debt?

What is Unitranche Debt?

Unitranche debt or financing represents a hybrid loan structure that combines senior debt and subordinated debt into one loan, allowing banks to compete better against private debt funds. The borrower of this kind of debt typically pays an interest rate that falls in between the interest rates that each type of loan would command individually.

Unitranche debt is typically used in institutional funding deals. It lets the borrower get funding from multiple parties, which can result in decreased costs from multiple issuances, allow for greater fundraising through a single deal process, and facilitate a faster acquisition in a buyout.

Unitranche debt is a hybrid model combining different loans into one, with an interest rate for the borrower that sits in between the highest and lowest rate on the individual loans.

Unitranche debt is commonly used in institutional funding deals as it allows the borrower to access the funds of multiple parties and potentially close the deal faster.

Unitranche debt is comparable to syndicated debt, as both types of loans are structured under an agreement that provides an average cost of debt to the issuer.

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.

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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.

Characteristics of Unitranche Debts

The following are the key characteristics of unitranche debts:

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1. Single Loan Agreement

Unitranche financing involves a single credit agreement and requires one set of collateral documents. It reduces the amount of documentation and paperwork that borrowers need to comply with before they can access funds. Traditional leveraged financing like junior, mezzanine, and senior debt require separate documentation, plus borrowers will have to comply with different covenant packages in each debt.

This means that for a borrower to qualify for a single debt, they have to fill out several documents, which takes both time and effort. The only instance when a borrower may be required to fill out more than one document in a unitranche debt is when there is a revolving credit facility that needs a separate loan agreement.

2. Call Protection

A unitranche lender may seek non-call/early prepayment protection for the first 12 to 24 months of the loan’s life. The prepayment fees and the length of the non-call period vary from one market to another but are negotiated before reaching a final agreement.

Most lenders include a “make-whole” provision in the credit agreement for the first two years so that any interest and fees that are due during this period can be paid alongside the other prepayment amounts. In the absence of this provision, some lenders may charge an extra 1%-2% on top of the prepayment amount.

3. Maturity and Bullet Repayment

A unitranche debt comes with a single interest rate and maturity term, which is usually between five and seven years. Unitranche financing usually requires a one-time lump-sum repayment of the entire loan at maturity.

4. Benefits to the Borrower

One of the benefits of unitranche financing is its simplicity, compared to traditional credit facilities. Borrowers only go through a single process of approval and prepare one set of documents for the lenders. Also, taking on a single debt instrument that is a combination of two types of debts reduces the number of legal reports that the borrower would be required to prepare. Due to this simplicity, borrowers are willing to pay a premium fee above what they would have paid to a traditional financial institution.

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When dealing with a time-sensitive transaction, unitranche financing gives the borrower the advantage of dealing with a single lender, and this helps to close the transaction quickly. This is unlike traditional credit loans where a borrower needs to deal with different lenders and provide several legal documents.

Since the borrower is dealing with a single lender, he can negotiate for flexible covenant documentation, amortization rates, and prepayment terms. Also, the borrower will incur lower administrative costs since only one administrative agent is authorizing the debt instrument.

In addition, unitranche financing allows small and medium-sized companies to access financing that would be impossible to get from a bank. Usually, most banks impose restrictive regulations that disadvantage small borrowers who are not as stable as large companies.

Unitranche financing gathers these lenders together to negotiate and come up with favorable terms that do not restrict small borrowers. When these senior lenders agree to the deal, they can offer a significant amount of senior debt and earn high interest in the long run.

Similarities between Unitranche Debt and Equity

Unitranche financing possesses a few characteristics that are similar to equity financing due to some of the contractual features contained in a unitranche agreement. One of the similarities between these two forms of financing is the comparability to shareholders.

Just like shareholders, the goal of unitranche financing is to provide capital for long-term financing. It offers the benefit of ensuring efficient decision-making during the loan period and also in negotiating the debt agreement.

In equity financing, investors participate in the decision-making process and are entitled to be informed of the company’s future plans. If the company decides to liquidate, shareholders are entitled to receive a share of the company after secured creditors are paid.

Similarly, unitranche providers request shares in the borrower’s company with the aim of gaining control over the company should an enforcement event occur. The lender also sends advisors to the borrower to provide market knowledge on strategic matters.