Unitranche facilities: one to watch?

The greater involvement of credit funds in the acquisition finance market over the past three years has led to unitranche facilities becoming a more prominent feature of the European acquisition finance landscape.

What is unitranche?

In the European market, "unitranche" is not yet a term of art as precise as, say, "mezzanine", from which all the key features of a facility can generally be discerned with certainty. Rather, the expression is used generically to describe single tranche term facilities, provided principally by credit funds. Within that broad category, there have been a variety of structures employed, depending on the needs of the particular borrower, the fund origin and the sector concerned. This contrasts with the US market where unitranche is understood more narrowly to mean a term facility which from a borrower's perspective contains only one class of lenders and under which a common interest rate is charged, but in respect of which the lenders have entered into an agreement among themselves as to which of them will have priority claims to proceeds and which allocates interest received on a non-pro rata basis to better reflect the relative risks to lenders. US-style unitranche has been used in the European market but it is just one of the structures captured by the term when used in a European context.

Key features

Although unitranche facilities are becoming an increasingly common product, the market for that product is less well established than for bank-led acquisition financing. Nevertheless, some key common features can be identified:

• the leverage available tends to be higher under a unitranche than would be available for the underlying credit under a traditional senior only structure;
• limited or no amortisation;
• pricing will tend to be higher than a traditional senior debt facility, with unitranche lenders at present looking for a yield (over the first three years) of at least 7 to 12 per cent through a combination of fees, margin (on a margin plus floating rate LIBOR basis) and LIBOR floors; and
• in addition, lenders will typically look for non-call/early prepayment protections for at least the first two years of the facility.

Why unitranche?

Given that a unitranche facility will price higher than a traditional all senior solution, why is a unitranche facility attractive to a borrower?

Needless to say, certain of the key features identified above are attractive to borrowers, such as there being a reduced need to service amortisation during the life of the facility and the higher leverage that may be available (particularly if that higher leverage results in a lower minimum equity requirement or, in a competitive acquisition process, the ability to make a higher offer for the asset in question). In addition, recent unitranche facilities have offered borrowers:

• a more flexible set of maintenance financial covenants than would often be the case under a traditional bank-led structure - traditionally, banks will regularly test total leverage (total debt to EBITDA) and interest cover (EBITDA to finance charges) with tests set at c. 22.5 to 25 per cent of base case projections and cash flow cover (cash flow to debt service) with the test requiring at least a 1:1 ratio. Unitranche facilities can provide greater flexibility - for instance, calculating that suite of financial covenants in a manner that is bespoke to the business in question, or providing more headroom against base case projections or, in a small number of cases, only testing total leverage;
• greater flexibility as to whether excess cash flow (free cash flow after debt service and certain other adjustments) needs to be applied in prepayment - a typical bank-led facility will require a portion of excess cash flow to be applied in prepaying the facility each year whereas credit funds have shown themselves to be more willing to allow that cash to remain in the business, particularly if there is a business case around using it to fund acquisitions or capital expenditure.

Intercreditor considerations

Borrowers could also look to achieve greater leverage on a transaction by obtaining a mezzanine facility in addition to the senior debt. However, this brings the need to negotiate a detailed intercreditor agreement to regulate the position of the lender classes. From a borrower perspective, this increases execution risk and potentially lengthens the transaction timetable. In contrast, a European-style unitranche mitigates that risk and allows the borrower to negotiate with a smaller number of counterparties.

However, that is not to say that unitranche facilities do not present a different range of intercreditor issues. Historically, credit funds have been less able to provide borrowers with revolving working capital facilities (at least on terms which compare favourably with what commercial banks can offer, particularly in terms of the range of ancillary products, such as clearing, overdrafts and derivatives, available under those facilities).

As such, a unitranche facility might be accompanied by a small working capital revolving facility provided by a bank (often the commercial bank with whom the borrower or target business has banked historically and which is keen to maintain a relationship). These revolving facilities tend to be provided on a super senior basis. This means that the rights of this small, but senior, lender class need to be agreed upfront.

While the market position on these rights continues to evolve, broadly speaking these relate to:

• the circumstances in which the revolving facility lenders can take enforcement action independently of the unitranche lenders;
• the protections available to the unitranche lenders in circumstances where an enforcement process is being led by the revolving facility lenders (who are not, per se, motivated to ensure maximum recoveries for the unitranche lenders ranking behind their super senior revolving facility); and
• the circumstances in which the revolving facility lenders have an independent say in amendments to and waivers of the terms on which the revolving and unitranche facilities are provided.

The future

Unitranche facilities are becoming a more prominent feature of the European mid-market. We expect the number of unitranche facilities executed in that market to continue to rise, along with the number of credit funds offering this product. This growth, coming as it does at a time when banks seek to reduce their balance sheets, will mean unitranche facilities will remain a common feature of the European financing landscape.

Please click on the links below for the other articles in this issue of Credit Funds Insight.

• CLO update: EBA publishes Final Draft RTS on Securitisation Risk Retention
• AIFMD: frequently asked questions
• Investment in credit funds by French insurance companies (and similar institutions)
• Securitisation vehicles subject to AIFM Law in Luxembourg