What’s the deal with unitranche loans and why does private equity like them so much? Private equity is constantly on the look for innovative financing solutions to make their lives easier and eek out a couple more basis points of returns. Unitranche loans can help with those goals and have emerged as a popular choice for firms looking to lever lever up. Let’s take a look at what they are and why they’re taking PE by storm.
Unitranche Loans Explained
The good thing with unitranche loans is that they’re super easy to understand – it’s a unique form of debt financing that combines both senior and subordinated loans into a single credit facility. That means replacement of multiple tranches of debt with one tranche, hence the name. These loans have becoming increasingly popular amongst private equity firms because they simplify the borrowing process and offer a flexible alternative to traditional lending structures.
Unitranche’s Transition to Prominence
Originally introduced as a niche offering in the mid-2000s, unitranche loans became more popular following the 2008 financial crisis. The increased regulations on banks fueled the need for alternative financing options in the private equity sector, leading to the growth of direct lenders and private credit.
Rather than working with an investment bank to syndicate out a loan in pieces to a bunch of different debtholders (the traditional route for PE financing), direct lenders will instead hold the entire loan themselves over the life of the deal. This allows private equity to engage and negotiate with one party, instead of the entire syndicate (which, no surprise, can be much more time consuming).
Direct lenders, in turn, have adopted unitranche loans as a preferred choice for many deals. Previous use of multi-tranche loans historically allowed lenders to determine who gets repaid first, or at all, in the event of bankruptcy. The more senior the tranche, the higher the likelihood of getting repaid.
With direct lenders now emerging as the sole debtholder, there’s no longer as much of a need to segment the debt by seniority. This eliminates a ton of complexity that was inherent in multi-tranche deals.
Now, as unitranche financings become more widespread, lenders have been able to take down larger and larger deals. Unitranche loans had previously been reserved for only smaller middle market deals, but are now making a play for some of the largest LBOs coming to market.
Part of this is due to the growth in private credit, with the late 2010s low rate environment driving a “thirst for yield” that lead to huge asset inflows.
As for the other part — with big deals, occasionally direct lenders will group up and complete what’s called a “club” deal. A small group of lenders will each take a portion of the loan, allowing greater total committed capital than would be possible with a single lender.
Comparison to Other Debt Financing Options
Unitranche loans stand out from other private equity debt financing options, like senior and mezzanine loans, by combining the features of both into a single debt instrument. This simplifies the capital structure and allows for faster execution and efficient pricing, making it an attractive option for private equity firms.
Senior loans rank higher in priority and generally have lower interest rates than mezzanine loans, which are subordinated and carry higher risk premiums (to compensate lenders for the lower likelihood of being repaid if things go South). Unitranche loans offer a blended interest rate falling between the two, providing a balanced cost of capital for private equity firms.
Here’s a comparison table that outlines the differences between unitranche loans and other types of private equity debt financing options:
Benefits of Unitranche Loans for Private Equity
Unitranche loans offer several advantages for private equity firms, including speed, simplicity, and flexibility. The streamlined negotiation process with a single lender allows for faster deal execution, making it ideal for time-sensitive transactions (which is pretty much every deal).
Moreover, the simplified capital structure eliminates the need for intercreditor agreements, reducing the complexity and associated legal costs. The flexibility of unitranche loans also allows private equity firms to tailor repayment terms, covenants, and other loan features to suit their specific needs and investment strategies.
Also important is the ongoing relationship with the lender. Syndicated deals are conducted at arm’s length and have less interaction between private equity and the debtholders. Now, there’s ongoing dialogue.
This can be helpful in situations where you need additional financing for an add-on or you need to work through a potential covenant breach. For the latter, you’re much more likely to find a workable solution with a direct lender, as both parties want to preserve the relationship and work together on future deals.
The Future of Unitranche Facilities in Private Equity
As the private credit market continues to grow, unitranche loans are expected to continue to take market share. The ongoing demand for alternative and flexible financing options, combined with the benefits unitranche loans offer, make it a no-brainer for PE to use them, when able.
Additionally, the increasing competition among direct lenders is likely to drive down pricing, eventually reaching parity with syndicated deals (that had historically been cheaper), thereby providing ease of use at a highly competitive cost.