October 9, 2018 / 3:29 PM / a year ago

RPT-‘Unitranche killer’ hits Europe’s middle market

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By David Brooke

LONDON, Oct 9 (LPC) - Banks are partnering with alternative lenders that can offer riskier Payment In Kind (PIK) loans to smaller European companies as they battle to protect their middle market lending businesses from private debt funds.

European commercial banks which arrange senior loans have been losing business to alternative lenders which are able to offer unitranche loans with higher leverage.

Unitranche loans combine senior and subordinated tranches of debt into a single loan at a blended cost.

Investment firm Pemberton is working with banks to offer holding company (holdco) PIK loans in addition to senior bank loans, which raises leverage on the overall financing package.

This allows banks to compete directly against private debt funds and retain business they would otherwise have lost.

“It (holdco PIK) is a unitranche killer. A bank is lending to a really good company for 15 years at 3 times leverage and a 3.5% margin, but if they want to get to 4.5 times then they can bring in a holdco PIK to bridge that gap.” said Ben Gulliver, a partner at Pemberton.

Some market participants are alarmed, however, that the extension of PIK loans to smaller middle market companies is another sign of an overheating leveraged loan market.

The deeply subordinated instrument allows borrowers to pay interest with additional debt rather than cash and has previously been reserved for larger, more liquid companies.

“The return of PIK to the market is the high watermark in financial engineering. It’s the next stage in a bull market,” a banker said.


PIK loans have no interest or payments until they are repaid at maturity. Adding a holding company PIK loan is attractive for borrowers as it halves cash interest payments, saving around 100bp, Pemberton said.

Alternative lenders are set to overtake banks as the majority provider of leveraged loans for UK middle market companies, according to AlixPartners.

Funds worked on 46% of all sponsored UK middle market loans in the first half of this year and non-bank lenders also account for an increasingly large chunk of Continental deals, particularly in France and Germany, the research company said.

As a PIK loan provider, Pemberton is restricting companies’ ability to raise additional debt on deals to maintain a second claim over assets.

Although the product is in its infancy, the investment firm is confident that holdco PIK loans will prove popular with private equity firms.

“Unitranche isn’t going away, but as institutions become more familiar with the (holdco PIK) product then people will see the greater flexibility and it will become more attractive to sponsors,” Gulliver said.

Although some lenders see the benefits, others remain wary of holdco PIK loans which require strong legal protection to pre-empt any potential intercreditor issues in a default, at a time when leveraged loan documentation is being weakened.

“There is still a risk that this PIK piece is a thin piece of the capital structure that is at risk of being left stranded between the banks and the equity without much protection or ability to act in a downside,” a fund manager said.

“On that basis it seems underpriced,” he added.


Banks and private debt funds traditionally worked together on conventional unitranche loans, with banks providing revolving credits and funds providing the term loans.

Some private debt funds are finding new ways of partnering with banks to offer cheaper middle market loans by selling a ‘first out’ piece of the term loan to banks in addition to the revolving credit.

Funds lending term loans at around 700bp are offering banks a ‘first out’ piece of the term loan with lower leverage and pricing of around 300bp.

This reduces the blended price of the loan for the borrower, helps funds to hit ambitious return targets and boosts banks’ income while strengthening client and sponsor relationships.

In a first out structure, banks are super senior lenders while funds have second claim over assets, unlike conventional unitranche loans where funds are senior lenders.

“A bank doing a super senior structure can be rational, but where do funds draw the line? At 2 times or 2.5 times (bank leverage) funds’ debt takes on more of a mezzanine flavour,” said said Andrew McCullagh, a managing director at Hayfin.

The return of a repayment hierarchy is similar to older middle market loans structures with separate senior and mezzanine tranches. Mezzanine loans were once common in middle market lending, but have fallen out of favour in recent years.

“The unitranche product was designed to specifically to take away a senior-mezzanine structure. Now it’s recreating that structure to get to that return point. There is an irony in there,” said McCullagh. (Editing by Tessa Walsh)

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