NEW YORK (Reuters) - Middle market sponsors in the US and Europe are demanding bigger unitranche loans as the structure, which has typically been used for smaller deals, gains wider appeal due to challenging market conditions for second-lien loans in the US and heightened competition in Europe.
The unitranche structure combines senior and subordinated debt into one credit instrument, provided to the borrower at a blended cost of capital. On average the facilities typically yield approximately 8%-9%.
The structure is prized by investors for its rich yields and favored by sponsors for its ease of execution and certainty of funding when markets turn volatile.
Earlier this month, GSO Capital Partners completed a whopping €625m unitranche financing, the largest ever in Europe. In the US, middle market lenders report seeing a handful of US$200m-$300m unitranche loans in market, while one lender said there is a roughly US$400m unitranche being lined up.
The €625m unitranche loan backed the merger of Investindustrial-owned Italian chemicals company Polynt and its US peer Reichhold. A source close to the deal said around €300m-€400m was contributed from GSO’s senior debt fund and the rest came from limited partners and co-investors.
The size of the unitranche – which was provided in dollars and euros – shows that larger direct lenders’ firepower can reach the upper end of the market.
“We’re in a strange market at the moment where mid-market deals, despite being smaller companies, are priced at a material discount to larger syndicated loans,” said Callum Bell, head of corporate and acquisition finance at Investec. “So by increasingly focusing on larger deals, funds are likely getting better risk adjusted returns at the moment as well as solving their deployment issues.”
Direct lending funds face “deployment issues” due to increased competition from banks and fewer deals in the mid-market space in Europe.
Only eight unitranche deals were signed in Europe during the first quarter, according to Thomson Reuters LPC data, which is a 69.2% drop year-on-year from 26 in the first quarter of 2015.
This is partly due to a drop-off in M&A activity, Bell said, but also due to a resurgent bank market which is offering better pricing and comparable leverage on club deals or club-style syndications.
“You’ve got unitranche guys feeling under pressure – not enough deals to do in their core heartland because the banks are competing, not much dealflow, [and] adverse selection,” said a senior direct lender.
“[They are] looking to stretch upwards in terms of the size of the deal and they can do that in the short term because you’ve got a slightly dislocated liquid loan new issue market.”
However, large unitranches could be a “short term phenomenon”, the direct lender argued, depending on the health of the syndicated market and banks’ underwriting appetite and flex terms.
Direct lending funds are also stretching leverage on unitranches for smaller companies with less than €15m Ebitda and working with tougher credits, he said, as the “hunting ground” thins in the mid-market.
In the US, unitranche deals have yet to reach the size of the Polynt/Reichhold deal. Since the beginning of last year, the vast majority of unitranche deals have run between US$100m and US$300m while averaging about US$175m with the largest unitranche deals reaching US$400m-$450m.
Unitranche has gained a significant share in the middle market arena as alternative debt capital providers and direct lending platforms have increased their presence, and sponsors have recently been requesting even larger deals since global volatility roiled the market in 2015 and early 2016. Tumbling oil prices, slowing economic growth in China and flat-to-weak corporate earnings in the US sapped demand for risk – in particular for junior capital – among loan investors, including CLO funds, the largest buyers of leveraged loans.
Jittery investors pulled back from the second-lien market, virtually shutting it down to syndication. This left private equity sponsors and issuers with the option of going to alternative lenders to privately place the second-lien debt, but borrowers found lenders more interested in unitranche, which gives them a bit more control over the structure.
“As the market contracted, equity sponsors were trying to privately place second-lien structure but got feedback from the alternative lenders that they were actually more interested in arranging unitranches so they could structure the overall yield properly,” said Stefanie Birkmann, a finance partner at Ropes & Gray.
The alternative lenders, which include the credit arms of private equity firms and hedge funds, have largely stepped up to offer this product as the traditional second-lien buyer, CLOs, pulled away. This dynamic is shifting slightly as the secondary market has climbed steadily since the end of February, but the principle remains at least for now.
“The CLO bid is pretty depressed right now, as a result the unitranche execution is coming into favor,” said a middle market lender. “With the unitranche, sponsors can tap a range of bids that are more yield-oriented instead of just the CLO bid.”
Market participants in the US expect unitranche to remain a big part of the lending landscape, especially for middle market deals, but it may pull back for larger deals as the syndication market opens up to second-lien deals again.
Borrowers that are big enough to warrant lining up more than US$500m of debt are often planning to grow and want room for incremental capacity for future acquisitions, sources said. This is more difficult to arrange with a unitranche structure.
From a lender’s perspective, it becomes difficult for a single entity to lend with large deals, and the lead lender may have difficulty ceding some control of the deal to additional lenders.
However, one lender said that there are at least half a dozen lenders or alternative capital providers that are willing to take more than US$100m on a given deal, making it possible to club a sizable unitranche loan.
Reporting by Jonathan Schwarzberg, Leela Parker Deo and Hannah Brenton; Editing By Chris Mangham and Michelle Sierra
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