Middle-market spotlight: Unitranche debt blooms in choppy market

In opting for unitranche debt, private equity firm Brentwood Associates went for the sure thing in last week’s dividend recapitalization of The Teaching Company, a for-profit secondary-education company based in Chantilly, Va. Brentwood tapped the Senior Secured Loan Program, a joint venture between Ares Capital and GE Capital, for $170 million of unitranche debt to back the recapitalization.

The road for dividend recaps has been bumpy lately. Several deals were scotched in the first quarter, and Grede Holdings and Spitzer Industries pulled their efforts last week after failing to hammer out agreeable terms with investors. Spitzer launched on Feb. 10, while Grede spent only two weeks in market before throwing in the towel.

By going the unitranche route, Brentwood sidestepped the headaches of syndication in a choppy market. The elimination of execution risk is the product’s biggest appeal to sponsors, especially in times of rattled markets. Unitranche lenders guarantee the entire financing amount. They also can turn around closing in roughly two to three weeks, versus a syndication period of 4-6 weeks for traditional senior loans. There’s one credit agreement and no dickering between senior and subordinated lenders.

When sponsors rushed to close deals last year ahead of potential tax changes, the Senior Secured Loan Program had one of its best years ever. The program closed $2 billion of loans for 13 deals, more than doubling the number of issuers in the portfolio to 22, according to Timothy Lyne, a senior managing director who oversees investments in the fund. The Senior Secured Loan Program was formed in December 2007 with about $3.6 billion of committed capital.

Of course, convenience comes with a premium. Brentwood did not disclose terms of the financing, and Lyne would not comment on specifics of that transaction. However, he said unitranche debt typically can command a premium of 50-100 bps over traditional senior financings, depending on market conditions. More-volatile markets will require higher premiums, while frothy conditions bring tighter pricing. Closing costs run about the same, Lyne said.

Prior to Spitzer’s cancellation, Credit Suisse shopped the company’s traditional senior loan at a revised 7.23% yield (L+525/1.5% floor/98.5). Even then, investors wouldn’t bite, and financial sponsor Stephens Group walked away.

Thoma Bravo collected a dividend from Vision Solutions this month but spent weeks in market revising terms, for a final blended rate of 7.3%, with a $240 million first-lien term loan at a 6% yield (L+450, 1.5%, 99) and a $90 million second-lien term loan at 9.85% (L+800, 1.5% floor, 99).

Market sources point out that while the initial outlay may be more expensive, the cost of unitranche debt over time is not as pricey as some think. It is structured as a single amortizing term loan, and that keeps the weighted average cost of capital constant over time. In a traditional senior/junior split structure, the weighted average cost increases over time, since senior debt amortizes and junior debt does not.

Unitranche pricing is set in stone at the time of closing – there’s no flex language in the loan agreement, which is great when a fluctuating market is shifting toward higher rates, but not so much when prices are trending lower.

The field of unitranche underwriters is limited. The most well known in the middle market include the Ares/GE venture, Golub Capital, Ableco Finance, Barclays Private Credit Partners and newcomer NXT Capital, which partnered with Ares to provide $143 million in unitranche debt to back a bid for Hooters of America by Wellspring Capital Management.

Allied Capital was one of the first finance companies to offer the product in the mid-2000s, and the firm was purchased by Ares about two years ago. A couple of Chicago-based lenders are considering adding the product to their lineup but have yet to make a move.

The Senior Secured Loan Program can hold up to $300 million per transaction, with GE providing a revolver on top of that amount, while Golub Capital can hold up to $100 million, according to sources.

At this point, unitranche debt usually competes against other capital structures, not other unitranche lenders, Lyne says. In addition to a split senior/junior debt deal, arrangers can offer senior stretch loans that stretch leverage by replacing a portion of junior financing. Unitranche underwriters can one-up that offer by going deeper into the capital structure by replacing all junior debt. Typically, senior stretch loans only stretch by a quarter to three-quarters of a turn, depending on the deal. Senior stretch loans also are syndicated and therefore are subject to execution risk.

The product is trying to lure business away from the mezzanine market, but does not yet pose a major threat. Mezzanine remains a firm staple of middle market financing: it’s widely available, it is unsecured, and it offers looser financial covenants than senior secured debt, unitranche or otherwise.

Moreover, in times of default, a borrower can conserve cash by having the ability to shut off payments to mezzanine holders. Asks one mezzanine banker: How many senior lenders are willing to forgo interest payments? – Kelly Thompson

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