Second-lien loans, with their bargain-basement interest rates, stole the hearts of mid-market sponsors in the early and middle part of the decade. Expensive mezzanine loans? Those were for suckers. But then came the credit crunch, and suddenly the hedge funds, business development companies and collaterialized loan obligation managers that supplied second-lien loans didn’t seem like the greatest partners to have. If you needed quick approvals on add-on aquisitions, or a little breathing room on some covenants, you might be out of luck.
Now, deep-pocketed mezzanine firms are getting phone calls again. Although the high-yield debt with an equity kicker remains expensive, sponsors appreciate that many mezzanine firms have long track records in the business, and that, as equity holders, they tend to be more supportive when it comes to add-ons and workout situations. Buyout shops have also taken a fancy to one-stop-shop sources of both senior and junior financing—again, in large measure because it means working with a single, friendly debt provider. And, if that isn’t simple enough, today borrowers even have the option of taking out a so-called unitranche loan. With these, borrowers pay a blended interest rate, calculated as a weighted average of the senior and subordinated debt rates. Perhaps the best-known unitranche provider is the newly raised $3.6 billion “Unitranche Fund” co-managed by GE Commercial Finance and Allied Capital.
“People are trying to minimize the headaches associated with multiple lenders,” said Ivan Zinn, founder of Atalaya Capital, a New York-based hedge fund that often invests in senior secured loans. “One-lien structures are easier and more seamless.”
For sponsors, going with suppliers of mezzanine financing, one-stop-shop loans and unitranche loans offers ease, speed and certainty of close—all coveted qualities in a credit crunch. But bear in mind that such loans do have their pitfalls. For one thing, they often prove more expensive than second-lien debt. And sponsors need to guard against hidden complexities, such as intercreditor agreements signed behind the scenes that could affect the ease of financing an add-on, amending a covenant, or refinancing out of a jam.
The Second-Lien Age
Ah, the good old days when the cheapness of second-lien debt reigned supreme.
Pre-credit crunch, sponsors could secure second-lien debt for interest rates as low as LIBOR plus 4 percent. In the first half of 2007, lenders issued $2.65 billion worth of second-lien loans to finance mid-market deals, according to Reuters Loan Pricing. That was up significantly from 2006, when just $204 million in seond-lien debt was issued to finance mid-market deals.
Today, second-lien loans are far less attractive. Interest rates can reach as high as LIBOR plus 10 percent. Meantime, that the loans come from a variety of lenders with varying motivations and funding abilities has created some problems for borrowers, according to Stephen Boyko, partner in the Boston office of law firm Proskauer Rose. Many of the suppliers are in financial trouble themselves, making them far less amenable to requests for additional financing, or for breathing room on payment terms. It’s also unclear how second-lien lenders will behave when it comes to actual defaults. Complex intercreditor agreements signed between the second-lien and first-lien lenders are supposed to keep second-lien lenders relatively docile; but the agreements have yet to be fully tested in the courts, and it’s tough to know how lenders will behave in workout situations.
Ronald Kahn, a managing director at mid-market investment bank Lincoln International, added that “more and more senior lenders realized it was crazy to have second-lien money in their capital structures—the inter-creditor agreement didn’t make sense.” Indeed, both lenders and sponsors have clearly migrated away from second lien loans. Issuance fell to $1.07 billion for mid-market deals in the second half of 2007, and to just $32 million in the first quarter of 2008, according to Reuters Loan Pricing.
Meantime, if fundraising activity is any indication, mezzanine lenders have rushed to fill the vacuum left by second-lien financing. Veterans and rookies alike have flooded the market with prospectuses, ready to compete with second-lien loans. Established mezzanine providers like New York Life Capital Partners, TCW/Crescent Mezzanine Partners, Caltius Mezzanine, Carlyle Mezzanine and Norwest Equity Partners have all raised new pools of capital in recent months. Meanwhile, firms like Marathon Asset Management and JPMorgan’s High Bridge Capital have entered the space for the first time. The past quarter saw $20.5 billion in fundraising dollars go to mezzanine funds, which is four times more than was raised in all of 2007.
As for pricing, mezzanine firms are charging interest rates of between 12 percent and 14 percent, not including an equity kicker in the form of warrants or co-invesments that increase the cost to the borrower, said Boyko. At face value, pricing is nearly comparable to that of second-lien loans. Another attraction for sponsors: In securing mezzanine finance, they will typically work with one to three lenders, not the upwards of 10 to 15 parties that could easily be involved in providing a second-lien facility. Using mezzanine not only simplifies documentation, but increases the certainty of close, with approvals from fewer parties needed. And with fewer parties involved, it’s easier for sponsors to get permission for add-ons in the future.
In the past two weeks, deals like Ohio-based
Unitranche lending was introduced in early 2005 by
Other lenders are now offering similar products, in which a borrower pays a single interest rate to one debt supplier. It’s a floating rate, typically in the LIBOR plus 5.5 percent to LIBOR plus 7.5 percent range, as well as a blended rate that lies between that of senior and unsecured loans. The lender has no obligation to disclose the breakdown of the loan’s debt, which occurs behind what some call the “unitranche curtain.” The sponsor is under no obligation to help work out the intercreditor agreements; instead, the uni-tranche lender handles those.
Just how popular unitranche loans have become is hard to determine. But the Unitranche Fund already has two deals under its belt, including North Carolina-based
George Henry, a partner at mid-market buyout shop
In a one-stop-shop loan, a lender visibly splits the loans into secured and unsecured facilities, often supplied by different funds managed by that firm. One-stop-shop financing offers the convenience of dealing with one lending entity, but sponsors are typically privy to the terms of inter-creditor agreements.
Alongside American Capital Strategies, industry veteran Golub Capital has been actively providing one-stop-shop and traditional loans since the fall, with more than $275 million in commitments so far in 2008, the majority of which are one-stops. Earlier this month,
Early criticism of one-stop-shop loans and unitranche loans has centered on whether sponsors appreciate all of the complexities that may be hidden behind the scenes. Since the interceditor agreements are negotiated by the unitranche lender, for example, the sponsor may lack a deep understanding of the gritty details of its company’s capital structure, and who is ultimately holding all of the debt.
The Riverside Company, for example, has a sense of the distribution of senior and subordinated debt between GE and Allied Capital, but it is unclear on the breakdown of pricing or ownership. Gosline said the firm has a strong enough relationship with GE that it is confident it will have no more problem doing, say, an add-on deal than it would with another form of financing.