If you needed debt financing for a mid-market company, your only alternative was senior debt (mostly asset-based but cash flow was available for the best companies) and relatively expensive mezzanine debt.
That was it!! But some insightful lenders decided that unsecured subordinated debt was just too costly and introduced second-lien loans to the market. Life got a little more confusing trying to decipher the differences in terms and intercreditor agreements between mezzanine and second- lien loans (particularly because, ironically, although second-lien lenders had liens, there was rarely, if ever, actual collateral value to support the loan).
But the market readily accepted this new security. And, of course, it wasn’t that many years ago when BDCs, hedge funds and credit opportunity funds made a full frontal assault on the entire financing market by bringing unitranche structures to the market. Senior lenders, second-lien lenders and mezzanine providers all felt the brunt of this onslaught, although many eventually tried to gain a piece of the pie for themselves by offering to tranche the unitranche loans by taking a first–out or last-out piece of the debt.
So we thought everything would remain status quo for a while. But those enterprising senior lenders just couldn’t let their hard-earned place in the financing market deteriorate so, lo and behold, another structure has emerged—senior stretch. It’s not a particularly complex structure. In fact it’s downright simple. And therein may lay its competitive advantage.
Take that 4.0x senior/6.0x total debt structure which seems to be right down the middle of the fairway these days. Well, senior lenders are now saying, “Why complicate things? We’ll lend you 4.75x in a senior stretch term loan, as long as no other debt comes behind us.” Just think, one loan document, no intercreditor agreement, and only one set of covenants. And with senior lenders now having side vehicles that allow them to increase their hold sizes, the number of lenders needed for this new structure is often no more than a traditional senior loan. Can any private equity firm pass up this new structure?
Lenders seem to be offering senior stretch loans to better credits with EBITDA in excess of $15.0 million. While there are no hard and fast rules, senior stretch loans increase the leverage ratio over a traditional senior term loan by approximately 0.75x in return for a roughly 50-100bp increase in interest rates. As a result, this new structure has about 1.00 – 1.25x less debt but, in return, the overall weighted average cost of this structure is usually 100 -150 bps lower than more conventional structures like unitranche or senior/mezz structures.
And private equity funds seem to readily embrace this new structure. Although a stretch senior loan requires the borrower to put up a little more equity, with sponsors having difficulty deploying capital, investing additional capital in return for a simple capital structure with lower borrowing costs is not a bad thing. The additional equity required by the senior stretch loan normally results in a slightly lower IRR, or cash on cash return, to the private equity firm, although, interestingly, the lower the company’s growth rates, the smaller the difference in yields. And certain private equity funds that still associate a negative stigma with unitranche loans, or bristle at the thought of paying 11 percent to 12 percent interest on a mezzanine loan, find this new structure particularly appealing.
So, with senior lenders once again clamoring their way to the top of the food chain, will the BDCs, hedge funds and credit opportunity funds try to slay the competition with the introduction of yet another structure? That remains to be seen, but the emergence of the senior stretch product is just more evidence that borrowers are in the driver’s seat in today’s financing market.
Ron Kahn is a managing director at Chicago investment bank Lincoln International.