But we all know what happened to the banks in 2009. And, as a result, non-bank lenders emerged and, with them, came the unitranche structure.
While many sponsors have embraced these alternative lenders and their new structure, many are still doubtful of the veracity of these institutions and express concern about the motivations behind these non-bank lenders. The biggest concern of sponsors is the way these new lenders will handle themselves in a downturn and whether they’re really just loan-to-own investors in disguise. Traditional senior debt/mezzanine structures always have at least two lenders, and often three or four, giving borrowers the comfort that, in a downturn, it’s likely that at least one debtholder will act reasonably and help stave off any egregious behaviour by the other lenders. Plus, most of these traditional lenders have been in the business for many years and have a track record of how they perform when their borrowers have issues.
Although unitranche facilities may have multiple lenders that are either pari passu with one another or are operating under a first-out/last-out tranched structure, just as often these facilities have only one provider. Sponsors and borrowers frequently shy away from this latter structure for fear that this single lender will act in a draconian manner if their company has even a small hiccup. Sponsors often fear that these lenders will refuse to waive any defaults and ultimately take over their company, a nightmare scenario for any borrower.
Since 2009, there have been few defaults and, therefore, little history that sponsors can draw upon to assess how unitranche lenders will act in a crisis. But, there are a few dynamics which can form the basis of an educated guess as to how these non-bank unitranche lenders will behave in a downturn.
Most non-bank lenders, such as BDCs, hedge funds and credit opportunity funds, have sources of capital, including their own lenders, that require them to provide quarterly financial statements that report their investments on a fair market value basis. These institutions are laser-focused on the value of these investments because it forms the basis of their net asset value and the NAV, in turn, determines whether these entities can raise additional debt or equity capital.
So when a portfolio investment has earnings issues, the accounting rules normally require that the lender write down the value of its loan, which negatively affects the lender’s NAV and, therefore, their ability to raise additional capital—a scenario that every lender will do anything to avoid.
But there is another step that a lender can take that can often mitigate, and potentially avoid, this write down—and it’s not by taking over the company—but rather by increasing the interest rate on the outstanding debt, whether payable in cash or PIK. For example, when a 4.0x levered unitranche loan priced at 9 percent becomes 5.0x levered because of the borrower’s deteriorating performance, there is a decent chance that, by raising the interest rate on that loan (to say 11 percent), the debt will still be at par. Leaving the default outstanding will almost surely result in a write down of the loan and, again, taking over the company will usually also result in a decline in value—both scenarios that lenders want to avoid even more than borrowers. But waiving defaults and raising the interest rate (and normally once performance returns to expected levels the interest rate is decreased) during times of turmoil have the best chance of keeping the loan at par and, thus, allowing the lender to continue raising capital, while the sponsor and borrower get to continue controlling the company—a win-win for everyone.
Unfortunately, there is a limit to the reasonableness of an increase in the stated interest rate and its effectiveness in enabling a loan to continue to be valued at par. But chances are that if a company is in that much distress, even traditional lenders are likely to have to write down their investment and potentially take the company over to mitigate their losses.
Ron Kahn is a managing director for Chicago-based investment bank Lincoln International