Capital intensive businesses often raise capital from multiple sources, including loans from senior and subordinated lenders and hybrid financing – most typically loans accompanied by warrants – from so-called mezzanine lenders. A borrower’s cost of funds with respect to each depends on the quantum of risk associated with the particular credit. Senior lenders enjoy priority in payment and recourse to discernible collateral and are able to offer lower interest rates and lower fees. Subordinated and mezzanine lenders with junior rights to payment and limited access to collateral typically demand higher yields. In this prototypical, senior/subordinate debt structure, separately negotiated credit agreements spell out rights, obligations, and remedies with respect to each borrower and lender, sometimes in conflicting and even contradictory terms. The loans are separately administered. Intercreditor agreements between lenders determine rights to payment and collateral as between the lenders if the borrower defaults.
In the aftermath of the Great Recession, market participants recognized that the existence of multiple, discrete and separately administered lending transactions substantially increased cost and complexity to borrowers and lenders alike. “Unitranche” financing thus emerged, especially in small and middle sized loan markets, as a means to provide borrowers with one stop shopping for senior and subordinate debt financing. Unitranche financing combines senior and subordinate debt under a unitary credit agreement with a single blended interest rate. The credit agreement delineates rights of lenders and borrowers and specifies the interest rate and other covenants applicable to the credit.
The unitranche structure simplifies negotiations. Because a single credit agreement governs the relationship, negotiations focus on a common set of covenants, conditions, and events of default. This decreases the time and expense associated with negotiating and drafting the credit agreement. It also eliminates the need to generate multiple sets of collateral agreements and attendant costs and machinations to perfect liens on pledged collateral. A single lender administers the credit. And atypically, from the borrower’s perspective, payments on the loan pay down the entire loan instead of first repaying lower cost credits, as is often the case in a first and second lien loan transaction.
An important feature of unitranche loans is the “agreement among lenders” (AAL), which is the unitranche analogue to the intercreditor agreement. AALs are negotiated without the borrower’s input and the terms of the AAL are commonly confidential as between lenders. Prominent AAL features include the following:
- Stratification of lenders into two or more classes.
- The appointment of one of the lenders as agent, usually based on the agent’s level of investment in the loan.
- Allocation of payments and recoveries in accordance with a predetermined waterfall or waterfalls.
- When a loan is performing, the AAL will typically provide for higher yields to lower tier lenders and lower yields to higher tier lenders giving recognition to the respective lender’s risk.
- When the loan is in default, payments and recoveries from the exercise of remedies are often allocated entirely to higher tier, or “first out” lenders, with any remaining payments or recoveries allocated to lower tier or “last out” lenders.
- Voting rights and control provisions respecting amendments to the credit agreement and the exercise of remedies upon the occurrence of an event of default.
- Insolvency provisions that restrict the rights of lower tier lenders to provide debtor in possession (DIP) financing or to object to DIP financing or the use of cash collateral, including foregoing any objection to a higher tier lender’s provision of DIP financing.
- A buy out option that affords a lower tier lender the option to purchase the higher tier lender’s position, to allow the lower tier lender an opportunity to control the disposition of collateral securing the loan.
- A right of first refusal to purchase the interest of a lender that wishes to offer its interest in the loan to a third party.
Because unintranche financing is a relatively new phenomenon, there is some uncertainty regarding these transactions in the context of a borrower’s bankruptcy, including whether lower tier lenders’ claims will be treated as secured or unsecured and whether each lender ought to file its own proof of claim. In addition, because the borrower is not a party to the ALL, it is not clear that bankruptcy courts will invariably exercise jurisdiction over disputes between lenders related to the terms of the ALL. In that regard, Section 510(a) of the Bankruptcy Code provides that a subordination agreement is enforceable in bankruptcy to the same extent as it would be under applicable state law, but it is not difficult to imagine arguments to the effect that the resolution of such disputes – which really do not involve the debtor – would not affect the administration of the bankruptcy case or property of the bankruptcy estate, the jurisdictional hooks upon which bankruptcy court jurisdiction is normally founded. Thus far, no case has directly resolved these issues, although the United States Bankruptcy Court for the District of Delaware, in the context of a contested asset sale, did observe that it would enforce an agreement by a lower tier lender not to object to the sale. The extent to which the courts will exercise jurisdiction over such disputes remains unclear.
On balance, unitranche lending provides an attractive, alternative vehicle for making loans to small and middle-market companies. As noted, the unitary structure reduces transactional costs and complications related to loan documentation and administration. It enhances the ability of small and middle-market companies to access capital. Small lenders and private equity firms are the principal participants in small and middle-market lending transactions. Due to regulatory constraints growing out of the Great Recession, banks are often unable to provide, on their own, senior loans under the traditional tiered senior/subordinate loan structure. Unitranche financing enables these lenders to participate in loans at a level and in a manner commensurate with their risk tolerance and underwriting practices. Its flexibility makes it an attractive alternative for small and middle-market lenders and borrowers alike.
Unitranche lending remains relatively new. It, therefore, remains uncertain what impact, if any, implementation of this structure will have on loan workouts, defaults, and ensuing bankruptcy cases. Taft lawyers are working through these issues as they emerge.