Authors: Heather Waters Borthwick, Tomasz Kulawik and Andrew Mavers
2021 witnessed explosive growth in the direct-lending segment of the leveraged loan market, fuelled by unprecedented liquidity and capital raised by private credit funds. Despite the dramatic increase in direct lending by private credit funds, the syndicated loan market remains robust, and significant pools of capital will continue to compete for positions in strong credits as they are brought to market.
In this article the authors unpack recent unitranche trends, identify reasons for the rising popularity of jumbo unitranche facilities and discuss what it may portend for the syndicated loan market.
WHAT THE NUMBERS TELL US
2021 was another record year for leveraged loan issuance. According to Leveraged Commentary & Data (LCD) of S&P Global Market Intelligence, more than $789bn flowed from lenders in 2021, representing an unprecedented year-onyear increase. It was also a record year for acquisition-driven financings, with LCD reporting a gargantuan $305bn fuelling the M&A frenzy that kept many of us tremendously busy for large blocks of the year.
Below the surface of these banner-year top-line numbers, private credit funds have continued to carve out an increasingly prominent role in the leveraged finance ecosystem. Once thought limited to the realm of the middle market, with term loans of up to an aggregate principal amount of $500m often regarded as a ceiling, private credit lenders now regularly provide jumbo unitranche facilities, with a seemingly everincreasing number of these facilities in the low billion-dollar range.
RECENT TRANSACTIONS AND TRENDS
In 2021, Direct Lending Deals (DLD) tracked a total of 21 deals funded by unitranche facilities with aggregate principal amounts in excess of $1bn, with a total aggregate value of $49bn. Examples include:
Inovalon Holdings Inc.'s $2.84bn facility incurred in the final weeks of 2021 in connection with a take-private transaction; a $2.15bn facility that enabled Cambium Learning Group Inc. to refinance its existing debt in November 2021; a $2.85bn facility that financed an acquisition by Guidehouse LLP in November 2021; a $2.6bn facility that financed the acquisition of Stamps.com Inc. by Thoma Bravo in October 2021; and a $3.4bn facility for Galway Insurance in the third quarter, which was described by DLD as "the largest unitranche on record".
Needless to say, unitranche facilities are being done at a size that, though some may have predicted possible in theory given overall market liquidity, few, we imagine, would have said with absolute confidence would become so common.
Is this a trend that will persist and offer private equity funds and their portfolio companies an alternative to the syndicated loan market for the types of facilities once considered the exclusive preserve of the latter? If 2022 is to be guided by what we witnessed in 2021, we would expect the overall number of jumbo unitranche facilities to continue its upward trajectory. However, we also expect the syndicated loan market to remain robust; its inherently competitive dynamic will continue to drive attractive pricing and other terms that appeal to a broad range of borrowers.
Let us take a moment to unpack the recent unitranche trends, identify reasons for the rising popularity of jumbo unitranche facilities and discuss what it may portend for the syndicated loan market. What has been driving recent enthusiasm for jumbo unitranche facilities, in particular?
In our estimation it is a confluence of factors, including attractive cost of capital (underpinned by unprecedent market liquidity) and certainty of execution (particularly for credits with a total leverage level at or above 6.5x).
CERTAINTY OF EXECUTION
According to reports at the time, when Thoma Bravo closed on a unitranche facility to fund its acquisition of Stamps.com, the decision to opt for this type of debt structure was motivated, in part, by the speed and certainty of execution that it offered.
One element of this certainty is the elimination of risks associated with a syndication process. The "bought" nature of a unitranche facility provided by a private credit fund or other direct lender means there is no time required to go through the ratings agency process or for a lead arranger to market the facility and build a book. There is also no risk of the facility meeting a chilly reception in the market should headwinds develop that require the parties to negotiate the exercise of "flex" points or address other bespoke lender requests which could, in turn, increase a facility's pricing while simultaneously limiting the borrower's flexibility under its other terms.
Elimination of syndication risk is particularly relevant in a highly competitive M&A environment, in which the salient advantage of unitranche facilities with respect to speed of execution is brought into sharp relief. In a competitive bidding process, a potential acquiror able to present its debt financing in the form of a committed unitranche facility finds itself, so the argument goes, in a favourable position relative to competitors relying on syndicated facilities to finance their bids. The attendant certainty is attractive to sellers and removes the risk from the acquiror's perspective of a "hung" deal, which could result in "fully-flexed" terms (ie more expensive and more restrictive than originally envisaged) for want of sufficient market interest in the indicative terms.
Let us, however, be careful of placing too much emphasis on the perceived syndication risk of a leveraged term loan facility that is arranged, but ultimately not held, by a bank. Over the course of the last several years, COVID-19 disruptions notwithstanding, the leveraged loan market has enjoyed unprecedent levels of liquidity - billions of dollars of inflows looking to be put to work. During the portions of a calendar year in which the syndicated loan market is typically most active, syndication risk for the vast majority of transactions has been relatively low. Nevertheless, certain M&A timing dynamics with respect to a given transaction can militate against pursuing a syndicated option. Such a scenario might involve an acquisition opportunity that presents on a compressed timeline in the fourth quarter and must close by the calendar year-end. Generally, a term loan facility cannot be successfully brought to the syndication market during the last two holiday weeks of the year, the December "blackout" period. In our example above, access to a unitranche facility provided by a private credit fund or other direct lender on a buy-and-hold basis would provide the acquiror with the required debt financing - an attractive alternative, despite likely higher pricing, if it means the deal gets done.
It is too soon, however, to count the banks out in this situation. Although yearend data is not fully available at the time of this writing, anecdotally, we saw a number of transactions toward the end of 2021 in which banks that would normally require pre-closing syndication of committed acquisition facilities, were willing to fund term loan facilities at the time of the acquisition closing and subsequently initiate the syndication process on a post-closing basis. Perhaps this was driven, in part, by a need to respond to increased competition from private credit funds and other direct lenders. Such speculation is perhaps not without merit, but by doing so the so-called "regulated" banks demonstrated flexibility necessary to meet one of the challenges posed by private credit funds, particularly during a period of the year during which there is traditionally less activity in the syndicated market.
If arrangers of syndicated facilities can solve syndication risk in certain situations, what other advantage does a jumbo unitranche facility provide with respect to certainty of execution?
In our experience, the ideal scenario presents in a transaction that carries a higher leverage profile than regulated banks may be permitted to entertain. When we look deeper into the numbers on unitranche facilities, data suggest that while this form of private credit is undoubtedly more common and prominent than it has ever been, these types of unitranche facilities appear best-suited to credits with higher total leverage levels which, in a highlycompetitive M&A market, can often mean acquisition financings for targets in the technology and healthcare sectors - sections that often carry high purchase-price-toEBITDA multiples.
Statistics comparing average leverage ratio levels in recent transactions in the syndicated and direct lending markets bear this out. The total leverage ratio across all deals for syndicated first-lien senior debt facilities in 2021 came in at around 5.27x, according to LCD, for 89 term B loans with a principal amount in excess of $1bn. Of these deals, 26 had aggregate principal amounts of $2bn or higher (compared to 10 unitranche facilities in this range). While details of direct lender and private credit deals are, as the name would indicate, typically private, of the jumbo unitranche deals tracked by DLD, the average total leverage ratio appeared to sit right around 7.4x.
If unitranche facilities provided by private credit funds and other direct lenders generally accommodate greater leverage levels than comparable syndicated first-lien facilities arranged by regulated banks, how do they stack up against syndicated first-lien, second-lien structures?
Data from Thomson Reuters on the first half of 2021 revealed that second-lien term loan issuance stood at $11.65bn - its strongest performance over the same period since 2014. Clearly, there was plenty of liquidity in this segment of the leveraged loan market. From a borrower perspective, the covenant packages in syndicated first-lien, second-lien facilities can provide significantly better operating flexibility relative to unitranche and "bought" second-lien facilities, and in many contexts this flexibility is judged to be worth higher pricing, including applicable call protection, of the syndicated second-lien facility.
Pricing of unitranche facilities is typically higher than stand-alone first-lien senior debt, a function of the so-called "blended" interest rate of a unitranche facility, which usually reflects the consolidation of what would otherwise be a first-lien second-lien structure. On the other hand, unitranche pricing is still typically below the levels available for second-lien debt, whether syndicated or "bought". However, in 2021, we saw pricing on unitranche facilities provided by private credit funds and other direct lenders squeeze first-lien and second-lien debt financings on pricing. According to data compiled by Bloomberg Law, at its most compressed, the spread differential between the two forms of debt saw unitranche pricing fall to around L+575 bps, though it more typically hovered around L+625-650 bps, while 2020 spreads of up to L+775 bps were typical. In a report issued in January 2022, DLD noted that competition moved unitranche spreads even lower in December 2021, to as low as L+540 bps, with lower spreads and eroding floors taking all-in yields for unitranche debt to 6.7% - "a 2021 low". Assuming we enter a rising interest rate environment in 2022 as a result of inflationary pressures, the relative pricing dynamic of unitranche facilities (jumbo or otherwise) provided by private credit funds and other direct lenders and syndicated facilities provided by regulated banks will be fascinating to observe, particularly given the extraordinary amount of "dry powder" just waiting to be deployed.
The incredible rise of jumbo unitranche facilities has been a compelling market development that we believe will continue in the year ahead. These facilities provide an innovative and attractive source of debt capital, particularly in the context of highly leveraged transactions. They are also likely to continue to bring a general level of competitive pressure to bear within the leveraged finance market as a whole. We anticipate the so-called "regulated" banks to rise to this challenge and for private equity sponsors and their portfolio companies within certain leverage ranges to continue to seek out the borrower-friendly terms offered in a remarkably robust syndicated loan market.
Originally published by Butterworths Journal of International Banking and Financial Law (JIBFL).