Agreements Among Lenders and Unitranche Facilities – a Fresh Look at a Trending Product

A unitranche facility has a blended senior and junior interest rate and is documented in a single loan agreement with a single set of collateral documents granting liens for the benefit of all lenders in the facility. Unitranche loans became increasingly prevalent in the market in the late 2010s and early 2020s, and continue to represent a significant number of financings. This growth has been driven by the ever-growing class of private credit and direct lenders who initially developed the unitranche facility structure, along with traditional bank lenders now joining this market. The unitranche structure has several advantages, including typically quicker execution for the parties involved and in some cases a lower cost of capital to the borrower.

The closest analog for a unitranche facility is often thought to be a first-lien/second-lien financing, a credit product that most traditional bank lenders are familiar with and rely on regularly, particularly due to the establishment over time of a well-defined set of market-standard intercreditor terms. Another similar product is found in certain broadly syndicated loans in which there is a revolving facility that is “first-out” or “superpriority” and paid out ahead of the term loan facility in a downside scenario, but otherwise there is no separate agreement among lenders or intercreditor documentation governing enhanced rights or obligations of the difference classes of lenders.

This Legal Update explores some of the distinctions between first lien/second lien financings and unitranche facilities, and discusses concerns over enforceability of the unitranche-style intercreditor agreement—an “agreement among lenders” (AAL)—in bankruptcy. With an understanding of these distinctions, and a well-negotiated AAL, we believe that the unitranche product can benefit borrowers, traditional bank lenders, and private credit and direct lenders alike. 

Developments of unitranche structures

Compared to first-lien/second-lien structures, unitranche facilities are a relatively new credit product, having largely developed in the middle-market credit segment. From the borrower’s perspective, the unitranche structure can offer simplicity, speed of execution, lower transaction costs, lower overall cost of financing given the blending of interest rates, and greater ease of compliance monitoring and facility administration. In fact, some unitranche borrowers likely are not even aware that sitting behind their credit agreement is a unitranche structure (typically divided into “first-out” and “last- (or second-) out” tranches of debt) documented in a separate AAL. The AAL sets forth the inter-lender terms with respect to, among other key features, sharing and allocation of interest and fees, rights to direct enforcement of remedies, caps and limitations on additional debt and protective advances, voting rights of each group of lenders on credit agreement amendments, and negotiated triggering events upon which the waterfall for distributions would shift to allocate payments and collateral recoveries, first to the first-out tranche, and second to the last-out tranche. 

In recent years, a common unitranche structure has developed as follows: the first-out tranche is primarily a revolving credit facility (sometimes with a “first-out” term loan, depending on the provider of the revolver and the needs of the borrower), with the last-out tranche consisting of some or all of a term loan facility (often provided by private credit and direct lenders), often significantly larger in size than the “first-out” part of the loan. This dynamic, and the relative difference in size between tranches, has led to AALs being negotiated to be, in some ways, more favorable to last-out lenders than one would typically see in a first-lien/second-lien intercreditor agreement.

A relatively new and innovative application of the unitranche structure includes asset-based lending. Traditionally, large ABL platforms were senior-bank funded and would not have been able to participate in this structure. However, with the growth of private capital funds and other non-bank funding sources entering the ABL market, this has permitted internal sourcing where the cash-flow group within an institution originates the deal and a different group within the same entity or an affiliated entity provides the first-out ABL portion. In this structure, instead of a cash flow revolving loan, an asset-based revolving loan is included in a facility with a term loan originated by a cash flow lender, allowing the cash flow fund to book the deal without separately sourcing an ABL facility, while providing the borrower with a built-in, outsourced ABL revolving facility to fund working capital needs. The ABL lender sets availability using traditional borrowing-base mechanics, but otherwise a conventional AAL will govern the relationship between the ABL first-out lender and the term lender (last-out).

Another significant distinction between a traditional split-lien ABL facility as compared to a “first-out” ABL facility is that, unlike in a split-lien ABL facility where the ABL lender’s lien is limited to specific asset categories, in a unitranche structure—just like where the revolver is cash flow based—the first-out ABL lender has security against all of the assets of the borrower. From the perspective of the first-out ABL lender, the trade-off for this enhanced collateral package is that it lacks the level of control and faces certain elevated legal risk as compared to a stand-alone ABL facility. The ABL lender in a first-out structure will have fewer legal rights than in a typical stand-alone ABL facility because of the documentation control that the last-out lenders will hold.

Where the last-out lenders’ hold size is a substantial majority of the total debt, they typically view themselves as having the most “skin in the game,” and therefore argue they should be entitled to control decisions with respect to many amendments to the credit agreement, as well as the enforcement of remedies. At the same time, first-out lenders offer lower pricing for less risk. They aim to ensure their overall exposure is protected in a downside scenario, and have more control over decisions should their credit position deteriorate. As part of the allocation of risk, lenders often negotiate a leverage threshold (e.g., total first-out debt to trailing 12-month EBITDA), over which, once exceeded, the first-out lenders have more control over enforcement of remedies and other matters.

For these reasons, even as the market continues to develop, there are a wide range of negotiated outcomes in terms of first-out and last-out rights in AALs. The following chart illustrates some key AAL provisions and the different positions that first-out and last-out lenders may take with respect to them.

Bankruptcy considerations

Since unitranche facilities and AALs are a relatively recent phenomenon, there has been uncertainty in the market regarding whether—and to what extent—bankruptcy courts will enforce provisions in an AAL. This uncertainty has been due in part to the fact that, historically, borrowers do not sign the AAL (and sometimes do not even know of its existence). As a result, borrowers once in bankruptcy would have little incentive to follow or enforce terms such as consent rights relating to debtor-in-possession (“DIP”) financing, use of cash collateral, or dispositions of collateral. Today, however, not only are borrowers more likely to be aware of the unitranche structure, they are often asked to sign and acknowledge the terms of the AAL. In fact, as the market has developed, terms that previously were typically documented in the AAL—such as the different economics between the first-out/last-out tranches and the payment waterfall—are being documented directly in the credit agreement. 

There is also uncertainty as to enforcement of the AAL when the first-out is an ABL lender. Since these structures are new—even more so than cash flow revolver first-out facilities—they have not fully been tested in court disputes. Upon enforcement, the first-out ABL lender may need to liquidate collateral directly, or force the term last-out lender to exercise a buyout or pay down the first-out position.

A key concern for both first-out and last-out lenders is the extent to which these parties will receive the benefit of their bargain in a bankruptcy proceeding of the borrower. Concerns around the enforceability of AALs in bankruptcy have typically focused on two issues. First, particularly if the borrower is not a party to the AAL, there is concern that a bankruptcy court could take a limited view of its jurisdiction, and require the lenders to resort to another forum if disputes among them arise, rather than the bankruptcy court enforcing the AAL. Second, because the unitranche facility lenders share a lien, this has led to questions about whether borrowers and/or a bankruptcy court would consider the tranches as separate and distinct for bankruptcy purposes, including for purposes of evaluating whether the debt was oversecured or undersecured, and for plan- classification purposes. 

Particularly where the borrower is a signatory to the AAL, the prevailing view is that bankruptcy courts will most likely treat AALs like other intercreditor agreements pursuant to Section 510(a) of the Bankruptcy Code, which provides that subordination agreements are enforceable in bankruptcy to the same extent that such agreements are enforceable under applicable nonbankruptcy law. The important interpretive issue that applies to all intercreditor agreements is how broadly to interpret what is a “subordination agreement.” Not all provisions in an intercreditor agreement go directly to the issue of lien or payment subordination, but may instead be corollary provisions that provide first-out lenders certain rights to protect their priority position. For example, an agreement over which lenders have the ability to provide a DIP financing that other lenders cannot contest is not, on its face, a lien or payment-subordination provision. However, providing DIP financing affords first-out lenders an opportunity to protect their collateral and facilitate a borrower’s restructuring plan, including the implementation of a sale, a reorganization, or other proposed outcome. While courts generally do enforce a fairly wide range of intercreditor provisions, they have at times been reluctant to enforce provisions that go to core rights under the Bankruptcy Code (such as waivers of plan voting, which some courts have viewed as unenforceable as impermissibly disenfranchising a class of creditors). It is also important to note that these provisions are often not litigated to a final order because the bankruptcy process encourages parties to reach a negotiated resolution rather than litigating their disputes, and even when these disputes are litigated, bankruptcy courts often provide guidance on how they might rule, which often leads to a settlement on the “courthouse steps.”

The single-lien nature of unitranche facilities also may raise complicated issues in bankruptcy proceedings relating to valuation. For example, an oversecured creditor is entitled to seek payment of post-petition interest and reasonable fees, costs and charges under Section 506(b) of the Bankruptcy Code. If the first-out tranche by itself is oversecured, but the facility as a whole is undersecured, should the first-out lenders be entitled to post-petition interest during the course of the bankruptcy proceedings? Although this issue hasn’t been litigated in the context of AALs, prior decisions suggest that, if litigated, bankruptcy courts might consider the entirety of the debt when assessing collateralization and consider all the lenders “undersecured.” That said, it is also possible that the issue can be resolved as part of consensual orders for a borrower’s use of cash collateral or its obtaining of DIP financing, in which context a bankruptcy court may approve payment of post-petition interest and fees to first-out lenders. Regardless of what happens in the bankruptcy court, the AAL waterfall provisions typically dictate that the first-out tranche is entitled to recoup post-petition interest and expenses before interest or principal goes to the last-out lenders.

Additionally, it is standard for AALs to provide that first-out and last-out lenders intend to have their interests classified separately in Chapter 11 plans of reorganization, and will not object to such separate classification. This separate classification mirrors how first-lien/second-lien facilities are typically structured, and tends to benefit the first-out lender holding a small size of the unitranche facility. Such first-out lenders could be outvoted by the last-out tranche if the last-out lenders constitute one-half the number of creditors (each lender counting as a separate creditor) and hold at least two-thirds of the dollar amount of claims. It is possible that the first-out and last-out claims could be classified in the same class due to their single lien, a risk that is particularly acute if the borrower is not aware of the AAL. In that case, the AAL will often have voting provisions stipulating that plan approval requires approval from both first-out and last-out tranches (by a majority of lenders holding at least two-thirds of the dollar amount of the claims).

Plan voting and post-petition interest present unique issues in bankruptcy, given the single-lien structure of unitranche facilities. AAL agreements, however, address a broad range of scenarios that may occur in a Chapter 11 case in a manner similar to how such scenarios are addressed in first-lien/second-lien intercreditor agreements. For example, many Chapter 11 cases are sales of substantially all of the business pursuant to Section 363. AALs typically provide that if the first-out lenders consent to such a sale, then the last-out lenders will be deemed to have consented as well (although this consent may also be subject to a first-out leverage threshold test). In connection with such a sale, the last-out lenders may credit bid their debt only if the first-out lenders consent or are paid out in full in cash at the closing of such sale. 

Although the unitranche product has evolved significantly since it was first introduced to the market, its popularity has endured, in no small part because of the benefits it provides to borrowers and lenders alike. As more parties enter the unitranche market, AALs should continue to evolve, and a more stable market standard for the product is expected to develop.