Understanding the Mechanics of an Unitranche Lending Structure
In the world of leveraged and asset-based lending, the unitranche (or “first out / last out”) structure has emerged as a practical tool for allocating risk and return among lenders participating in a single credit facility. Rather than creating two distinct tranches of debt with separate credit agreements and intercreditor arrangements, the first out/last out structure achieves a form of internal subordination within a single credit facility. This article provides lenders with an overview of how these arrangements work, the key economic and structural features involved, and the considerations that should inform a lender's decision to participate.
What Is a Unitranche Structure?
A unitranche structure involves a single secured credit facility in which two or more groups of lenders share in the same security interest on the borrower's collateral but agree among themselves to a payment priority and other arrangements.While unitranche facilities can take many forms, a common structure will implement a “first out” asset-based lending facility with a “last out” term loan facility. The structure is intended to provide the "first out" lender reduced risk and return, providing the "last out" lender increased risk and return (as compared to the first out lenders), and the borrower with a single, streamlined credit facility.
The unitranche structure is not the same as a traditional first lien/second lien arrangement. In a first lien/second lien deal, there are two separate liens on the collateral, governed by an intercreditor agreement between two distinct groups of secured parties. In a unitranche arrangement, there is only one lien, and the priority of payment is governed by an agreement among the lenders (often documented in an agreement among lenders (an "AAL") rather than by the relative priority of competing security interests.
Historically, an AAL was not a document to which the borrower is a party, although recent market practice arising out of concerns regarding enforceability in bankruptcy proceedings increasingly dictates that borrowers are made aware of, and often sign and acknowledge, the AAL. In any case, from the borrower's perspective, the facility often looks and operates like a single credit facility.
How the Structure Works in Practice and Key AAL Provisions
Generally. The unitranche facility is typically documented in a single credit agreement, with the borrower owing its obligations to a single group of lenders represented by a common agent at “blended” pricing reflecting one interest rate applicable to the obligations. The first out/last out features are set forth in the AAL, which is generally a highly bespoke document, but ordinarily provides for the following interlender arrangements (which we explain in greater detail, below):
(a) an interest rate and fee “skim” mechanic;
(b) interlender voting mechanics;
(c) provisions detailing the enforcement of remedies under the facility, specifically whether first out or last out lenders control the implementation thereof; and
(d) the payment waterfall among the first out and last out lenders.
Interest and Fee Skims. Many AALs contain provisions pursuant to which the blended interest rate and facility fees visible to the borrower in the primary loan documents are re-allocated to reflect the higher yield payable in respect of the last out obligations.For example, the credit agreement might require the borrowers pay monthly interest to the Agent at a rate of SOFR + 800 basis points on all obligations, with the AAL prescribing that the margin is then split (or “skimmed”) such that the last out lenders receive 500 basis points of the margin, with the first out lenders receiving 300 basis points.The same can be true with respect to borrower-facing fees described in the credit agreement or fee letter, with the last out lenders receiving additional economics in compensation for their riskier position in the capital structure.
Voting. A typical AAL will provide extensive detail regarding which lender groups are required in order to approve amendments and modifications of the credit agreement. In the most first out-friendly arrangement, 50% of first out lenders and 50% of last out lenders are required to approve modifications.In another typical arrangement (especially where the last out obligations outsize the first out obligations), only 50% of the last out lenders are required to approve modifications, with the exception of a list of specific modifications that also require 50% of the first out lenders to implement. In the latter arrangement, the first out lenders often bargain for a specific list of (often highly-negotiated) voting “trigger events”, the occurrence of which typically flips the voting arrangement to the first out-friendly arrangement described above.It is important to note, however, that such voting provisions may not, in any case, override lenders’ “sacred rights” under the credit agreement itself.
Payments and Waterfall. In a typical structure, payments received in respect of the obligations are paid pro rata to all lenders (subject to the “skims” described above).However, following the occurrence of certain waterfall “triggering events” and delivery of a “waterfall activation notice” from the first out representative to the last out representative, all payments of principal and interest received from the borrower, whether as scheduled payments or as proceeds of a collateral liquidation, are first applied to satisfy the first out lender's obligations in full before any amounts are paid to the last out lender.Waterfall trigger events are also heavily negotiated, but nearly always include payment and insolvency defaults, with many transactions also including financial covenant defaults (often at a cushion to the levels in the credit agreement itself) and financial reporting defaults.
Enforcement of Remedies. As both lender groups hold a single grant of a security interest in the collateral with a single lien, it is essential to define which party has the power to take enforcement actions such as acceleration, foreclosure, and the disposition of collateral. In the most aggressive formulation from the first out perspective, the first out lender has the power to take enforcement actions until the first out obligations have been paid in full.However, in many structures (particularly where the last out lenders’ principal obligations are larger than the first out obligations), the last out lenders initially control the exercise of remedies, on the argument that they have more incentive to assure maximum recovery as the last out position.Similar to the voting and waterfall constructs mentioned above, in these structures, first out lenders negotiate for remedies “triggering events,” following which, the first out lenders control the exercise of remedies exclusively.Many structures also include additional protective provisions for the last out lender, such as a right to purchase the first out position at par in order to gain control over the workout process.
Key Considerations for Lenders
For first out lenders, the principal advantage of the structure is enhanced credit protection. The first out lender benefits from the cushion provided by the last out lender's commitment, which absorbs initial losses in a downside scenario. This additional layer of protection can make it possible for the first out lender to extend credit in situations where the overall facility size might otherwise exceed the lender's comfort level on a standalone basis.
For last out lenders, the structure offers the potential for higher returns through increased spread, origination fees, or other economic enhancements. However, the last out lender must carefully evaluate the collateral coverage, the borrower's financial profile, and the specific terms of the AAL. Because the last out lender has agreed to ultimately be subordinate to the first out lender, its recovery in a distressed scenario depends on the residual collateral value after the first out lender has been paid in full.
Both parties should pay close attention to the AAL provisions mentioned above, in addition to the definition of first out and last out obligations, the treatment of protective advances and post-petition interest, the circumstances under which the last out lender may exercise a buy-out right, and any restrictions on amendments to the underlying credit agreement that could affect the relative positions of the parties. Provisions addressing the allocation of expenses in an enforcement scenario are also critical and should be negotiated with care.
For lenders considering participation in such an arrangement, a thorough understanding of the AAL and the internal mechanics thereof is essential. While the structure can be advantageous for both the first out and last out participants, AALs are typically extremely bespoke, heavily-negotiated documents, and the benefits of such a structure are only as strong as the documentation that governs them, making careful negotiation and drafting a prerequisite to any first out/last out transaction.
