Over the past several years, unitranche facilities have become increasingly prevalent. 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. 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. 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. 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 in unitranche structures
Compared to first/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 yield given the blending of interest rates, and greater ease of compliance monitoring and facility administration. In fact, it is possible that some unitranche borrowers are not even aware that sitting behind their credit agreement is a two-tranche 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 limits 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.
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.
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/second lien intercreditor agreement.
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.
|Enforcement of remedies
First-out lenders will want the first opportunity to exercise remedies, perhaps after a short standstill period that is triggered by any event of default under the credit agreement. Last-out lenders should be subject to a longer standstill period.
Last-out lenders will only want first-out lenders to direct exercise of remedies following certain, more serious, events of default such as the first-out leverage threshold being exceeded. Last-out lenders should be able to exercise remedies sooner and after any event of default.
|Voting on credit agreement amendments (other than “sacred rights”)
|A majority of first-out lenders and a majority of last-out lenders should be required to approve any amendment that otherwise requires the consent of Required Lenders under the credit agreement, meaning that first-out lenders have a separate approval right.
|Other than a specific list of amendments (which are often highly negotiated among the lenders), last-out lenders (or Required Lenders under the credit agreement) should be able to approve amendments without a separate vote of the first-out tranche. Voting may flip to tranche voting (majorities of both tranches must approve) upon certain trigger events occurring.
|Waterfall triggering events (events that cause payments to go to the first-out tranche first)
|In addition to the typical waterfall triggering events (insolvency, payment default and exercise of remedies), first-out lenders will negotiate to have triggering events included such as the first-out leverage threshold exceeding a certain amount or other financial covenant defaults (often with an additional cushion to the covenant set forth in the credit agreement) and failure to deliver financial statements after a certain time period (typically longer than the credit agreement allows).
|Last-out lenders will want the list of triggering events to be as limited as possible, but will generally agree that the waterfall is triggered upon a bankruptcy or other insolvency event, default in payment of the first-out obligations, and exercise of remedies. If they agree to a financial covenant trigger, it will typically have an additional cushion to what is set forth in the credit agreement.
|First-out lenders will seek robust bankruptcy protections, including first or exclusive opportunity to provide a DIP financing subject to agreed-upon conditions. They will also want to limit what, if any, DIP financing last-out lenders can provide that first-out lenders agree they will not object to.
|Last-out lenders will negotiate for the ability to provide a junior or even a priming DIP if one is not first offered by the first-out lenders or if the first-out leverage threshold has not been exceeded.
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, 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.
The general consensus 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 agreement is enforceable under applicable nonbankruptcy law. The important interpretive issue—which applies to all intercreditor agreements—is how broadly to interpret “subordination agreements.” 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, particularly on 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, will 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/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/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.