Private equity firms are increasingly turning to an obscure type of loan, once almost exclusively used to finance smaller deals, to fund larger and larger buyouts. Yet a growing number of analysts and investors warn the debt may be riskier than it appears.
Demand for unitranches, which blend first-priority and subordinated loans into a single facility from just a handful of lenders, is surging as borrowers bypass conventional sources of financing in pursuit of greater speed and simplicity. Previously used solely to fund middle-market transactions, volume reached a record $10.7 billion last quarter as non-traditional lenders deploy more cash for deals that in the past may have gone to the institutional loan market.
The frenzied growth is another example of how red-hot demand for private credit is reshaping the global lending landscape. Yet the boom in unitranches is worrying some who say the debt, which is sometimes carved up via sophisticated side deals, remains unproven, especially in the face of a potential economic downturn and increase in restructurings. That could ultimately hurt investors who’ve plowed hundreds of billions of dollars into private debt funds in recent years.
“Unitranches have taken a lot of the market share because the market has evolved toward that need for speed,” said Garrett Ryan, head of capital markets at Twin Brook Capital Partners, a direct lender that provides financing, including unitranche loans, to middle-market companies.
That need for speed has come at a price, some market participants say.
By combining senior and junior debt into a single tier and eliminating the syndication process, unitranches can be arranged in a fraction of the time it takes to complete a traditional leveraged loan.
The structure made up about 21% of private equity sponsored middle-market deals this year through September, up from 14% in 2018 and just 2.5% five years ago, according to data from Refinitiv LPC.
Yet recently more buyout firms are turning to unitranches to finance bigger deals as direct lenders amass larger pools of capital to invest. The pacts that can be used to spread out the risk once a loan is complete are also becoming increasingly complex.
More importantly, they remain largely untested in distressed scenarios, fueling a degree of uncertainty not present in other types of financing, firms including Fitch Ratings warn.
“All of this is going to be tested, and there will be some real pain,” said Jeff Dickson, executive managing director and head of alternatives at PGIM Private Capital. Dickson said he’s avoiding unitranche deals because they’re not compensating investors enough for the underlying risk.