allied5In the leveraged buyout run up of the past 5 years, there was a never ending search for debt to finance transactions.  While equity multiples reached into the stratosphere, relative to historical norms, the ability of private equity funds to utilize cheap debt to underwrite deals seemed to provide a justified rationalization for paying significant equity premiums.  Where senior debt and senior stretch ran out, second lien loans were tapped to get deals done with minimum equity contributions.  Second-lien loans, due to their secured nature, were preferred to unsecured or subordinated debt (read — they were cheaper).   Second-lien lenders used to say, “mezzanine is for suckers.”

Second-lien loans made a lot of sense in many deals.  Prior to the credit crunch, private equity sponsors could secure second-lien debt for LIBOR  + 400 – 500 bps.   In the first half of 2007, lenders issued $2.65 billion worth of second-lien loans to finance middle market deals, up significantly from 2006, when $204 million in second-lien debt was issued to finance these same types of transactions.

During all the euphoria, speed to close became a significant differentiator for sponsors, and while second-lien was a great tool to get equity contributions down, it often elongated the process to close, due to the fact that the lender often needed to assess the collateral base at a detailed level so as to ascertain any overflow from the senior secured that would accrue to it in the event of default.  To provide private equity firms a means of overcoming this obstacle, unitranche debt was birthed by Allied Capital, a publicly traded business development corporation (BDC), in 2005.

Unitranche debt combines traditional senior and junior debt terms into a single senior debt facility.  This allowed parties to sign a single loan agreement, involving a single interest rate from a single lender.  The unitranche structure also offers simplified documentation, reduced amortization requirements, and the ease of future add-ons and modifications.  Unitranche was an excellent tool for companies with sub-$15 million EBITDA, whose loan size often did not reach into the syndication market.  Unitranche facilities are floating rate and tend to range in price from LIBOR + 500 – 750 bps.  While this is more costly than parsing the debt structure, the ease of use and speed to close, in many cases, offset the more expensive relative cost.

On the backs of its success in unitranche, Allied began making a name for itself with “one stop buyouts”, providing the equity underneath its simplified debt structure.  As an agent, Allied and its chief competitor American Capital Strategies became first calls for those seeking a stalking horse in a competitive bid process.  Both Allied and American Capital were perceived to have the ability to pay higher equity multiples due to their inputted IRR from providing the debt financing.

As deal velocity increased so did Allied’s stock price.  Offering investors a handsome dividend yield of ~ 8% which it funded using a combination of current interest and asset sales.  Allied raised new pools of capital by issuing new equity through secondary offerings.  In December 2007, the unitranche movement peaked when Allied Capital and GE Commercial Finance raised $3.6 billion for Unitranche Fund, LLC.   Prior to the financial meltdown, Unitranche Fund closed two deals, backing Carousel Capital’s acquisition of Brasseler USA and The Riverside Company’s acquisition of Central Power Products.

Despite its simplicity, unitranche and one stop buyouts have their detractors.  In a one stop, the lender splits the loan between secured and unsecured tranches.  Often times these tranches are funded from different vehicles and commingled pursuant to an inter creditor agreement that is negotiated by the funding entities without consultation of the borrower or sponsor.   This can create some adgeda when it comes time to do additional add-ons.  However, may people state that the speed and simplicity to close over come this obstacle in spades.

The other common criticism of one stop buyouts, is that it puts the lending organization directly in competition with the equity community.  In effect Allied and American Capital, an others of that ilk, drive up equity multiples for other bidders, who are also their customers.  Allied is careful to disclaim this notion by being very cognizant not to compete as a standalone bidder in a multiparty auction process.   In my experience they have always toed this line gracefully.  I’ve never heard a sponsor make a substantive complaint, thought I am sure it has happened.

So if unitranche/one stop buyout makes so much sense, why is Allied stock yielding ~ 87.5%, American Capital ~ 66.4% and Gladstone Capital (a smaller version of the two) ~ 20.4%?  The answer to that is the perception that the model is clearly broken, for now (for the purposes of this discussion we will leave aside Allied’s tussle with David Einhorn, which you can read about here).

Long short, Allied and its ilk face liquidity challenges caused by the current market turmoil.  Remember, these funds fill their coffiers through secondaries, but at their current valuations such issuances would be highly dilutive.  Their other option for liquidty is through asset sales of companies that it own equity in through one stop buyout transactions.  Yet, selling assets in this environment is surely to be disadvantageous given the prevailing multiples.  Sort of a dammed if you do, dammed if you don’t scenario. Further, if these unitranche players had captive liquidity, the option of buying fully collateralized senior debt on the open market at 60% of face value or repurchasing their own stock, seems like a much better use of capital than issuing new debt at par.

That all being said, I don’t see unitranche or one stop buyouts going the way of the dodo bird.  There are several reasons to support this assert.  First, unlike the investment banks, publicly traded BDC are largely underleveraged.  Allied’s current debt to equity ratio is less than 1.0x.  Further, due to the nature of regulations in their business,  Allied and other BDC’s cannot count preferred equity investments in their equity base, so their real leverage is, to an extent, over stated.  While Allied is going to have issue with its tangible net worth covenant related to its current third party indebtedness, lenders are likely to work with Allied given its current position in the industry.  Additionally, Allied will likely cut its dividend in order to preserve capital.  The stock is currently trading in anticipation of such an event.  While this would be a downer for investors, it is in the best interest of long term equity value.  Third buying senior debt on the open market appears to be a realitvely good risk reward tradeoff for capital, with the potential to create real returns for shareholders.  Finally, I think BDC play a significant and valuable role in the middle market for both companies and private equity firms alike.  This ability to deliver long term value will likely be their saving grace.

/bryan

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