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Restructuring Unitranche Facilities: Key Considerations and Risks

Unitranche financing has gained popularity in recent years, particularly in middle market lending, as a streamlined alternative to the traditional bifurcated senior/junior debt structures. By combining what would normally be separate first lien and second lien facilities into a single credit facility, unitranche financing offers several advantages to borrowers - a single set of loan documents, a blended interest rate, and greater efficiency in terms of lower overall financing costs and a simplified closing process.

However, while unitranche facilities present a simpler debt structure on the surface, behind the scenes lies a complex web of inter-lender arrangements spelled out in an agreement among lenders (AAL). The AAL synthetically separates the lenders into a "first out" tranche and a "last out" tranche, effectively mimicking the senior/junior lien structure while maintaining a single credit agreement and set of covenants with the borrower.

When a company with unitranche financing becomes distressed, navigating a restructuring or workout process poses unique challenges given the nuances of the AAL and various competing lender interests. This article examines some of the key considerations and potential pitfalls that borrowers and lenders should be aware of when a unitranche facility needs to be restructured.

Out-of-Court vs. In-Court Restructurings

As with any distressed credit, the path a unitranche restructuring takes - whether out-of-court or through a formal in-court proceeding like Chapter 11 - depends on the specific circumstances and dynamics at play. Factors such as the nature and severity of the company's issues, liquidity needs, implications for operations and vendor/customer relationships, and the degree of consensus (or lack thereof) among stakeholders all influence whether an out-of-court solution is achievable.

In general, companies and lenders alike tend to prefer out-of-court restructurings when possible to avoid the higher costs, delays, publicity and business disruption that often accompany a bankruptcy filing. The relative simplicity of the unitranche debt structure itself coupled with the relationship-driven nature of middle market lending can lend itself to constructive out-of-court resolutions in many cases.

On the other hand, there are situations where Chapter 11 is necessary or preferable as a tool to achieve certain restructuring goals - for example, where more dramatic balance sheet deleveraging is needed, leases or contracts need to be rejected, or holdout lenders are obstructing an out-of-court deal. A key factor is whether the company has sufficient liquidity to effectuate an out-of-court restructuring; otherwise, the protections and DIP financing available in Chapter 11 may be required.

From a unitranche lender perspective, while out-of-court restructurings are often preferable, the some of the unique features of unitranche facilities can actually provide more leverage to drive an out-of-court deal. In particular, the voting provisions and "required lender" construct under the AAL, coupled with the ability of "first out" lenders to impose standstill periods on "last out" lenders' exercise of remedies, afford the first out lenders significant control over the restructuring process in many cases absent a Chapter 11 filing.

Categorization and Voting Under AALs 

The AAL voting construct in a unitranche facility can have significant implications for a restructuring. Typically, AALs require a majority of both first out and last out lenders to amend the credit documents, with certain customary "sacred rights" requiring unanimity. However, AALs also layer on additional voting rules and lender categorization that can alter what would normally be simple majority amendment thresholds.

Most notably, while the borrower-facing credit agreement may define a single "required lender" concept based on a majority of total credit exposure, the AAL creates separate "required first out lender" and "required last out lender" definitions, setting different thresholds for certain actions that either lender group may take under the AAL. Majority first out lenders are often given greater unilateral latitude to take actions like increasing their commitments up to a defined cap without last out lender consent.

The AAL voting provisions can get even more complex when it comes to treatment of lenders that hold positions in both the first out and last out tranches, either directly or through affiliated funds. To prevent cross-over lenders from effectively being able to "double dip" and override the majority last out lender vote, AALs often exclude a first out lender's last out exposure when tallying required last out lender votes. Similar restrictions often apply to first out lenders voting their last out share in a manner adverse to other last out lenders.

A restructuring can magnify these inter-lender voting dynamics under the AAL. If amendments to the credit documents are required, navigating the layered voting thresholds and consent rights can be tricky, particularly if there are divergent interests between the first out and last out groups. Even if majority first out lenders can theoretically cram down certain changes on the last out, doing so can inflame tensions and create a more litigious restructuring environment.

The various tranches' respective leverage and willingness to compromise will often depend on where each sits in the capital structure and their relative economic positions given current valuations. A last out lender group, for instance, may be more inclined to challenge actions by first out lenders or refuse certain concessions if they are at risk of being substantially impaired or wiped out in a restructuring.

Payment Waterfalls and Buyout Rights

Another critical component of unitranche facilities that comes into play in a restructuring context is the payment waterfall provisions. While the borrower-facing credit agreement provides for a single blended interest rate and unitary waterfall, the AAL splits this into separate waterfalls for the first out and last out tranches, with the last out's right to receive payments deeply subordinated.

A distressed company's failure to make principal or interest payments, or the occurrence of another event of default, can trigger a shift from the ordinary course "pre-default" waterfall to a "post-default" regime. Once triggered, the post-default waterfall allocates all payments and collections according to a priority scheme that favors the first out lenders, with the last out's principal essentially being "last in line" behind all other first out obligations and even certain last out interest and fees.

Besides its obvious economic impact, the payment waterfall has a number of other important implications for a unitranche restructuring:

- Cross-defaults and blockages: In a stressed situation, companies need to carefully consider the impact of payment and covenant defaults on their ability to continue to pay interest or fees to the last out lenders. Given the standstill provisions common in many AALs, last out lenders may be left in limbo and unable to exercise remedies even as the company prioritizes payments to the first out tranche.

- Valuation and "flip" analysis: In situations where collateral valuations are depressed and the first out tranche is at risk of being undersecured or "out of the money," the calculation of the first out deficiency claim that flips to the top of the post-default waterfall (ahead of last out principal) can be contentious. Lenders and financial advisors may reach very different conclusions based on differing valuation methodologies. 

- Marshaling and reinstatement risk: Another potential point of contention arises from the interplay of the unitranche waterfall with the bankruptcy doctrine of "marshaling." In bankruptcy, if a senior secured creditor has recourse to multiple pools of collateral, it may be forced to first look to collateral sources in which a junior creditor lacks an interest, thereby "marshaling" the senior creditor's recovery to maximize the junior creditor's potential recovery. In a unitranche context, disputes could arise, for example, if the first out lenders seek to apply unencumbered assets first to any unsecured deficiency claim at the top of their post-default waterfall to the detriment of last out recoveries. Absent clear drafting in the AAL, some of these intercreditor marshaling issues remain unsettled.

- Enforcement of payment blockages in bankruptcy: A recent trend in many AALs is to require the borrower to sign the AAL, at least in an acknowledgment capacity, to bolster its enforcement in a borrower bankruptcy. Historically, many bankruptcy courts were reluctant to enforce AAL payment subordination terms that were not signed by the borrower based on perceived limitations on the court's jurisdiction to adjudicate inter-creditor disputes. While borrower acknowledgment helps mitigate this enforceability risk, it remains an area ripe for potential disputes. 

In response to some of these payment-related risks, AALs often arm both first out and last out lender groups with "buyout" rights in certain default scenarios. For last out lenders, the ability to purchase the first out obligations at par can provide a path to taking control of the restructuring process and pushing through a favored outcome. Conversely, first out lenders may have the option to buy out the last out's position as a way to capture upside in an improving credit while still getting repaid.

While buyout rights can provide leverage to "out of the money" lenders, their exercise remains relatively rare in practice. More often, the threat of a buyout serves to motivate the parties to reach a consensual resolution and avoid the risk of the buyout being consummated.

Divergent Interests and Remedies

Taking a step back, perhaps the overarching challenge of restructuring a unitranche facility is managing the often divergent interests of two lender groups who on paper share a single lien and set of collateral but in reality have very different economic motivations and legal rights. On one end of the spectrum are the first out lenders, who by virtue of their senior position in the post-default waterfall and control over exercise of remedies have a strong interest in preserving collateral value and may be more apt to favor a quick sale or foreclosure.

Last out lenders, on the other hand, may prefer a restructuring path geared more towards maximizing total enterprise value and potential recoveries, especially in situations where the last out is impaired or out of the money based on current valuations. Perceived inequities in the waterfall, or actions by first out lenders that are viewed as overly hasty or punitive, can provoke objections and lead to a more adversarial inter-lender dynamic.

In most AALs, while the first out lenders have the right to direct enforcement actions after a negotiated standstill period, last out lenders still retain certain baseline rights to take actions that unsecured creditors would typically be entitled to, such as objecting to DIP financing terms, asserting rights in bankruptcy, and challenging actions that are inconsistent with the underlying credit documents. Thus, even with an AAL in place, there are limits on the first out lenders' ability to completely curtail last out lenders' rights as creditors.

These competing interests and remedies between unitranche lenders manifest most acutely in a Chapter 11 context. While there is limited bankruptcy case law specifically addressing unitranche facilities, they do raise a number of potential issues and questions that remain unsettled:

- Classification of claims: A key dispute that may arise is whether the first out and last out lenders should be classified together or separately for plan voting purposes. While many AALs include explicit classification provisions purporting to require joint classification, the enforceability of such provisions in bankruptcy remains uncertain and may depend on the specific payment and subordination mechanics in the AAL. Lenders should expect bankruptcy courts to closely scrutinize the underlying economics and actual treatment of the different tranches when evaluating classification. The outcome of this issue can have profound implications for the trajectory of the case, particularly if cramdown or other plan challenges are in play.

- Allowance of claims: Another potential friction point relates to the allowance of lender claims and deficiency claims in bankruptcy. Valuation-based disputes over the extent and seniority of any first out deficiency claim that flips to the top of the waterfall can spill into the claims allowance process. While the AAL payment prioritization would presumably still govern, bankruptcy courts may be reluctant to fully allow or estimate a first out deficiency without addressing any last out objections to the underlying valuations.

- Enforcement of voting restrictions: Many AALs incorporate explicit voting restrictions that can limit junior lenders' ability to vote on a plan in certain scenarios. However, the enforceability of such voting assignments remains an open question. Several bankruptcy courts have been loath to approve provisions that completely disenfranchise creditors or are perceived as an impermissible infringement on voting rights. Here too, the specific language and mechanics of the AAL's voting clauses are critical.

- Other inter-creditor disputes: Beyond these technical bankruptcy-specific issues, unitranche restructurings can spawn a range of other disputes between lender groups that may be litigated in bankruptcy - from disagreements over cash collateral usage and adequate protection to outright challenges to the first out lenders' control of the restructuring process. While a comprehensive AAL can go a long way towards mitigating some of these risks, the complexity and bespoke nature of many unitranche facilities makes anticipating and warding off every potential dispute impossible.

Takeaways and Best Practices

For companies and lenders contemplating or already party to a unitranche financing, proactively managing some of these restructuring risks and hot-button issues is critical. A few key takeaways and best practices:

- AAL Diligence and Stress-Testing: Lenders should closely scrutinize AAL terms with an eye towards how they will function in a live restructuring. AALs tend to be highly negotiated and can vary significantly across deals in terms of their payment mechanics, control provisions, and bankruptcy-specific clauses. Stress-testing these provisions and modeling out potential downside scenarios is essential.

- Cross-Voting Considerations: The interplay of the voting provisions in both the AAL and the borrower-facing credit agreement often get short shrift but can have significant consequences in a workout scenario. Lenders should pay particular attention to quorum and voting thresholds, limitations on cross-over voting, and any inconsistencies between the two agreements that could frustrate a smooth amendment process.

- Valuation Assumptions: Given the prominent role that collateral valuation plays in the context of post-default waterfalls and potential bankruptcy classification fights, building a clear valuation framework into the AAL at the outset can help ward off disputes down the line. Addressing key assumptions and methodologies, such as the treatment of any unencumbered assets and the allocation of enterprise value, can provide greater predictability.

- Pre-Emptive Restructuring Discussions: Perhaps most importantly, unitranche lenders should engage in active, pre-emptive discussions at the earliest signs of credit deterioration with an eye towards building consensus around a restructuring framework. Getting all lender constituencies on the same page before a default occurs can be instrumental in avoiding a more drawn-out, contentious process. Here the parties' broader relationships and history of working together can be pivotal.

Conclusion

Despite their many benefits and increasing popularity, unitranche facilities are still a relatively untested product in a restructuring context. The overlay of an AAL on top of an already complex lending arrangement presents fertile ground for divergent lender interests and agendas to collide, often in unpredictable ways.

Understanding and anticipating some of these potential friction points is crucial for lenders and companies looking to proactively manage restructuring risk. While many potential defaults and lender disputes can be mitigated with careful drafting and pre-emptive dialogue, the relative paucity of case law addressing unitranche facilities in bankruptcy means that some level of uncertainty is inevitable. As more of these deals are tested in the years to come, a greater degree of clarity and market convention will likely take hold. In the meantime, stakeholders should remain vigilant and proactive in identifying and warding off risks throughout the life of a unitranche financing.