The recent growth and renewed confidence in the UK economy has seen increasing buoyancy in the debt markets and numerous new non-bank funds entering the market. With the prolonged low interest rate environment, fund managers are increasingly keen to set up direct-lending operations to generate returns of 10% or more.
With the continuing scarcity of high quality deals in the mid-market, non-bank debt funds are applying 'unitranche' debt structures to increasingly small transactions. A unitranche structure allows the lender to provide the first pound of senior secured debt in a structure, while also stretching leverage into territory traditionally thought of as mezzanine. The borrower benefits from the 'one-stop-shop' without the complexity of inter-creditor negotiations.
Small growing businesses whose capex and working capital funding requirements mean cash conversion is limited attract only modest debt multiples from bank lenders, who traditionally require significant amortisation in Term Loan A/Term Loan B debt structures. A unitranche provides a higher leverage multiple of non-amortising debt, thereby freeing up cash flow to fund growth, so benefiting both management and equity investors.
As well as targeting smaller mid-market deals, non-bank debt funds are seeking to be more creative in how they put money to work. Some fund lenders are keen to provide PIK notes and even minority/senior equity investment, in the often mistaken belief that PE investors are focused solely on maximising returns. However, the significant number and volume of PE funds chasing a small number of high quality deals means they may prefer to put equity in the part of the capital structure previously occupied by mezzanine. Bank lenders, fearful of being squeezed out of the market altogether, are seeking to provide 'super senior' layers of term debt within unitranche structures.
As a result of this increased competition among banks, non-bank fund lenders and PE investors are competing for a slice of the capital structure, and there are various signs of the market over-heating. The weight of equity is pushing up enterprise values for quality businesses and the desire to properly equitise transactions has meant leverage multiples for any (senior/mezzanine or unitranche) debt structures are rarely above 6x in the mid-market.
Despite this apparent discipline, competition to put money to work among lenders is driving aggressive behaviour in other areas - lower fees, fewer covenants and lower margins. PE owners of businesses seeking leveraged recaps can significantly de-risk their investment - owning the business with no cash at risk while lenders provide significant leverage, places the burden of debt service squarely on the shoulders of management.