What Hedge Funds and Private Equity Funds Need to Know When Providing Subordinated Debt Through Unitranche Facilities

February 22, 2017

Recently there has been a trend in the U.S. middle market to structure loan transactions involving a senior lender and a subordinated lender utilizing a Unitranche Loan Structure. Unitranche Loans are generally structured as a single debt instrument by the senior lender. As the name implies, the proposed loan contemplates a single loan instrument between the senior lender and the Borrower, a single tranche of interest and principal payments, a single set of covenants and defaults and a single security arrangement between the senior lender and the Borrower. The arrangement contemplates that the senior lender may obtain funding of a portion of the funds advanced from other lenders, but the Borrower is generally not involved in those arrangements except to acknowledge their existence.

This structure is promoted by banks that are active senior lenders in the middle market space on the basis that it: (a) allows the Borrower to negotiate only one loan agreement and one set of security agreements, which allows for such a facility to be put in place faster than traditional structures involving separate senior and junior loan facilities and an inter-creditor agreement among the lenders in each; (b) simplifies ongoing compliance and reporting since there is only one set of covenants and reporting requirements to administer; and (c) often eliminates the cost of independent collateral agents and other agents for each of the senior lenders and the subordinated lenders that are often required in more traditional senior/subordinated loan structures.

Unitranche Facilities have become a popular tool in the world of middle market lending. While this market generally was dominated by large banks and asset based revolving lenders, over the last few years middle market lending has evolved to include a larger variety of lenders including hedge funds specifically formed for purposes of acquiring mezzanine debt in this market. Due to the larger return generally allocated to the subordinated tranche of these facilities, hedge funds and private equity funds have become very active in providing the subordinated tranche, even though there is a larger risk associated with such tranches.

This article provides an introduction to the Unitranche Facility and then focuses on some of the concerns the Last-Out Lender (i.e., the subordinated lender) should consider when entering into a Unitranche Facility.

An Introduction to the Unitranche Facility

As noted above the funds are made available to the Borrower by the originating senior lender under a single loan agreement between the senior lender and the Borrower. For purposes of the discussion which follows, this loan agreement is referred to as the “Primary Loan Agreement” and the loan pursuant to it as the “Primary Loan.”

The other lenders participate in the Primary Loan through an agreement among lenders (the “AAL”), which primarily serves two purposes. First, it functions as the inter-creditor agreement between the senior lender (referred to as the “First-Out Lender”) and the subordinated lender (referred to as the “Last-Out Lender”). Second, it sets forth the respective rights of each of the lenders in the cash flow, by splitting the principal, interest, make-whole payment, fees and other payments received by the senior lender from the Borrower under the Primary Loan into separate first-out and last-out tranches (referred to herein, respectively, as the “First-Out Loan Tranche” and the “Last-Out Loan Tranche”).

The inter-creditor issues addressed in the AAL are not unlike those addressed in a more traditional inter-creditor agreement between senior lenders and subordinated lenders providing loans through separate facilities, and a full discussion of these issues is beyond the scope of this article. However, there are some issues unique to a Unitranche Facility that will be pointed out later.

The AAL typically deals with each element of cash flow arising out of the Primary Loan. Generally, in the absence of the occurrence of a Trigger Event (discussed and defined below): (a) principal payments received under the Primary Loan are applied to the repayment of the principal of the First-Out Loan Tranche and the Last-Out Loan Tranche in proportion to the initial outstanding balance of each; (b) interest payments received under the Primary Loan are applied to pay interest on the First-Out Loan Tranche and the Last-Out Loan Tranche on the basis of a split mechanism described below under “Interest” designed to assign appropriate interest returns in respect of each; and (c) other amounts are allocated as may be agreed. After the occurrence of a Trigger Event, the subordination features of a typical inter-creditor agreement come into play, with cash flows being applied first to repay the First-Out Lender. While the goal of the AAL in dividing the cash flows from the Borrower under the Primary Loan Agreement is to approximate what would have occurred had the senior loan and the subordinated loan been separately negotiated, that goal cannot be reached fully given that the Primary Loan interest payments, make-whole payments and certain other obligations are geared solely to the performance of the Primary Loan. In contrast, if the subordinated loan had been a separate obligation of the Borrower, the interest payments, make-whole payments and certain other obligations of the Borrower to the subordinated lender would be geared to the performance of the subordinated loan.

With the forgoing introduction as a basis, the remainder of this article will discuss various issues from the point of view of the subordinated lender.


The Borrower pays interest only to the First-Out Lender in accordance with the terms of the Primary Loan. The AAL will provide that the First-Out Lender pays over a portion of any interest payment received from the Borrower pursuant to the Primary Loan to the Last-Out Lender. Typically, the AAL will provide that the First-Out Lender pays a portion of the interest payments received under the Primary Loan equal to the excess, if any, of such interest payments over the accrued and unpaid interest computed at a rate set forth in the AAL (the “First-Out Loan Rate”) computed with reference to the outstanding balance of the First-Out Loan Tranche. The First-Out Loan Rate is generally set at a rate that is sufficiently lower than the interest rate payable by the Borrower pursuant to the Primary Loan, so that if the Borrower makes all payments under the Primary Loan on a timely basis, the excess interest received by the First-Out Lender and paid over to the Last-Out Lender is sufficient to provide the Last-Out Lender a return that is appropriate for its subordinated loan position For example, if the outstanding balance of the Primary Loan is $100,000 and bears interest at 6% simple interest, there will be $6,000 of interest payments per annum from the Borrower. If the First-Out Lender provides $60,000 of the funding and assigns a First-Out Loan Rate of 4% simple interest, it will keep $2,400 of that interest and pay the Last-Out Lender $3,600 of interest on the $40,000 that the Last-Out Lender funded, or a rate of 9% simple interest.

Unfortunately, if the ratio of the First-Out Loan Tranche outstanding to the Primary Loan principal amount outstanding declines, the effective rate of interest on the Last-Out Loan Tranche will also decline. This is one of the more troubling aspects of the Unitranche structure for the subordinated lender. As in most senior/subordinated loan structures, upon occurrence of certain events (referred to herein as “Trigger Events”) payments that normally would have been applied to the principal balance of the Last-Out Loan Tranche are applied to repay the First-Out Lender until the First-Out Lender has been paid in full. However, in the more traditional structures, the obligation to pay the subordinated lender the accrued and unpaid interest does not go away and the interest rate that accrues in respect of the outstanding principal of the subordinated lender does not decline. However, in the Unitranche Facility, an effective reduction in the contractual interest rate payable to the Last-Out Lender results from disproportionate repayment of principal of the First-Out Loan Tranche and the Last-Out Loan Tranche. That reduction is referred to in this article as the “Unitranche Last-Out Interest Rate Adjustment”. It is essentially a contractual agreement by the Last-Out Lender to a reduction in its contractual interest rate following a Trigger Event.

There is no easy fix for the Unitranche Last-Out Interest Rate Adjustment. As between the First-Out Lender and the Last-Out Lender, it is a zero sum game and the First-Out Lender is unlikely to reduce its economics for the benefit of the Last-Out Lender. While it would not be unreasonable to ask the Borrower to agree to a higher interest rate following a Trigger Event sufficient to preserve the Last-Out Lender’s assumed interest rate, in general we have not seen that done. While the obligation of the Borrower to pay a higher past due interest rate during the period when certain payments required of it are not being made in a timely manner, the past due interest rate is often not structured to fully eliminate the Unitranche Last-Out Interest Rate Adjustment. Accordingly, this puts a lot of pressure on: (a) the negotiation of the events that constitute “Trigger Events”; (b) the negotiation of events that give the Last-Out Lender a right to insist upon the exercise of remedies; and (c) the need for the Last-Out Lender to carefully evaluate the likelihood that a Trigger Event will occur.

Prepayment Fees and Make-Whole Payments

Generally, AALs’ provide that First-Out Lenders pay over to the Last-Out Lenders a portion of prepayment fees, make-whole payments, commitments fees, facility fees and other regularly accruing fees under the Primary Loan Agreement. The amount of such items to be paid over is often subject to negotiation (including the negotiation of thresholds to such payover or limitations on the maximum amounts that may be paid over). Moreover, the First-Out Lender may seek to provide that under certain circumstances, including the continuance of a Trigger Event, any amounts allocable to the Last-Out Lender are subordinated to the payment of all amounts due to the First-Out Lender.
Therefore, when negotiating an AAL, the Last-Out Lender should recognize that there are no market precedents that control these issues.

Trigger Events

The definition of what is a Trigger Event and the depth of subordination during such events are both points that are heavily negotiated in these types of transactions. It is clearly market for
Trigger Events to include: (a) bankruptcy or insolvency events constituting Events of Default under the Primary Loan Agreement; (b) an ongoing series of payment defaults relating to interest or principal under the Primary Loan Agreement; and (c) the actual acceleration of the Primary Loan and commencement of enforcement actions in respect of the collateral. That much is certainly reasonable and consistent with the shifting of priorities under most inter-creditor agreements.

However, it is also common to see Trigger Events include lesser defaults, including defaults under the financial covenants in the Primary Loan Agreement that have not yet resulted in a material interruption of the cash flows. Given the Unitranche Last-Out Interest Rate Adjustment that would result from such a Trigger Event, this would be a point on which the Last-Out Lender may wish to push back.

Beyond the foregoing events, additional Trigger Events are normally the subject of negotiation. Last-Out Lenders should be aware of the following events which First-Out Lenders frequently seek to include as additional Trigger Events: (a) any bankruptcy or insolvency event that has not yet become an Event of Default under the Primary Loan Agreement (such an involuntary proceeding which normally does not become an event of default unless it is not dismissed after a certain period of time); (b) a single payment default relating to interest, principal or fees under the Primary Loan Agreement, without regard to the size or duration thereof; (c) acceleration of obligations under any hedging agreements that are separate from the Primary Loan Agreement; or (d) the failure of the Borrower to deliver financial statements on or close to the required dates set forth in the Primary Loan Agreement.

Another related issue is whether the normal allocation of cash flows between the First-Out Lender and Last-Out Lender should resume (with or without a catch-up for the Last-Out Lender) if a Trigger Event has occurred but is thereafter cured by the Borrower and any cash flow deficiency resulting from it is restored.


An AAL generally contains voting arrangements with respect to amendments, waivers or remedies. These provisions are normally heavily negotiated. They frequently give the Last-Out Lender a controlling vote not only on modifications, but also waivers of defaults and other matters that could impact the risks that it is taking as the first loss party. Sometimes, the First-Out Lender will seek to restrict the Last-Out Lender’s right to control such issues to periods of time when a Trigger Event has occurred and is continuing. The First-Out Lender may also seek to withhold from the Last-Out Lender the power to initiate the exercise of remedies or the grant of a waiver during the continuance of a Trigger Event, but may allow the Last-Out Lender the power to veto such actions.

A further complication arises when a Last-Out Lender acquires a portion of the First-Out Lender’s position – either as a result of a buy-out option in the AAL or as a result of a market transaction. A First-Out Lender often seeks to provide in the AAL that in such situations the First-Out Lender’s vote held by a Last-Out Lender is not counted.


Like a standard two-tier transaction with an inter-creditor agreement, an AAL will provide the Last-Out Lender with a purchase option, a right to buy the First-Out Lender’s loan at par, subject to certain criteria. This purchase option may be a critical component to the Last-Out Lender since it may well be the Last-Out Lender’s only option in certain circumstances where it cannot otherwise control the exercise of remedies under the Primary Loan. Therefore, the Last-Out Lender needs to fully understand and be comfortable with the terms of such an option, including: (a) the circumstances under which it can be exercised; (b) the computation of the price it must pay and what it must purchase; and (c) the obligations it is assuming as a result of the purchase. It should be noted that this option does not provide a fix for the Unitranche Last-Out Interest Rate Adjustment and may be economically disadvantageous to the Last-Out Lender, since the funds advanced to make the purchase will earn interest at the lower First-Out Loan Rate.

One of the most contentious issues relating to the buy-out option is the point in time when it can first be exercised. Generally speaking the First-Out Lender will seek to require that: (a) the Last-Out Lender defer the exercise until a negotiated period (generally 30 to 120 days) has expired from the date of the notice of exercise without the commencement of an enforcement action on the part of the First-Out Lender; and (b) the notice of exercise can only be given upon the occurrence of certain events, generally, but not always, including Trigger Events that could give rise to a change in the allocation of loan proceeds. Again, there is no controlling market precedent to these issues.

Some of the other issues that may arise are as follows: (i) whether in connection with the purchase option, the purchase price should include an amount equal to unpaid interest accruing after the commencement of the Borrower’s bankruptcy proceedings even if such interest is not allowable in those proceedings; (ii) whether the Last-Out Lender should be required to post collateral sufficient to provide payment to the First-Out Lender for any unresolved contingent claims; and (iii) if the Last-Out Lender receives any prepayment premium within a specified period of time after it has exercised the purchase option, whether the Last-Out Lender should be required to pay such amount to the First-Out Lender as an additional purchase price. In addition, as with a traditional inter-creditor agreement, the length of the standstill period before a Last-Out Lender may exercise its purchase option is a point that is heavily negotiated.

Tax Considerations

It is uncertain how the arrangements contemplated by an AAL would be treated for U.S. federal income tax purposes. A Last-Out Lender should bear in mind that it is possible the Internal Revenue Service might determine that such an arrangement is a partnership for tax purposes. If that were to happen and the determination were upheld, it is unclear how the parties would be taxed on the interest payments received from the Borrower. It is likely however, that the taxable income arising from the interest received from the Borrower would be appropriately allocated among the lenders based upon how those interest payments are distributed. However, any loss sustained by the Last-Out Lender could be deferred until its partnership interest is deemed to become worthless (or is otherwise disposed of).

If, however, the arrangement is treated as separate senior and subordinated loans from the lenders to the Borrower, then the treatment of the Last-Out Lender for tax purposes is uncertain. If no interest rate is specified for the Last-Out Loan and the Last-Out Lender simply gets a share of the interest received in excess of the First-Out Lender’s stated interest rate, then it is likely that the Last-Out Loan will be viewed either as an obligation issued at an original issue discount or as being a contingent payment debt instrument which requires that the amount of interest on which it is taxable each year will be determined under the rules applicable to such obligations. This approach may also impact the deductibility of interest payments by the Borrower. Alternatively, if there is a stated rate of interest for the Last-Out Loan, this could result in the Last-Out Lender being subject to tax on payments received as interest (even where it is clear that it will not recover principal). In either case, if the value of the Last-Out Loan Tranche declines in value, the Last-Out Lender will be subject to current taxation on the interest received (or deemed received) but will not be able to claim the loss until the Last-Out Loan becomes worthless or is otherwise disposed of. In certain circumstances, such a loss could be a capital loss and subject to significant limitations. Last-Out Lenders should consult with their tax advisers to discuss potential solutions to these issues.

Finally, an offshore fund that is participating in such transactions should consider how the Unitranche documentation bears on the risk that the fund may be deemed to be engaged in a lending business in the United States. To the extent the documentation supports the view that the fund is acquiring from the First-Out Lender a portion of a loan initiated by the First-Out Lender, that may be helpful in overcoming an argument that the fund is engaged in a lending business in the United States. However, as noted below, there are other concerns that may create a tension between this goal and certain other objectives of the Last-Out Lender.

Bankruptcy Concerns

Perhaps the biggest concern that subordinated lenders should consider with respect to Unitranche Facilities is how an AAL would be construed and enforced in a bankruptcy proceeding of the Borrower. Section 510(a) of the United States Federal Bankruptcy Code (the “Bankruptcy Code”) clearly provides that the bankruptcy court has jurisdiction to enforce a subordination agreement among creditors of the debtor in a bankruptcy proceeding. Unfortunately, the Bankruptcy Code does not define “subordination agreement” so the precise scope of this power is unclear.

However, the question is whether the AAL will be viewed as an inter-creditor/subordination agreement if it is not clear that a debtor-creditor relationship exists between the debtor and the Last-Out Lender. In the purest form of Unitranche Facility, there is no privity of contract between the Borrower and the Last-Out Lender. The Borrower is generally not a party to the AAL. Faced with such facts, it is possible that a bankruptcy court might determine that it has no jurisdiction over any dispute between the lenders arising from such agreement. If that were to happen, presumably the dispute would end up in the appropriate state court.

In a recent oral ruling in the RadioShack bankruptcy case, the Delaware Bankruptcy Court stated that it was not ruling on the jurisdictional issue but nevertheless implicitly recognized the court’s ability to construe and enforce an AAL, given its importance in deciding whether to proceed with an asset sale. Although this decision seemingly would provide comfort to lenders, it did not definitively rule that a U.S. bankruptcy court would assert jurisdiction to consider arguments arising out of an AAL. In RadioShack, all of the relevant parties in the case had consented to the bankruptcy’s court’s jurisdiction to consider the AAL in the underlying dispute. Therefore, it is unclear if the parties have not initially agreed to the court’s jurisdiction, whether the court would agree to assert its jurisdiction. Clearly, lenders should be conscious of this issue and carefully draft their AAL to ensure the protections afforded by an AAL are not circumvented in a bankruptcy proceeding.

It is often possible to address this issue in the Unitranche Facility documentation. Provisions that are usually permitted to assist in this regard are: (a) a provision in the Primary Loan Agreement pursuant to which the Borrower acknowledges that the lender under that agreement intends that a subordinated lender will be providing a portion of the loan proceeds in exchange for a right to a portion of the principal, interest and other payment obligations of the Borrower under the Primary Loan Agreement; and (b) a provision in the Primary Loan Agreement pursuant to which the Borrower acknowledges that the lender under the Primary Loan Agreement holds the contractual rights under the Primary Loan Agreement as agent of all of the lenders pursuant to the AAL.

Another area of uncertainty in the bankruptcy context with respect to Unitranche Facilities is the classification of the senior lender and subordinated lender of a Unitranche Facility under a bankruptcy plan. Claims may not be classified together if they are not substantially similar. It is unclear if the senior and subordinated lender would be classified in the same class (since their claims originate from the same loan agreement) or separate classes (since the two lenders have different priorities under the AAL). The answer to this question greatly affects both creditors’ rights when it comes to recoveries and voting.

Senior Lender Credit Risk

In its purest form the Unitranche Facility is drafted such that the Primary Loan Agreement and the related security agreements do not include the Last-Out Lender as a party. This could lead to an argument that the only party to which the Last-Out Lender may look for payment is the First-Out Lender and that unless the documentation clearly assigns to the Last-Out Lender or an agent for the Last-Out Lender an interest in the security provided by the Borrower to the First-Out Lender, the obligations of the First-Out Lender to the Last-Out Lender under the AAL are unsecured obligations of the First-Out Lender.

It is important to the secured position of the Last-Out Lender, albeit a subordinated security position, that the documentation clearly give the Last-Out Lender or an agent acting on its behalf, a security interest in the collateral. In a well negotiated Unitranche Facility this is accomplished by providing in the security documentation that the First-Out Lender (or another party) is being granted the security interests provided therein as agent for all of the lenders including the Last-Out Lender.

If you should have any questions concerning this article, please contact either James H. Hancock of the Firm’s Corporate Finance Group, Ronald L. Cohen of the Firm’s Bankruptcy and Restructuring Group or James C. Cofer of the Firm’s Tax Group.