Australia leveraged finance: Best blend?

There is some debate as to when unitranche-like structures – which combine senior and mezzanine facilities into a single debt piece – took hold in Australia. The first announced deal closed in September 2017, with Pacific Equity Partners and The Carlyle Group’s acquisition of iNova Pharmaceuticals. However, it is claimed that KKR’s purchase of a majority stake in Laser Clinics Australia quietly completed its pricing a couple of weeks earlier.

As to what has happened since then, there is no debate. Unitranche has taken off as the financing tool of choice for private equity sponsors pursuing leveraged buyouts, corporates embarking on M&A, and assorted recapitalizations and refinancings. While some industry participants regard the structure as an unhealthy symptom of a market in which ample liquidity has caused investors to lose sight of risk, others describe it as harbinger of long-term structural change. 

“Unitranche is attractive to borrowers because it gives a certain degree of flexibility, which is aligned with an equity strategy to grow a business. Borrowers have been asking for this for a long time,” says Edward Tong, head of private debt in Asia Pacific at Partners Group. “There is nothing wrong with a traditional banking facility – sometimes it caters to a certain business need – but this year will likely be the first in which unitranche takes over in terms of volume.”

Willing participants

Partners Group led the financing for Laser Clinics, with HPS Partners providing the bulk of the debt for iNova. Both remain active in the market. During the 12 months post-iNova, HPS supported nearly a dozen more transactions, deploying around $2 billion. It has now put nearly twice that amount to work, typically taking substantial positions in deals at the top end of the market.

They are by no means the only willing debt providers. Global private PE firms with private debt strategies, such as Bain Capital and KKR, have made their presence felt in the market, competing with regional and local credit specialists, from ICG and Barings to Challenger Investment Partners, Tanarra Capital, Metrics Credit Partners, and Revolution Asset Management. Investment banks are also increasingly keen to arrange and syndicate deals, tapping local institutional investor demand.

The arrival of funds that prioritize yield over credit preservation has left the big four commercial banks somewhat isolated. Previously the go-to senior lenders, their lot is now to meet the super senior revolving credit facility (RCF) needs of these deals. Held back by the innate conservatism of credit committees with no stomach unitranche, numerous bankers have moved on.

“You want to be useful to your firm and to your clients, but it’s difficult to do that when you can’t generate deal flow that sits comfortably with your firm,” says Russell Sinclair, who left Westpac in June after six years covering acquisition finance and loan syndication. “The traditional lenders have great relationships and structures. However, to stay relevant as structural shifts occur, you need to find an employer whose risk appetite matches your own.”

Unitranche has featured in $2 billion worth of PE-backed loans, including buyouts, refinancings, and dividend recaps, so far this year, according to Debtwire. This compares to $1.89 billion in term loan B (TLB) and $3.43 billion in traditional bank loans. In 2018, the volumes were $750 million, $2.75 billion and $6.43 billion, respectively.

Others claim the unitranche share is even higher, with Macquarie putting it at 40% of all Australian private market debt issuance in 2017 and 2018. Credit Suisse's records of transactions since mid-2017 indicate an equal split between TLB, unitranche and bank financing. The bank adds two caveats. First, very large TLB deals skew the headline number. Second, the line between TLB and unitranche is becoming blurred.Having already gained traction in the US and Europe, unitranche found its way to Australia in the wake of an explosion in US debt financing. A string of financial sponsors tapped the TLB market between 2012 and 2014 as quantitative easing prompted a surge of money into the debt capital markets and the demand-supply imbalance meant there was less resistance on terms. 

The fundamental characteristics of a US TLB cannot be matched in Australia: incurrence covenants, which are only tested when the borrower takes certain actions, such as issuing new debt or engaging in M&A; flexibility on dividend payments and investment in capital expenditure; a bullet repayment on maturity after seven years instead of gradual amortization; and tight pricing. 

However, TLB is not available to all borrowers – an established sponsor, a well-understood industry, and EBITDA of at least $75 million are helpful in winning the favor of US-based investors – and it doesn’t always make economic sense. “We were issuing US dollars into the TLB market as if we were US credits. We had US dollar liability, so we would swap that back into Australian dollars,” says one GP of the 2012-2014 period. “As a result, we were incurring a significant cost over and above the rate we were paying to the US dollar investors to make sure we didn’t get caught out on currency.”

Despite efforts to issue Australian dollar-denominated TLB products, progress has been minimal. David Couper, a partner at law firm Allens, describes it as “basically a redenomination of a portion of a deal that has a US distributed element.” The portion is swapped back into Australian dollars and the buyers are mostly global funds that participate in the US piece as well. “There isn’t a local Australian dollar TLB that is cov-lite, the market hasn’t evolved yet,” he explains.

Middle ground

Unitranche represented the optimal compromise solution: local currency, cheaper than mezzanine products, lighter covenants than bank loans (there is usually just one governing leverage), more leverage than Australian lenders are willing to allow, and no need to negotiate with multiple counterparties across different tranches. Moreover, the institutional credit funds that pioneered the structure in the US were looking to expand into new markets. 

These solutions don’t work in every situation. A bank package is best for companies that cannot sustain a high degree of leverage – 4.5x in senior debt is up to 300 basis points cheaper than 6x of unitranche – or where they rely on banks for an array of ancillary services. This may include transaction banking services, capital expenditure facilities, or performance bonds issued to guarantee satisfactory completion of a project by a contractor.

“I’ve seen deals where the sponsor has initially asked for a high level but then dropped it back to 3x and asked for the rest in structured facilities,” says Lyndon Hsu, global head of leveraged and structured solutions at Standard Chartered. “There will be deals that are better suited to banks, but they are the minority. Most plain vanilla industrial or services businesses can utilize a unitranche structure. Some sponsors always go for the most aggressive structure, while others don’t.”

Complexity may also be a turn-off for unitranche providers. When a company needs substantial bank guarantees on an ongoing basis, this may inflate the RCF that sits on top of the unitranche structure. If this pushes out the unitranche position, effectively subordinating it because the RCF is classified as super senior, it can make deals harder to do, Tong of Partners Group notes. 

While PEP used unitranche on the iNova transaction, this is not the firm’s typical approach. It is relatively conservative on the use of leverage upfront – seldom pushing for 6x, according to a source familiar with the GP’s strategy – because an acquisition is usually followed by a period of intense operational change. With getting flexibility built into terms more of a priority than trying to stretch for leverage, a single senior tranche sourced from the bank market is preferred. 

Once the operationally intensive phase is completed, more aggressive options are pursued for refinancing. For example, when the TLB window opened in 2012, PEP refinanced the debt held by eight of 10 portfolio companies over an 18-month period. Three were done in the US market. 

Nevertheless, the firm often runs dual-track processes or unitranche versus senior debt to ensure it is getting optimal coverage in terms of price, covenants and overall leverage. “With the weight of capital moving into these credit funds, they are only becoming more competitive as to the broader solution they offer within the unitranche structure,” the source adds.

Limited supply

As it stands, the main constraint on unitranche is probably capacity. Of the nine Australia and New Zealand-based buyouts of $500 million-plus announced since the start of 2018 – excluding infrastructure and resources – only Greencross and Navitas feature a unitranche structure. Accolade Wines, Trade Me, and MYOB Group sourced cov-lite financing out of the US and Europe, and Campbell International is expected to follow suit. I-Med Holdings and Healthscope relied on local banks, while Sirtex Medical – acquired by CDH Investments – used Chinese lenders.

Broadly speaking, PE-backed deals that qualify for TLB tend to take it, assuming they are comfortable with the costs, rating agency coverage, and flex provisions that could prompt an adjustment in price. However, it is no coincidence that the two largest transactions – Healthscope and Campbell, at A$4.3 billion and $2.2 billion in enterprise value, respectively – avoided unitranche. The consensus view is that investor appetite for this structure extends no further than debt packages of A$1 billion

This limitation might be short-lived. Indeed, B although BGH's Capital acquisition of Navitas is said to have been supported by A$1.1 billion in unitranche financing.

“In the past, you might’ve had three institutional investors club together and their single asset exposure was A$150-200 million, so you’d cap out at A$500-600 million,” says Couper of Allens. “Now, with so much more depth in the market, some investment banks are willing to underwrite and distribute unitranche deals that deliver a greater quantum of liquidity. We’ve not yet hit A$1 billion, but I could see it happening in the next 12-18 months.”

Several other industry participants echo this view. It is speculated that HPS could do A$1 billion on its own for the right deal. If not, others could step in, either non-bank lenders that hold exposure within funds – HPS is a good example of this – or investment banks that syndicate within the local institutional market. While syndication can significantly boost capacity, it also introduces an element of uncertainty because sponsors don’t know where the paper might end up.

“Many of these deals don’t end with the acquisition. There are add-ons, recaps, and other things that happen post-acquisition where value is created for the sponsor and they might require a more flexible, accommodative debt provider who can grow with you as you grow,” says Gary Stead, a managing director with HPS. “If some lenders in your syndicate might say they can’t do any more or they don’t want to fund your expansion overseas, you might have to redo your entire debt stack.”

Syndication would also be the first line of weakness should the market suffer a shock – a deal goes wrong, investor demand dries up, and suddenly the structure falls out of favor. The archetypical scenario sees a unitranche provider become too aggressive in underwriting a sponsor’s business case, leverage is pushed to an unsustainable level, covenants are breached, and the target company needs an equity lifeline, which may or may not be forthcoming. 

Opinion is divided on the likelihood of this happening and whether it would prompt a wholesale withdrawal from the market. The bear view is that, with Australia’s economic outlook uncertain, it would take one or two standard deviations of downside on the risk to shake loose a 6x unitranche structure. One banker says that PE investors are already “waiting for the knife to fall, when they will come in and buy up this debt at A$0.30 on the dollar.” Unitranche is a passing fad and the market isn’t deep enough to hold firm if it comes under stress, he adds.

Others argue that the structure’s track record is long enough to withstand the effects of an isolated blow-up. “Enough deals have been done that if one fell apart, it would be more to do with the business than the structure,” says Couper. “Some commentary suggests only nine deals have happened since iNova, but that isn’t the case. There have been many privately financed unitranche transactions backed by a single fund or a group of funds clubbed together.”

Moreover, structures are by no means as fragile as the cov-lite deals with 7x leverage now routinely seen in the US market. Industry participants claim that, for the most part, discipline has been maintained in terms of leverage levels and underlying credit quality. 

“If you have good borrowers, good lenders, good underlying credits, good structures, and good pricing, that doesn’t ensure there won’t be a problem, but it’s the best way to protect a deal,” says Stead of HPS. “And I think there is a correlation between scale and risk. There are questions to be asked as to what level of leverage is appropriate for a smaller business and for a bigger business.”

Seeking a role

Assuming unitranche adoption remains on its current trajectory, local banks must decide how they want to participate. Providing the RCF guarantees some fee income from these transactions, but such is the discomfort with unitranche, some lenders pass on that if the covenants are too wide. Similarly, there is little interest in the first out-last out structures used in Europe, where the unitranche is split in two and the uppermost part is paid out first on enforcement alongside the RCF.

The most obvious entry point is targeting senior loan positions where the sponsor does not need 6x leverage. The Healthscope and I-Med transactions are said to fit this profile. Brookfield Asset Management secured a A$2.15 billion multi-tranche senior loan from a group of local and international banks to support its A$4.38 billion buyout of Healthscope, with a leverage level of around 5.1x

As for Permira's I-Med purchase, in addition to making the most of their pricing advantage, the banks tweaked their offering so it was as flexible as possible: leverage was pushed up as far as it could go; amortization was pushed out (though not indefinitely); and the number of covenants was reduced from four to two (they kept interest cover and leverage, but jettisoned debt service cover and capital expenditure).

These concessions offer insights into how commercial lenders can be competitive in the senior debt space, but also highlight their limitations. First, flexible propositions might only be made in highly stable sectors like healthcare. Second, banks are willing to bend the rules, not break them – they may broaden definitions within documentation, but they wouldn’t countenance a fundamental shift in policy such as abandoning five-year tenor. 

It remains to be seen whether commercial lenders could ever embrace a version of unitranche for the less aggressively leveraged deals. Much rests on the broader institutionalization of Australia’s private debt markets – a trend many industry participants regard as irreversible. 

“The last time we saw the market at its current heights was before the global financial crisis,” says Sinclair, formerly of Westpac. “Australian banks take a through-the-cycle view on lending practices and are currently more conservative versus some of the non-bank lenders. They may think the market will come back to them like it did after the crisis, but when I look at the number of non-bank lenders in the market, I’m not convinced it’s just a cyclical shift.”   

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• Topics
• Australasia
• Buyouts
• Financing
• Credit/Special Situations
• Australia
• Leveraged finance
• HPS Partners
• Partners Group
• Standard Chartered
• Pacific Equity Partners
• KKR