The impact of unitranche on interest rate hedging

Alice Murray
29 January 2014

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As unitranche lending reaches increasingly heightened levels of activity, its impact on the pricing of hedging products, typically provided by banks, is becoming a cause for concern. Alice Murray reports

As banks have increasingly pulled out of acquisition finance, there's no denying the need for alternative lenders in order to finance deals in the current market. However, with debt funds providing only the unitranche portion, traditional banks are still needed to supply the revolving credit facility and the interest rate hedge.

The new tendency for unitranche lending is causing concern among certain advisers, as the nascent structures are beginning to throw up some unforeseen problems. Recent unitranche transactions have seen traditional lenders coming in to provide the revolving credit facility on top of (ie, in a super senior position) the unitranche loan, and therefore are the natural counterparty to provide the interest rate hedge, or any other hedging that may be required for risk management. As unitranche is typically provided on a floating interest rate, it requires interest rate derivatives to hedge against rising interest rates. A recent example of this was LDC's purchase of restaurant group D&D London, which was supported by Lloyds Bank, supplying a super senior revolving credit facility and acting as sole hedging provider, on top of BlueBay's £25m unitranche facility.

The interest rate hedge is usually ranked level (pari passu) with the revolving credit facility in the capital structure. This should mean that the price of the interest rate hedge reflects its super senior status with expected credit spreads lower due to the substantially reduced risk position of the hedging counterparty. However, this is not always the case.

"This therefore allows borrowers to go out to market to find alternative, standalone hedge providers," explains Jackie Bowie, CEO of JC Rathbone Associates. "This allows competitive tension in the pricing and ultimately can benefit the borrower and the unitranche provider. Also, depending on the hedge structure chosen it can mean no further credit line is needed to support the hedge."

Recent partnerships between alternative and traditional lenders make the issues around creating the optimal hedging strategy, and ultimately creating transparency in the price/rates being quoted, even more difficult. By setting up a one-stop shop for borrowers to source their unitranche and revolving credit facility, the interest rate hedge is likely to be automatically obtained from that bank. "If lenders become a one-stop shop then choice over who provides the interest rate hedge is taken away, therefore removing any competitive tension, which could be detrimental to the price," explains Bowie.

While the increased availability of non-bank debt is certainly a welcome feature in the acquisition finance market in that it is enabling better dealflow, it could also be the cause of much greater complexity around financing deals. In the old world of bank club deals, multiple banks being available to compete on the price of any auxiliary products (such as hedging) offered the borrower more choice. Providing the hedge is a very lucrative income source for the banks, so in the old style multi-bank deals, an auction process could be arranged to ensure best pricing and outcome. With just one unitranche provider and one bank in the mix in recent deals, this is more difficult to achieve.

One other feature of unitranche-funded deals is the existence of interest rate floors (Libor floors). While they may be benign (although expensive) in their own right, they have large repercussions for the interest rate hedging strategy and the choice and price of instrument that can be implemented.

When putting together acquisition finance for a new transaction, private equity houses should be engaging with relevant advisers as early on as possible. "It is vital that the hedging requirement is set up early in the process," advises Bowie. In order to finance deals in the most streamlined and efficient way, bringing in an adviser to find an interest rate hedge provider, which does not need security for the best price, might be the best way forward. "It's about finding the best way to carve up the credit line," says Bowie.