1.2 Unitranche and first-out/last-out structures

PC101 3.1 introduced the unitranche: a single first lien loan that replaces a separate first lien and second lien loan, with one blended interest rate. It's one of the core products of direct lending. Behind that single loan, though, the lenders often divide the risk among themselves. Some take a safer first-out piece at a lower spread. Others take a riskier last-out piece at a higher spread.

For analysts, this changes what a loan really is: a fund that holds "unitranche" may hold the safer or the riskier slice. LP-side analysts need to read portfolio reports that label positions as unitranche, first-out or last-out. Investor relations teams have to explain why one fund's unitranche yield is higher than another's, and service providers such as administrators and valuation agents have to track the split in cash flows and marks.

Why borrowers like a unitranche

A traditional buyout financing might have two layers of term debt: a first lien loan and a second lien loan, each with its own lender group, credit agreement and pricing, tied together by an intercreditor agreement (PC101 3.1). A unitranche replaces this with:

• One loan. One interest rate, one maturity and one set of covenants.
• One document. One credit agreement to negotiate, which saves time and legal cost.
• One lender group. Often a single lender or a small club. The borrower has fewer parties to deal with when it needs a waiver, an amendment or more money.

The result is speed and certainty of execution, which sponsors value highly (lesson 1.1). The borrower may pay for that, as the comparison later in this lesson shows.

The agreement among lenders

When a unitranche is split, the lenders sign an agreement among lenders (AAL). It's a contract between the lenders only. The borrower usually signs one credit agreement, makes one payment, and is often not a party to the AAL. In many deals it may not even know the detail of the split.

The AAL divides the loan into:

• First-out. This piece is paid first from interest, principal and any recoveries if the borrower defaults. It carries a lower spread. It's often held by a bank or a more conservative lender, such as an insurance-focused fund, that wants senior risk and can accept a lower return.
• Last-out. This piece is paid only after the first-out in a default or when payments are short. It carries a higher spread. It's commonly held by a direct lending fund seeking a higher return.

The AAL also sets out matters such as:

• The payment waterfall. How interest and principal are shared in normal times, and how that changes after a default or enforcement.
• Voting. Which lenders control decisions such as waivers, amendments and enforcement. Last-out lenders commonly keep significant say even though they're paid later.
• Buyout rights. Often, the last-out lender can buy the first-out piece at par if the loan gets into trouble, so it can take control of the workout.

AAL terms vary widely and are negotiated deal by deal. PC301 covers intercreditor terms and AALs in depth.

A worked FOLO split

The following example is illustrative.

Hollin Bay Capital leads a $100m unitranche for Pellworth Veterinary Group at SOFR + 600 bps. With term SOFR at 4.00%, the all-in rate is 10.00%, so Pellworth pays $10.0m of interest a year.

A bank wants a safer piece at a lower spread. Under an AAL, the lenders split the loan:

Piece	Amount	Spread	All-in rate (SOFR 4.00%)	Annual interest
First-out (bank)	$25m	SOFR + 300 bps	7.00%	$1.75m
Last-out (Hollin Bay)	$75m	SOFR + 700 bps	11.00%	$8.25m
Total unitranche	$100m	SOFR + 600 bps	10.00%	$10.00m

The check is that the spread income adds up:

25 × 300 + 75 × 700 = 7,500 + 52,500 = 60,000 = 100 × 600

The borrower pays the same blended spread either way. The AAL just reallocates the income and the risk between lenders. Because the first-out takes a lower spread than the blend, the last-out gets a higher one.

Two points are easy to miss:

• The blend is not a simple average. Averaging 300 and 700 gives 500, not 600, because the pieces are different sizes. Always weight by amount.
• The last-out is riskier than its "first lien" label suggests. It's secured and sits in a first lien loan, but in a default it's repaid only after the first-out. Its risk sits somewhere between a first lien and a second lien loan. Analysts and LPs should look through the label to the AAL.

Compared with a first lien/second lien stack

The following example is illustrative.

Pellworth could instead have borrowed through a traditional two-lien stack:

Layer	Amount	Spread	All-in rate (SOFR 4.00%)	Annual interest
First lien	$70m	SOFR + 450 bps	8.50%	$5.95m
Second lien	$30m	SOFR + 800 bps	12.00%	$3.60m
Total	$100m	SOFR + 555 bps	9.55%	$9.55m

The blended spread is (70 × 450 + 30 × 800) ÷ 100 = 555 bps. In this illustration the unitranche costs Pellworth 45 bps more, about $0.45m a year on $100m. That's the price of one loan, one document and one lender group, plus the certainty of dealing with a lender it knows. In other deals the comparison can come out the other way; it depends on the market and the borrower.

The structures also differ beyond price:

	Unitranche with AAL	First lien/second lien stack
Documents the borrower signs	One credit agreement	Two credit agreements
Contract between lenders	AAL, often without the borrower	Intercreditor agreement, usually with the borrower as a party
Security	One lien shared by all lenders	Two liens on the same collateral, ranked first and second
Who the borrower deals with	One lender group, often one agent	Two lender groups, often two agents
In bankruptcy	The AAL split is a private arrangement and its treatment can be less certain	Well-established two-lien structure

That last row matters. A two-lien stack creates two separate claims, which courts and practitioners understand well. An AAL is a private deal among lenders sharing one claim, and how it holds up in a bankruptcy depends on its terms and the court. This is one reason AALs are negotiated carefully.

Key terms

• Unitranche: a single first lien loan with one blended rate that replaces a first lien and second lien split.
• Agreement among lenders (AAL): a contract among unitranche lenders that splits the loan into first-out and last-out pieces.
• First-out: the piece of a split unitranche that is paid first and earns a lower spread.
• Last-out: the piece that is paid after the first-out in a default and earns a higher spread.
• FOLO: shorthand for a first-out/last-out structure.
• Blended spread: the amount-weighted average spread across the pieces of a loan or stack.
• Buyout right: a last-out lender's right, under many AALs, to buy the first-out piece at par.

Key takeaways

• Borrowers like a unitranche for one loan, one document and one lender group, and may pay for that simplicity.
• An AAL splits a unitranche among lenders; the borrower usually pays one blended rate and is often not a party.
• In the worked example, $25m first-out at SOFR + 300 and $75m last-out at SOFR + 700 blend back to SOFR + 600 on $100m.
• A last-out piece is labeled first lien but carries more risk; read the AAL, not just the label.
• The comparable two-lien stack blends to SOFR + 555 bps, so here the unitranche costs 45 bps more.