There has been some speculation (including in a thoughtful and well-articulated article from Mariana Valle et al in Debtwire, 21 September 2020) that the First Out / Last Out ("FOLO") financing structure is falling out of fashion. Here, having recently represented sponsors, clearing banks and credit funds on such structures, we add to the debate with a perspective from the UK mid-market, and conclude that we are not necessarily seeing the death of FOLO, but rather its evolution through an inherently difficult phase.
What is FOLO?
The FOLO structure has been a popular and much-talked-about feature of the UK mid-market leveraged finance space for a number of years now. These structures typically involve the provision of non-amortising term debt (the so-called 'last out facility') by a credit fund (the 'unitranche' provider). The unitranche facility will rank junior (in a post-enforcement scenario) to 'super senior' facilities. These 'super senior' facilities are typically a standalone RCF and/or a tranche of drawn term debt (the so-called 'first out' facility) provided by a clearing bank.
The less risky 'first out' position of the super senior facilities following enforcement is reflected in the relatively low returns (in terms of margin) that the super senior lender can expect to receive as compared to the returns to which the unitranche lender is entitled. The unitranche lender is also able to control the enforcement process, other than in exceptional circumstances. One might say that the FOLO structure allows the unitranche lenders to drive the car but the super senior lenders are tightly strapped in their seatbelts in the back.
Points of focus now
The use and character of FOLO structures has been shaped by a number of factors, some of which pre-date Covid-19 and the economic uncertainty that has followed.
Whilst in no way intended as a comprehensive summary of issues, the following points are intended as complimentary to those already discussed in the Debtwire article and elsewhere.
A direct impact of the pandemic on many companies has been a need to access urgent liquidity as regular income streams have been adversely impacted since March 2020. In response to this need for liquidity, companies with undrawn working capital lines or revolving lines of credit quickly sought to draw as much as needed to counter the absence of money coming in from business as usual.
This also applied to the super senior facilities forming part of FOLO structures, which are commonly arranged as revolving facilities that are, in usual times, not fully drawn. Post-Covid, new money super senior credit lines imbedded as part of a FOLO structure have often been arranged on the commercial understanding that they will almost certainly be fully drawn once available.
This sharpens the focus of the super senior lenders' minds, as their credit analysis shifts from contingency 'as needed' funds to drawn funds deployed to counter cyclical downturns in liquidity flows. This may lead to super senior lenders calculating their risk exposure on different terms to a traditional cyclically revolving facility.
The willingness of super senior lenders to provide their piece of the FOLO debt structure was always - and will always be - dependent on achieving a certain return. The return is measured in terms of both direct pricing (margin plus upfront fee) and ancillary wallet i.e. relationship rewards for the super senior lender in the form of providing bank accounts, overdraft lines, derivative arrangements and local lines of credit. Alongside the tangible return might also be added the less easily quantifiable but significant rewards for being seen to support a portfolio company of a given sponsor, leading to the possibility of more lucrative opportunities in providing the senior debt to other portfolio companies of the same private equity house.
A clearing bank's assessment of whether the return justifies the risk may not always be reflected in the margin quoted. A high margin may actually reflect the absence of the less tangible benefits, and in reality be an indication that the deal is not one which the bank wishes to do. This is especially true at a time when many clearers may put a premium on supporting existing customers (and existing sponsor relationships) through turbulent times, as opposed to chasing new-to-bank super senior opportunities.
Set against the rewards are the perceived risks. Truly super senior facilities might be seen as effectively risk-free – for example, one turn of leverage, with a large equity buffer and the junior debt to insulate from risk in an enforcement. Less a seat belt and more a cloak of invincibility. However, many of the facilities written on a purportedly super senior basis are nothing of the sort. We regularly see super senior/unitranche documents which feature practically no protection for the super senior lender as against a clued-up unitranche provider in an enforcement scenario, and ought to be priced on an all senior basis. (In fairness, we also see the opposite, leaving the unitranche provider in an invidious position upon a default.)
Clearing banks are getting wise to the ways in which sieve-like drafting (especially disposals clauses, various of the 'permitteds', change of control and the enforcement provisions) can be utilised to erode their position (see our previous related insight). If a bank suspects it won't get truly super senior terms, it will price accordingly / reject the opportunity, especially in a climate in which the perception is that enforcement scenarios may be more likely.
As we move through the economic cycle, we see certain market factors influencing the way that FOLO structures are used.
Less is more
Before the pandemic, we were already seeing a trend towards private equity houses shying away from a focus on maximum leverage for their portfolio companies and moving towards the safety offered by a diversification of lender relationships. With the true reckoning still to come for many over-levered businesses in sectors facing an existential crisis, we expect that trend to gain pace.
Sponsors recognise the value in having clearing bank relationships, including as part of FOLO structures, as part of their lending mix.
As has been well-reported, there is a significant amount of private equity 'dry powder' for deployment in this quarter and into 2021. There is already, and will likely continue to be, a move towards equity-funded deals where the super senior style piece is only brought in at a point when the perceived execution disadvantages of FOLO structures are less critical.
The fact remains though that, even if put in place after the main transaction is completed, working capital facilities are frequently needed and banks are often best-placed, and most willing, to provide them (in particular where true revolving facilities and bespoke ancillaries are required).
Many of the points already raised in the conversation around super senior-unitranche structures are well-made and absolutely on-point. However, the current unique market conditions are not conducive to a full assessment of whether the market has fallen out of love with FOLO and we feel that, at least as far as the UK mid-market is concerned, it is too early in the relationship to say that we'll be going solo without FOLO.