One direct lender recently said to 9fin: “We’ve traded out in some situations and would expect to see more direct lenders sell out in the near future as lots of teams don’t have the capacity or desire to go through a full-blown restructuring”.

That’s normal enough in bonds or syndicated loans, but in the relationship-driven world of direct lending, trading out risks damaging a fund's reputation and relationships with sponsors.

A second direct lender said: “For lenders it’s a lose-lose situation. It’s a choice between having a difficult conversation with a sponsor and trading out or still ending up having the difficult conversation with the sponsor and staying in the deal.”

A third lender said they would sell out in some instances which wouldn’t damage the relationship with the sponsor.

For example, in an event where there is a club of lenders in a unitranche, the lender would consider selling out to another holder who has more workout experience if they offered a reasonable price.

Embodying the ‘good lender’ line, a fourth lender disagreed: “We wouldn’t trade out. Our view is to hold onto our assets as looking through the cycle their performance typically returns to profitability and in the case of a downturn, we would rather work things out rather than sell out at a loss.”

The mechanics of unitranche documents make actually executing a sale much more difficult than with a leveraged loan.

If a borrower triggers an event of default, then technically the lender can freely sell the debt facility — but only to a limited pool of buyers.

This remains much more likely than in the syndicated market, because unitranche deals still feature financial maintenance covenants (as seen in Euromoney’s recent unitranche docs) — so breaching an agreed leverage level can still trigger an event of default, and hence open up the possibility of selling a position without a sponsors’ permission.

After an event of default, lenders would be still restricted from selling out to competitors of the business or to entities which are defined as ‘loan-to-own’ funds. However, this can vary from deal to deal, and in some documents there is a more relaxed regime for a ‘loan-to-own’ fund to purchase the debt once the borrower falls into default, but there is no wiggle room for competitors.

The practicalities of selling a direct lending deal make it most likely that the buyer would already be involved in the credit, whether it had triggered an event of default or not — with no financials available, any sale to a third party would need a bundle of data disclosure to get them up to speed, while other funds in the club would already know the borrower.

There is another route, but it’s not recommended. A lender could remain as lender of record and sell its economic interest to a third party. In the event of sub-participating, voting rights cannot be transferred, limiting the appeal of such a transfer to distressed funds. This risky move hasn’t been seen in practice and is relatively ill-advised, a legal source suggested.

Market participants told 9fin that recovery rates for unitranche loans are relatively high, putting a rough estimate at 65-75%. The close relationship with the sponsor, the smaller number of lenders (and egos) in the mix and more meaningful covenants in documentation were mentioned as key drivers for the higher recovery rates.

This supports the view that it makes more sense for funds to go through workouts themselves, as the recovery rate is likely to be relatively robust, rather than selling out, damaging the sponsor relationship and crystallizing losses.

Indeed, in 2020, in anticipation of a wave of Covid-induced workouts, larger direct lenders brought in restructuring talent tapping professionals from financial advisors. Despite their newfound expertise, their options are more limited as they are loathed to take equity and are incentivised to extend loans rather than take necessary haircuts, noted one advisor.

But even at these potential recovery levels, smaller funds with less manpower, could be incentivised to free up capacity and focus on new deals, where they have the chance to make the losses back through unitranche fees and interest. Even for a deal where recoveries were expected in the 65-75 context, but the fund may need to agree a lower price to give the purchasing fund some upside.