Direct Lending and Unitranche

Direct Lending is the provision of loans directly to middle market companies without the involvement of intermediary banks. This is the dominant strategy in private credit, accounting for more than 55% of the entire market. Unitranche is a hybrid structure that combines senior and subordinated debt into a single instrument.

Mechanics of Direct Lending

Typical Deal Structure

Parameter	Senior Secured	Unitranche
Leverage	3.5–4.5x EBITDA	4.5–6.0x EBITDA
Pricing	SOFR + 400–550 bps	SOFR + 550–700 bps
Tenor	5–7 years	6–7 years
Amortization	1–5% per annum	0–1% (bullet)
Security	First lien on all assets	First lien + equity pledge
Covenants	2–3 maintenance covenants	1–2 maintenance covenants

Deal Flow and Origination

Sources of deals for direct lenders:

PE sponsors (70–80%): LBO and add-on financing for portfolio companies
Investment banks (15–20%): Referrals from M&A and debt advisory teams
Direct relationships (5–10%): Companies and their advisors directly

Due Diligence Process

Screening (1–2 days): Basic analysis of CIM, size, leverage, industry
Preliminary analysis (1–2 weeks): Financial model, industry research, preliminary term sheet
Deep dive (2–4 weeks): Management meetings, site visits, third-party reports
Documentation (2–3 weeks): Credit agreement negotiation, legal due diligence
Closing: Funding, security perfection

Unitranche: First Out / Last Out Structure

How Unitranche Works

Unitranche is a single credit instrument with a blended rate, but internally divided into tranches with different priorities:

Tranche	Share in Structure	Rate	Priority
First Out	60–70%	SOFR + 350–450 bps	First to be repaid, first lien priority
Last Out	30–40%	SOFR + 700–900 bps	Subordinated within unitranche
Blended rate (borrower pays)	100%	SOFR + 550–650 bps	Single facility from borrower view

Agreement Among Lenders (AAL)

A key document regulating the relationship between first out and last out lenders:

Waterfall provisions: Allocation of payments and proceeds
Voting rights: Required lender thresholds for different decisions
Enforcement rights: Who controls the process in case of default
Purchase options: Right of last out to buy out the first out
Yank-a-bank: Right to replace minority lenders

Pricing: Yield Components

Pricing Structure

Component	Description	Typical Level
Base Rate	SOFR (formerly LIBOR)	4.50–5.50%
SOFR Floor	Minimum base rate	0.50–1.00%
Credit Spread	Compensation for credit risk	450–700 bps
OID (Original Issue Discount)	Discount to face at issuance	1–3% (98–99 issue price)
Commitment Fee	On unused portion of revolver	37.5–50 bps
Ticking Fee	From signing to closing	50% of spread
Prepayment Premium	Call protection	101–102 in Year 1–2, par thereafter

All-in Yield Calculation

Example: Senior secured loan, $100M facility

Base: SOFR 5.00%
Spread: 500 bps
OID: 2% (issued at 98)
Term: 5 years

Cash yield: 5.00% + 5.00% = 10.00%
OID amortization: 2% / 5 = 0.40% per annum
All-in yield: 10.00% + 0.40% = 10.40%

Covenant Packages

Maintenance vs Incurrence Covenants

Type	Description	Example
Maintenance	Tested quarterly, independent of actions	Leverage ≤ 5.0x, FCCR ≥ 1.1x
Incurrence	Tested only upon certain actions	Leverage ≤ 5.5x for additional debt

Typical Financial Covenants

Leverage Ratio: Total Debt / EBITDA ≤ 5.0x (with step-downs)
Interest Coverage Ratio: EBITDA / Interest ≥ 2.0x
Fixed Charge Coverage Ratio: (EBITDA − Capex) / Fixed Charges ≥ 1.1x
Minimum Liquidity: Cash + Revolver availability ≥ $10M

EBITDA Adjustments (Controversial Issues)

Add-backs: Non-recurring items, transaction costs, run-rate synergies
Synergy caps: Limit on pro-forma adjustments (usually 20–25%)
Definition battles: What is considered recurring vs non-recurring
Audit requirement: When auditor confirmation is required

Middle Market Lending: Specific Features

Definition of Middle Market

Segment	EBITDA	Revenue	Loan Size
Lower middle market	$5–15M	$25–100M	$25–75M
Core middle market	$15–50M	$100–500M	$75–250M
Upper middle market	$50–100M	$500M–1B	$250–750M

Characteristics of Middle Market Borrowers

Ownership: 70–80% backed by PE sponsors
Industries: Software, healthcare, business services, specialty manufacturing
Geography: US (60%), Europe (30%), Other (10%)
Rating equivalent: B to BB (implied, often unrated)

Historical Default Rates

Default Rates by Strategy (2010–2024)

Strategy	Average Default	Peak (2020)	Recovery
Senior Secured First Lien	1.5–2.5%	3.5%	75–85%
Unitranche	2.0–3.0%	4.5%	65–75%
Second Lien	3.5–5.0%	7.0%	40–55%
Mezzanine	4.0–6.0%	8.0%	30–45%

Drivers of Recovery

Collateral quality: Asset-rich companies recover better
PE sponsor involvement: Sponsors often inject equity to cure
Covenant structure: Early warning via maintenance covenants
Lender control: Ability to control restructuring process

Sponsor-backed vs Non-sponsored

Aspect	PE-Sponsored	Non-Sponsored
Equity cushion	35–50% equity	Variable, often lower
Governance	Professional board, reporting	Family/founder control
Support in distress	Equity cure rights, follow-on capital	Limited access to capital
Documentation	Standardized, sponsor-favorable terms	More lender-friendly possible
Pricing premium	25–50 bps tighter	Baseline

Recommendations for CIO

Senior secured focus: In times of uncertainty — prioritize first lien
Sponsor quality matters: Top-tier PE = better outcomes in distress
Covenant discipline: Maintenance covenants — early warning
Sector selection: Avoid highly cyclical industries late in the cycle
Documentation review: EBITDA add-backs must be reasonable
Manager due diligence: Origination capability, workout experience