First-Out, Last-Out: Still Trending?
First-Out, Last-Out structures (FOLO), traditionally a key feature of the European mid-market space, seem to have experienced a gradual decline in some markets – whether because of an inadequate return profile or due to a reshaping of the relationships between credit funds and banks vis-à-vis their respective market shares. While market commentary has been quick to point out the decline, FOLO days may not be over yet.
What Is FOLO?
Post financial crisis, the rise of private debt funds combined with reduced bank liquidity has meant that banks are no longer the key credit providers. FOLOs are a derivative of unitranche structures, allowing a single tranche of term loan to combine senior and junior debt with a blended interest component.
Whilst the primary goal is to create one efficient streamlined process, certain features should be noted:
Deals which would include two main credit documents (e.g., senior/mezzanine or first-lien/second-lien) are papered using just one. FOLOs are documented under a single credit facility, but behind the scenes, in a side agreement between the lenders (AAL), the loan is split into first-out and last-out pieces, where the last-out are paid more interest (given longer skin in the game).
The AAL is a separate document entered into between the lenders and kept confidential from the borrowers. There has been no notable testing of AALs in the English courts.
Unitranche facilities are often coupled with revolving facilities for liquidity (RCFs) provided on a super senior or first-out basis and often by traditional lending banks rather than credit funds. In FOLOs, the super senior term loan and RCF (and sometimes a proportion of the hedging liabilities) will constitute the first-out piece and rank ahead of the senior term loan (last-out) as to enforcement proceeds.
Whilst RCFs have traditionally been provided by banks, private credit funds are increasingly willing to either underwrite these for quick execution before selling down their position, or even to provide the RCF on an ongoing basis.
In a typical unitranche deal, the instructing group for enforcement purposes is based on a ‘majority senior lenders’ concept, with FOLOs instead utilising (primarily) the majority of the last-out creditors and the super senior or first-out lenders are given certain step-in rights following the expiry of a standstill period after which they can, subject to certain conditions, take control of any enforcement process.
Pricing is typically higher than syndicated bank financings but lower than that of first-lien/second-lien.
Advantages and Disadvantages
From a borrower’s perspective, FOLOs represent simplified negotiation processes, reduced execution risk and certainty through an absence of flex terms (as present in syndicated financings), but market participants have raised some concerns that bring the future of FOLOs into question:
FOLO returns may not be sufficient in comparison to the returns the banks often need to yield to make a trading profit.
Banks view providing the RCF as supporting the direct lenders, which makes them significantly less attractive, the only concomitant benefit being some control over the day-to-day banking requirements of the underlying borrower.
Early covenant triggers for the last-out creditors keep banks out of any enforcement process, thereby reducing their participation in recovery strategies.
Some LPs (e.g., pension funds) are taking on the super senior or first-out piece direct to benefit from the associated return, further reducing bank involvement.
A layer of super senior debt can be viewed as obstructive in a restructuring, particularly in light of cross-class cramdown regimes being introduced in the United Kingdom and globally.
Does FOLO Still Have a Part to Play?
With the COVID-19 outbreak leading to increased and speedy utilisation of working capital lines, traditional FOLO players are reassessing their risk strategies. The increasing competition between private debt funds and banks has brought further debate into an already-troubled dynamic.
The proliferation of funds willing to provide a one-stop shop may mean that FOLO structures lose their place in the market. Questions are being asked from both sides: on the one hand, banks are less willing to sit behind credit funds in an enforcement process, and on the other, in a market where restructurings are becoming a more popular means of debt reorganisation, direct lenders view a layer of super senior debt as potentially worsening the process for them, without the traditionally high returns associated with FOLO structures.
It is not all doom and gloom for FOLOs across Europe, however. Certain jurisdictions, such as Germany and Belgium, have been able to continue to offer lower pricing and therefore to benefit from the advantages of FOLOs without being under-compensated for their risk. It remains to be seen if there will be some return to this lower-risk style of lending in a post-COVID-19 environment.