First out, last out: still trendy? | McDermott Will & Emery
First-Out, Last-Out (FOLO) structures, traditionally a key feature of the European mid-market space, appear to have experienced a gradual decline in some markets – whether due to an inadequate return profile or due to an overhaul of the relationship between credit funds and banks vis-à-vis their respective market shares. While market comments quickly pointed to the downside, the FOLO days may not be over yet.
After the financial crisis, the increase in private debt funds combined with the reduction in bank liquidity made banks no longer the main providers of credit. FOLOs are a derivative of unitranche structures, allowing a single term loan tranche to combine senior and junior debt with a blended interest component.
Although the main goal is to create an efficient streamlined process, some characteristics should be noted:
- Transactions that would include two main credit documents (for example, senior / mezzanine or first-lien / second-lien) are upholstered using only one. FOLOs are documented under a single credit facility, but behind the scenes, in a side agreement between lenders (AAL), the loan is split into first out and last out chunks, where the last out is paid more interest ( considering longer skin in the game).
- The LAA is a separate document entered into between lenders and kept confidential from borrowers. There has been no notable testing of LAAs in English courts.
- Unitranche facilities are often coupled with revolving liquidity facilities (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 part of the hedging liabilities) will be the first coin and will take precedence over the senior term loan (last out) when it comes to the proceeds of execution.
- While RCFs have traditionally been provided by banks, private credit funds are increasingly willing to either guarantee them for quick execution before selling their position, or even provide RCFs on an ongoing basis.
- In a typical unitranche agreement, the instruction group for enforcement purposes is based on a ‘Majority senior lenders‘, the FOLOs instead (mainly) using the majority of last-out creditors and the super senior or first-out lenders are granted certain intervention rights after the expiration of a standstill period after which they can , under certain conditions, take control of any execution process.
- Prices are generally higher than syndicated bank financing, but lower than first / second privilege.
Advantages and disadvantages
From the borrower’s perspective, FOLOs represent streamlined negotiation processes, reduced risk and execution certainty due to the absence of flexible terms (as in syndicated finance), but Market players have raised some concerns that call into question the future of FOLOs:
- FOLO returns may not be enough compared to the returns that banks often have to give up in order to make a trading profit.
- Banks view the provision of RCF as a support to direct lenders, making them significantly less attractive, with the only concomitant benefit being some control over the day-to-day banking needs of the underlying borrower.
- The early triggers of debt covenants keep banks out of any enforcement process, thereby reducing their involvement in recovery strategies.
- Some vinyl records (for example, pension funds) directly assume the super senior or first-out part to benefit from the associated return, which further reduces the involvement of banks.
- A layer of super senior debt can be seen as a barrier to restructuring, especially in light of the inter-class restriction regimes introduced in the UK and around the world.
Does FOLO still have a role to play?
With the COVID-19 epidemic resulting in increased and rapid use of working capital lines, traditional FOLO players are reassessing their risk strategies. The growing competition between private debt funds and banks has sparked a new debate in an already troubled dynamic.
The proliferation of funds ready to offer one-stop shopping can mean that FOLO structures are losing their place in the market. Questions are asked on both sides: on the one hand, banks are less willing to support credit funds in an execution process, and on the other hand, in a market where restructuring is becoming a more Popular debt reorganization, direct lenders see a layer of super senior debt as potentially compounding the process for them, without the traditionally high returns associated with FOLO structures.
However, all is not gloomy for FOLOs across Europe. Some jurisdictions, such as Germany and Belgium, have been able to continue to offer lower prices and therefore benefit from the advantages of FOLOs without being undercompensated for their risk. It remains to be seen whether there will be a return to this style of low-risk lending in a post-COVID-19 environment.