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Private Markets Pathway · Private Debt

Direct Lending and Unitranche Loans Explained

Updated 8 October 2026 · Fact-checked

Direct lending is when non-bank lenders, usually private debt funds, lend straight to mid-sized companies without a bank or public bond market. A unitranche loan blends senior and junior debt into one facility with one blended rate. You solve questions by matching structure, covenants, rate and risk to the borrower and investor.

Understand Direct Lending and Unitranche Loans

Direct lending means a fund or institution originates a loan itself and holds it. No bank arranges it and no public market trades it. Borrowers are often mid-sized, private-equity-backed firms. They value speed, certainty of funding and a single lender to negotiate with.

A senior secured loan ranks first in claim on the borrower's assets and cash flows. It is secured by collateral. Because loss risk is lower, it carries a lower spread. In a traditional structure, a borrower may also have a second-lien or mezzanine layer below it, each with its own lender and price.

A unitranche loan combines those layers into one facility with one blended interest rate, one set of documents and one lender or small club. The blended rate sits above a pure senior loan and below pure mezzanine. The borrower gets simplicity and speed. The lender takes more risk than a senior-only lender and earns more. Where a first-out/last-out split exists, lenders may share it through an agreement among lenders, so the 'last-out' piece bears first losses and earns a higher return.

Most direct loans are floating rate: a reference rate plus a fixed spread. Reference rates may carry a floor. Rising rates lift lender income and cut the borrower's interest cover. So rate risk for the investor becomes credit risk. Lenders also use covenants: maintenance covenants are tested regularly (for example leverage or interest cover), while incurrence covenants are tested only when the borrower takes an action such as new debt or a dividend. Direct loans typically have tighter, more negotiated covenants than broadly syndicated or public debt.

Return comes from the spread, fees (upfront or origination fees) and any floor benefit, with an illiquidity premium. Risks are default, recovery, illiquidity, concentration, leverage at fund level, and valuation uncertainty because loans are not market-priced.

Key rules to remember

Floating-rate coupon
Coupon rate = Reference rate (or floor if higher) + Spread
Apply the floor only if the reference rate falls below it. The spread stays fixed.
Blended unitranche rate
Blended rate ≈ (Senior share × Senior rate) + (Junior share × Junior rate)
Use as a weighted average of the implied layers. Actual pricing is negotiated, so treat it as an approximation.
Interest cover
Interest cover = EBITDA ÷ Interest expense
Typical covenant test. Check the definition given in the question.
Leverage ratio
Leverage = Total debt ÷ EBITDA
Maintenance covenants set a maximum; senior-only leverage may be tested separately.
Yield to lender, approximate
All-in yield ≈ Coupon + (Upfront fee ÷ Expected life in years)
Rough approximation for comparing loans. Ignores default losses and compounding.

How to solve Direct Lending and Unitranche Loans questions

Use this order for any direct lending or unitranche question, and tie each point to the investor's goals.

  1. 1Identify the borrower and the investor: size, sponsor backing, cash flow stability, and what the investor needs (income, yield, liquidity).
  2. 2Identify the loan's position: senior secured, second lien, unitranche or mezzanine. State the ranking and collateral.
  3. 3Read the pricing: reference rate, spread, floor, fees. Compute the coupon or all-in yield exactly as the vignette defines it.
  4. 4Test covenants: compute leverage or interest cover and compare with the covenant level. Say whether it is a maintenance or incurrence test.
  5. 5Assess rate sensitivity: how a change in the reference rate affects lender income and borrower interest cover.
  6. 6Weigh risk and return: default and recovery, illiquidity, valuation, concentration. Compare with senior-only or mezzanine alternatives.
  7. 7Answer the command word precisely (calculate, justify, recommend) with the fewest words that earn the point, and show the calculation.

Quickest way: Rank, price, test

When to use it: Use for item set questions where you must choose the correct statement or number quickly.

  1. Rank: place the loan on the capital structure (senior, unitranche, mezzanine). Higher risk means higher spread and more covenant protection needed.
  2. Price: coupon = max(reference rate, floor) + spread. Add fees only if asked for all-in yield.
  3. Test: compute one ratio, EBITDA ÷ interest or debt ÷ EBITDA, and compare with the covenant.
  4. Eliminate options that call a floating-rate loan fixed, treat unitranche as lower risk than senior, or ignore illiquidity.

Common mistakes in Direct Lending and Unitranche Loans

  • Treating a unitranche loan as lower risk than a senior secured loan.

    The word 'single' and 'secured' suggests safety.

    Fix: Remember unitranche includes junior risk. Its blended rate is higher than senior because the lender bears more loss risk.

  • Ignoring the floor when the reference rate is below it.

    Students add reference rate and spread automatically.

    Fix: Use the higher of the reference rate and the floor, then add the spread.

  • Saying rising rates only benefit the lender in a floating-rate loan.

    Coupon rises, so income looks better.

    Fix: Also state that higher interest raises the borrower's burden and lowers interest cover, which raises default risk.

  • Confusing maintenance and incurrence covenants.

    Both are financial tests with similar ratios.

    Fix: Maintenance is tested on a schedule regardless of action. Incurrence is tested only when the borrower does something, such as borrowing more.

  • Assuming direct loans are priced in the market, so valuation is easy.

    Students link loans to bonds.

    Fix: State that valuation is model-based and uses credit spreads and expected losses, so reported values are less certain and returns can appear smoothed.

  • Giving a long discussion when the command word asks for one item.

    Fear of losing marks.

    Fix: Answer only the number of responses requested, in order, with a short reason.

Worked examples

Example 1

A direct lender makes a ₹100 crore floating-rate senior loan priced at reference rate + 5.0%, with a 2.0% reference rate floor and a 1.0% upfront fee. The reference rate is 1.5% and the loan life is expected to be 4 years. Calculate the coupon rate and the approximate all-in yield.

Show the solution
  1. The reference rate of 1.5% is below the 2.0% floor, so use 2.0%.
  2. Coupon rate = 2.0% + 5.0% = 7.0%.
  3. Annualised fee = 1.0% ÷ 4 = 0.25%.
  4. All-in yield ≈ 7.0% + 0.25% = 7.25%.

Answer: Coupon rate is 7.0% and approximate all-in yield is 7.25%.

Example 2

A borrower has EBITDA of ₹40 crore and total debt of ₹180 crore, of which ₹120 crore is a unitranche loan at 9.0% fixed-equivalent cost and ₹60 crore is other debt at 6.0%. Interest is paid on both. The maintenance covenants require leverage of no more than 4.5× and interest cover of at least 3.0×. Determine whether the borrower complies and explain the implication for the lender.

Show the solution
  1. Leverage = 180 ÷ 40 = 4.5×. The covenant maximum is 4.5×, so it is met at the limit.
  2. Interest = (120 × 9.0%) + (60 × 6.0%) = 10.8 + 3.6 = ₹14.4 crore.
  3. Interest cover = 40 ÷ 14.4 = 2.78×, rounded.
  4. The minimum is 3.0×, so the interest cover covenant is breached.
  5. Implication: a maintenance breach gives the lender a seat to renegotiate, such as a higher spread, a fee or tighter terms, or to enforce remedies.

Answer: Leverage of 4.5× just meets its covenant, but interest cover of about 2.78× breaches the 3.0× minimum. The lender can use the breach to renegotiate terms or take remedies, which is a key protection of direct lending.

Exam tips

  • Show every calculation line in essay sets. A correct number alone earns credit, but a clear method protects you if a step is off.
  • Always state the rate formula in order: check the floor first, then add the spread, then fees if the question asks for all-in.
  • When asked to justify a recommendation, link one point to the client's objective (income, yield) and one to a constraint (liquidity, risk tolerance).
  • For compare questions, use ranking: senior secured lowest spread, unitranche in the middle, mezzanine highest.
  • Use the exact command word shown in bold. 'Identify' needs a name, 'justify' needs a reason.

Direct Lending and Unitranche Loans in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Direct Lending and Unitranche Loans: frequently asked questions

What is the difference between a unitranche loan and a senior secured loan?

A senior secured loan has first claim on collateral and is priced at a lower spread. A unitranche loan combines senior and junior debt into one facility with a blended rate. It carries more risk than senior debt and pays more.

Why are most direct loans floating rate?

A floating rate resets with the reference rate, so the lender's income keeps pace with market rates and interest rate risk on the loan's value is low. The cost is that higher rates strain the borrower, so credit risk rises.

What are maintenance and incurrence covenants?

Maintenance covenants are tested regularly, such as quarterly leverage or interest cover. Incurrence covenants are tested only when the borrower takes a specified action like issuing new debt or paying a dividend.

Why do direct loans offer higher returns than public bonds?

Lenders earn compensation for illiquidity, for the work of originating and monitoring the loan, and for lending to mid-sized firms without market access. Higher returns also reflect credit risk and the difficulty of valuing loans.