Pro-Rata Tranche

What Is a Pro-Rata Tranche?

A pro-rata tranche is a portion of a syndicated loan that is comprised of two features: a revolving credit facility, and an amortizing term loan. Pro-rata tranches are common within the leveraged loan market or in loans to companies with existing high debt loads.

Within the pro-rata tranche, the revolving credit line will typically have the same ending or maturity date as the term loan. Pro-rata tranches have historically been much larger than institutional tranches in terms of their dollar size.

Understanding a Pro-Rata Tranche

Syndicated Loans

A syndicated loan, also known as a syndicated bank facility, is financing offered by a group of lenders — referred to as a syndicate — who work together to provide funds for a single borrower. The borrower can be a corporation, a large project, or a sovereign government.

The loan can involve a fixed amount of funds, a credit line, or a combination of both. Syndicated loans arise when a project requires too large a loan for a single lender or when a project needs a specialized lender with expertise in a specific asset class.

The Leveraged Loan

A leveraged loan is a type of loan that is extended to companies or individuals that already have considerable amounts of debt or a poor credit history. Lenders consider leveraged loans to carry a higher risk of default, and so a leveraged loan is more costly to the borrower.

Default occurs when a borrower cannot make any payments for an extended period. Leveraged loans for companies or individuals with high levels of debt tend to have higher interest rates than typical loans; the increased interest reflects the greater level of risk involved in issuing the loans.

Most leveraged loans are structured and syndicated to accommodate two primary types of lenders: banks (domestic and foreign) and institutional investment companies. So, leveraged loans consist of pro-rata debt (the pro-rata tranche), and institutional debt.

Investors in pro-rata loans are primarily banks and other financing companies. Loans in the pro-rata tranche allow borrowers to draw down funds, repay them, then draw down again. Investments in institutional loans — which, for the most part, are term loans — include structured finance products, collateralized loan obligations (CLOs), and mutual funds, among other investment vehicles.

Characteristics of the Pro-Rata Tranche

In business and finance, pro rata translates from Latin to mean "in proportion." In this context, pro rata refers to a process where whatever is being allocated will be distributed in equal portions. So the pro-rata tranche distributes the debt among a number of banks proportionately, thereby greatly reducing each lender's potential loss or credit risk. This is seen as being favorable toward the syndication of lending institutions.

The pro-rata tranche is usually comprised of working-capital lenders that hold a pro-rata share of the revolving credit facility and the shorter-maturity amortizing term loan. As a general rule, these investors are actively engaged in the business of lending, and the sizes (dollar amount) they hold in any particular loan are relatively significant compared to those of their institutional counterparts.

Inherent Risk of the Pro-Rata Tranche

Investing in leveraged loans has more inherent risk than many other investments, including equities. Because of this risk potential, the pro-rata tranche is characterized by a hands-on approach, which often subjects the borrower to tighter monitoring and oversight.

An economy that's experiencing a contraction in its institutional markets would tend to have a somewhat risk-averse lending mentality. So investors in this economy — particularly in the middle market — might feel more comfortable with a smaller, more active lending group, as opposed to the widely syndicated, large institutional-investor driven leveraged loan market of the 1990s, for example.