Senior Debt
Senior debt refers to a class of debt that takes priority over other unsecured or more “junior” debt owed by the issuer. It has a higher claim on the issuer’s assets and earnings than other forms of debt. In the event of bankruptcy or liquidation, senior debt must be repaid before other creditors receive any payment.
Here are some key characteristics and concepts associated with senior debt:
- Priority in Repayment: In a bankruptcy scenario, holders of senior debt are in the front of the line to get repaid, before subordinate or junior debt holders and, of course, equity holders.
- Secured Status: Often, senior debt is secured, meaning it’s backed by specific assets of the company, such as property, plants, or equipment. If the borrower defaults on the loan, the lender has the right to seize and sell the collateral to recoup the loan amount.
- Lower Risk, Lower Yield: Since senior debt is considered less risky from the lender’s perspective due to its priority in repayment and often its secured nature, it typically comes with a lower interest rate compared to more junior or unsecured debt.
- Covenants: Senior debt agreements might have strict covenants or terms that set out particular actions the borrower must do (affirmative covenants) or is prohibited from doing (negative covenants). These covenants are meant to protect the interests of the senior debt holders.
- Usage: Senior debt is commonly used for various corporate purposes, such as funding acquisitions, refinancing existing debt, or financing capital expenditures. It’s a staple in the corporate finance world and often forms a significant portion of a company’s capital structure.
- Syndicated Loans: Large senior loans might be syndicated, meaning they’re provided by a group of lenders and are structured, arranged, and administered by one or several commercial or investment banks known as arrangers.
In the capital structure hierarchy, equity is on the bottom, followed by junior or subordinated debt, with senior debt on top. This hierarchy is crucial for investors and creditors as it dictates the order of repayment and, thus, the risk associated with each type of financing.
Example of Senior Debt
Let’s look at a hypothetical example to illustrate the concept of senior debt.
Company: XYZ Manufacturing Inc.
Scenario: XYZ Manufacturing Inc. wants to expand its operations by building a new factory. The total cost of the project is estimated to be $10 million. To finance this, the company decides to raise money through a combination of debt and equity.
Financing Breakdown:
- Senior Debt: XYZ secures a $6 million loan from Bank A, which is backed by the company’s existing factories and machinery. This is the senior debt, and it comes with certain covenants. For instance, XYZ might be required to maintain a certain level of profitability or is restricted from taking on any more debt without Bank A’s approval.
- Subordinate Debt: To raise more funds, XYZ issues $2 million in subordinate or junior bonds. These bonds are not backed by any specific assets (they’re unsecured), and they rank below the senior debt in terms of repayment priority.
- Equity : Finally, XYZ raises the remaining $2 million by issuing new shares to the public.
Fast forward a couple of years: Unfortunately, the expansion didn’t go as planned. The new factory faced multiple operational issues, and market demand for XYZ’s products declined. Struggling with diminished revenues, XYZ Manufacturing Inc. can no longer service its debt and is forced to declare bankruptcy.
Repayment Order:
- Senior Debt : In the liquidation process, the assets of XYZ are sold off. The proceeds from the sale are first used to pay off the $6 million to Bank A, the holder of the senior debt. If, for instance, the assets fetch $5 million, Bank A would get the entire amount, as they are the senior creditor.
- Subordinate Debt: Only after the senior debt is fully paid off will the holders of the subordinate bonds get paid. In this case, since the assets only fetched $5 million, the subordinate bondholders get nothing.
- Equity Holders: Equity holders are last in line. Here, they also get nothing since the sale of the assets wasn’t even enough to cover the senior debt.
This example highlights the priority of senior debt in a company’s capital structure and why it’s considered less risky from a lender’s perspective.
