Subordinated debt, often referred to as junior debt, is a type of debt that ranks below other debts in terms of its priority for repayment in the event of a company’s bankruptcy or liquidation. If the company goes under and its assets are liquidated, subordinated debt holders are paid back only after all senior (or primary) and unsecured creditors are satisfied.
Since subordinated debt is riskier for lenders or investors—given its lower repayment priority—it usually comes with a higher interest rate than senior debt to compensate for this increased risk.
Here are some key points to consider:
- Risk and Return: Given the riskier nature of subordinated debt, it generally carries a higher interest rate. This offers a potential higher return for investors willing to take on this risk.
- Flexibility for Borrowers: For companies, issuing subordinated debt might be a way to obtain financing when they’ve reached their limit with traditional borrowing. Since it’s treated as equity on the balance sheet, it can improve certain financial ratios and help companies obtain more senior debt.
- Typical Lenders: Due to its riskier nature, subordinated debt is typically issued to more sophisticated investors, such as private equity firms, hedge funds, or other institutional investors.
- Usage in Leveraged Buyouts (LBOs): Subordinated debt can be an important instrument in LBOs, where a company is acquired using a significant amount of borrowed money. The debt is used to finance the acquisition, and it’s expected that the acquiring company will pay off the debt using cash flows from the acquired company.
- Covenant Structures: Subordinated debt may come with less restrictive covenants compared to senior debt. However, it still often contains protective provisions for lenders.
In essence, subordinated debt can be a valuable financing tool for companies, especially those in need of capital while aiming to avoid further dilution of equity. However, it’s essential for both the issuer and the investor to be fully aware of the terms and risks associated with it.
Example of Subordinated Debt
Let’s delve into a hypothetical example to better understand subordinated debt.
Scenario: “CityMall Enterprises”
Background: CityMall Enterprises owns and operates a chain of malls across the country. Over the years, it has taken on senior debt from banks to expand its operations. Now, it wants to acquire a piece of prime real estate to build a new mall but has reached its limit in obtaining more traditional senior loans without overleveraging.
The Subordinated Debt Solution: CityMall decides to issue $50 million in subordinated debt to finance the acquisition. Given the subordinate nature of this debt, the interest rate offered is 8%, which is higher than the 5% on their existing senior debt.
Investor Involvement: A private equity firm, PE Ventures, sees an opportunity. They are comfortable with CityMall’s management team and believe in the potential profitability of the new mall. They decide to purchase the entire subordinated debt issuance, understanding its position in the repayment hierarchy.
Outcome: Years later, while CityMall has successfully built and operated the new mall, the overall retail industry faces challenges. CityMall’s revenues decrease, putting strain on their ability to service all of their debt.
In a situation where CityMall struggles to meet all its obligations:
- The senior debt holders from the banks are prioritized and paid first from any available funds or from the liquidation of assets.
- Only after all senior debt holders are satisfied, PE Ventures, holding the subordinated debt, would get its repayment.
If CityMall’s assets are insufficient to repay all creditors, PE Ventures may not recover the full amount they invested in the subordinated debt.
This example demonstrates the nature of subordinated debt: while it offers higher potential returns (in terms of higher interest rates), it also comes with increased risks. In this case, PE Ventures was willing to take on this risk for the potential of higher returns. However, they also knew that in a situation of financial distress for CityMall, their claim would be secondary to that of senior creditors.