Subordinated Debt Overview

Subordinated Debt Overview

Subordinated debt describes a loan that is in a subordinated position to another loan in a company’s capital structure. Often this loan is characterized by being in second position to a bank loan. Bank loans are usually always secured by assets and in the first position with respect to a first lien on assets. Subordinated debt is usually unsecured by assets and beneath the bank loan in the capital structure. It is also known as mezzanine debt or junior debt. Typically, it is provided by mezzanine lenders. There are rules that govern how the senior debt and the subordinated debt can act in a variety of different scenarios. It is most commonly associated with leveraged finance wherein a company is purchasing another company and needs to borrow more than the senior lender can provide. Because of its unsecured position, subordinated debt is risk capital in that its repayment is not certain unless certain cash flow performance is achieved. As a result, this form of debt carries a higher interest rate than senior debt. As, its principal repayment is often extended so that it matures after the maturity of the senior loan in front of them. There are inter creditor provisions that the senior lender, subordinated debt lender and the borrower agree to. These allow for the senior lender to control the payment of interest and principal to the subordinated lender if certain performance targets are not met. Subordinated debt is most valuable to a borrower when it is used an equity substitute. It is patient capital, much like equity, but it is significantly less expensive than equity in that is carries only an interest rate and a small upside called a warrant.