Senior Debt

What is senior debt?

Senior debt refers to a type of corporate debt that takes priority over other forms of debt and equity in the event of a company's liquidation or bankruptcy. It sits at the top of the capital structure, meaning that senior debt holders have the first claim on a company's assets if the company defaults on its obligations. Private equity funds use senior debt, often alongside other debt instruments, to finance their leveraged buyouts (LBOs). Doing so allows them to acquire larger companies with a smaller equity outlay, amplifying their returns.

Key takeaways

• Senior debt sits at the top of the capital structure, and senior debt holders have the first claim on a company's assets if it defaults.
• Senior debt can be secured (backed by collateral) or unsecured. Secured senior debt holders are first to receive repayment during liquidation, while unsecured senior debt holders are repaid next, followed by subordinated debt holders. Equity holders are last in line.
• Senior debt offers lower interest rates compared to other types of debt due to its lower risk profile and priority in repayment. This is why it is typically the preferred borrowing option for private equity funds, although can be combined with subordinated debt instruments.
• Despite its advantages, senior debt comes with rigidity in repayment terms, strict covenants that can restrict a borrower's actions and the potential to negatively impact a company's credit rating if taken on in excess.

Characteristics of senior debt

Priority in repayment

Let's consider a fictional company called Company A, a manufacturer of solar panels and renewable energy solutions. Company A has been operating for 15 years and has experienced significant growth due to the increasing demand for clean energy.

The company's capital structure consists of:

• $200 million in secured senior debt
• $100 million in unsecured senior debt
• $75 million in subordinated debt
• $50 million in mezzanine debt
• $25 million in equity

Despite its success, Company A has recently faced several challenges. Intense competition from low-cost manufacturers in emerging markets have eroded Company A's market share and profit margin. A major product recall due to faulty components, which led to significant legal costs and reputational damage, was followed by the unexpected bankruptcy of a key supplier, disrupting Company A's supply chain and causing production delays. As a result of these challenges, Company A failed to meet its debt obligations and defaulted on its payments.

The company's assets were subsequently liquidated for $350 million.

In this scenario, the repayment would occur as follows:

1. Secured senior debt holders would receive their full $200 million, as their debt is backed by collateral.
2. Unsecured senior debt holders would receive their full $100 million, as there are sufficient remaining assets to cover their debt.
3. Subordinated debt holders would receive $50 million, which is the remaining amount after senior debt holders have been fully repaid.
4. Mezzanine debt holders and equity holders would not receive any repayment, as the liquidated assets were insufficient to cover their investments after paying off the senior and subordinated debt.

This demonstrates the importance of seniority in the capital structure and highlights the risks associated with different types of debt and equity investments. While senior debt holders are more likely to recover their investment in the event of a default, subordinated debt holders, mezzanine debt holders and equity holders face increasingly higher risk of losses.

Collateral and security

Senior debt can be either secured or unsecured. Secured senior debt is backed by specific assets, such as real estate, equipment or inventory, which serve as collateral. If the borrower defaults, the lender can seize the collateral to recover their losses. Unsecured senior debt, on the other hand, is not backed by any specific assets and relies on the borrower's creditworthiness and ability to repay the debt.

Collateral plays a crucial role in mitigating risks for senior debt holders. By securing the debt with assets, lenders can reduce their exposure to default risk and potentially recover a portion of their investment if the borrower fails to meet their obligations.

Senior debt vs. other forms of debt

Senior debt vs. subordinated debt

Subordinated debt, commonly referred to as junior debt, ranks below senior debt in the repayment hierarchy. In the event of a default, subordinated debt holders only receive repayment after senior debt holders have been fully compensated. As a result, subordinated debt carries higher risk and typically offers higher interest rates to compensate for this.

Senior debt vs. mezzanine debt

Mezzanine debt is a hybrid form of financing that combines features of both debt and equity. It ranks below senior debt but above equity in the capital structure, hence its name. Mezzanine debt often includes an equity component, such as warrants or convertible features, which allows the lender to participate in the company's upside potential. Due to its higher risk profile, mezzanine debt typically carries higher interest rates than senior debt.

Comparison with equity

Equity represents ownership in a company and ranks below all forms of debt in the capital structure. Equity holders are entitled to the residual value of the company after all debts have been paid off. While equity holders have the potential for higher returns through capital appreciation and dividends, they also bear the highest risk since they are last in line to be paid in the event of a liquidation.

Advantages and disadvantages of senior debt

Advantages of senior debt:

• Lower interest rates: Senior debt generally offers lower interest rates compared to other forms of debt, as it carries the lowest risk due to its repayment priority and potential collateral backing. This is why it typically makes up the largest proportion of debt instruments in an LBO.
• Priority in liquidation: In the event of a company's liquidation, senior debt holders are first in line to be repaid, increasing the chances of recovering their investment. This makes it an attractive lower-risk asset class and is why investors often have large allocations to corporate loans and bonds in their portfolios.

Disadvantages of senior debt:

• Rigidity in repayment: Senior debt often comes with a predetermined repayment schedule, which outlines the principal and interest payments that the borrower must make over the life of the loan. This schedule is typically inflexible, meaning the borrower must adhere to the agreed-upon payments regardless of their financial situation or cash flow fluctuations.
• Covenant restrictions: Senior loans often include strict covenants that dictate what the borrower can and cannot do. These covenants may include restrictions on additional borrowing, minimum financial ratios the borrower must maintain, or limitations on capital expenditures. Violating these covenants can lead to default, even if the borrower is adhering to its repayment schedule.
• Impact on credit rating: Taking on excessive senior debt can negatively impact a company's credit rating, as it increases the company's financial leverage ratios and default risk. This can lead to higher borrowing costs in the future and may limit access to additional financing.

Senior debt plays a vital role in corporate finance and is the most common source of debt funding in private equity firms’ LBOs. While senior debt offers advantages to both borrowers and lenders, such as lower interest rates and priority in repayment, respectively, it also comes with potential drawbacks including strict repayment terms, restrictive covenants and the risk of negatively impacting a company's credit rating if used excessively.

Nevertheless, senior debt is a common and essential tool in the corporate borrowing toolkit. Its prevalence in capital structures across industries underscores its importance in providing companies the financing they need to operate, grow and create value. For PE, the judicious use of senior debt alongside other debt and equity instruments is crucial to generating the attractive returns that draw investors to this highly performant asset class.