Subordinated (Junior) Debt

What is subordinated debt?

Subordinated debt, also known as junior debt, is a type of debt that ranks below other, more senior forms of debt in terms of repayment priority. In the event of a company's liquidation or bankruptcy, subordinated debt investors receive repayment only after senior debt obligations have been satisfied.

Key takeaways

• Subordinated debt ranks below senior debt in terms of repayment priority during liquidation or bankruptcy.
• It typically carries higher interest rates than senior debt due to the increased risk for investors.
• Subordinated debt can be an attractive financing option for private equity funds as they can layer additional debt into a company’s capital structure.
• For investors, subordinated debt is riskier than senior debt but less risky than equity investments. For borrowers, subordinated debt can provide greater flexibility than senior debt.

How subordinated debt works

Priority in repayment

In the event of a company's liquidation or bankruptcy, creditors are repaid in a specific order based on the seniority of their debt. This is known as the seniority hierarchy. Senior debt, such as secured loans or bonds, is repaid first, followed by subordinated debt, and finally, equity investors.

Imagine a company, Company A, has the following capital structure:

• $10 million in senior secured debt
• $5 million in subordinated debt
• $3 million in equity

If Company A were to file for bankruptcy and its assets were liquidated for $12 million, the repayment would occur as follows:

1. Senior secured debt investors would receive their full $10 million.
2. Subordinated debt investors would receive the remaining $2 million.
3. Equity investors would receive nothing, as there are no remaining funds after satisfying the debt obligations.

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Benefits of issuing subordinated debt for companies

Companies may choose to issue subordinated debt for several reasons:

• Non-dilution: Like all forms of debt, subordinated debt allows companies to raise capital without diluting ownership, which is the primary motivation for borrowing. Subordinated debt typically has a lower cost of capital compared to equity financing, though a higher cost than senior debt.
• Flexibility: Junior debt can be a flexible financing option, with terms and conditions tailored to the company's needs. This can include longer repayment periods, customised interest rates and other features that may not be available with senior debt.
• Non-amortising: Subordinated debt often has a bullet or balloon structure. In this case, the borrower makes regular interest payments throughout the life of the debt, with the entire principal amount due at maturity.

Although bonds are also non-amortising, syndicated leveraged loans are less likely to have flexible repayment terms or unique features like PIK interest, which are more common in subordinated debt. This is because senior lenders generally prefer the added security of regular principal repayments. This structure can be attractive for companies that prefer to retain cash for operations or investments during the loan term and plan to refinance or repay the debt in full at maturity.

Subordinated debt vs. other forms of debt

Subordinated debt vs. senior debt

Senior debt takes priority over subordinated debt in repayment. It typically carries lower interest rates due to the reduced risk for investors. The primary types of senior debt used by private equity funds to leverage their buyouts are syndicated leveraged loans, high-yield bonds - and more recently, leveraged loans from private credit funds, which are also known as direct lenders.

Subordinated debt vs. unitranche loans

Unitranche loans are a type of debt that combines senior and subordinated debt into a single facility. These loans are typically provided by direct lenders and have become popular in mid-market PE-backed transactions. Unitranche facilities offer borrowers the simplicity of dealing with a single lender and a more streamlined documentation process. Interest rates on unitranche loans are generally higher than traditional senior debt but lower than subordinated debt, reflecting the blended risk profile of the combined facility.

Subordinated debt vs. mezzanine debt

Mezzanine debt is a hybrid form of financing that is often referred to as "subordinated debt with equity features" because of its unique characteristics. It combines both subordinated debt and equity and ranks below senior debt but above equity in the repayment hierarchy. Mezzanine debt often carries higher interest rates than subordinated debt and may include an equity component, such as warrants or conversion rights.

Subordinated debt vs. equity

Equity represents ownership in a company and ranks below all forms of debt in terms of repayment priority. In the event of liquidation or bankruptcy, equity investors are the last to be repaid, if at all. This segment of the capital structure can be divided between preferred equity and common equity, the latter being at the very bottom of the cap structure. Despite the higher risk of losses, equity investors have the potential for higher returns through capital appreciation and dividends, commensurate with the higher risk they assume.

Subordinated debt in private equity

When executing leveraged buyouts or financing the growth of their portfolio companies, private equity firms often turn to subordinated debt to optimise the capital structure of a portfolio company. Subordinated debt, including mezzanine debt, allows PE firms to raise additional capital without increasing senior debt obligations. This is particularly useful in situations where senior lenders are unwilling to provide additional financing due to the company's risk profile or the existing level of senior debt. By layering subordinated debt into the capital structure, private equity firms can achieve higher returns on their equity investments while maintaining a balanced risk profile.

This makes it a valuable tool for financing growth and acquisitions while maximising returns on invested equity. Junior debt may also be used to fund dividend recapitalisations, whereby PE funds borrow loans to pay out a special dividend to themselves and their investors, effectively recouping a portion of their initial investment while maintaining control of the company.