What it means
Every lender who takes security over an asset is placed in a queue, and the order of that queue is set by the loan documents and by law. Senior debt sits at the front, and anything behind it is subordinate.
The most familiar example is a second mortgage, which is repaid only after the first mortgage on the same property. Businesses use subordinate financing to raise more money than the senior lender will provide on its own.
A company that has used up its senior bank facility might add mezzanine debt (a layer of funding between senior debt and equity) or subordinated notes to fund an acquisition or expansion. The senior lender usually has a say.
Loan agreements often require the subordinate lender to sign an intercreditor agreement, which sets out who gets paid first, when the subordinate lender may demand repayment and what happens if the borrower defaults. Without that document, a senior bank may refuse to lend.
For the borrower, the trade-off is cost against capacity. Subordinate funding can be more expensive than senior debt and may include warrants (rights to buy shares) or fees, but it is generally cheaper than raising equity and does not dilute ownership as much.
Priority also matters in a restructuring. If a company cannot meet its debts, senior lenders can usually enforce their security first, and a subordinate lender may be asked to accept delays, a lower interest rate or a conversion of its loan into shares.
This is why the subordinate lender studies the borrower's cash flow as closely as the value of the assets. Lenders judge the combined load rather than each loan alone.
The key question is how much total debt sits ahead of and alongside the subordinate loan compared with the value of the assets or the cash flow available to repay it.
In practice
Real-world examples.
Example
A homeowner takes out a $50,000 second mortgage to pay for an extension. The original mortgage keeps first claim on the house, so the second lender charges a higher rate.
Example
A manufacturing company buys a rival using a senior bank loan of $12,000,000 and a $4,000,000 subordinated note from a specialist fund. The fund accepts a lower claim on the assets in return for an interest rate several points above the bank's.
Example
A property developer uses a mezzanine loan to cover the gap between the bank's loan and the equity put in by the owners. The bank agrees only after the mezzanine lender signs an intercreditor agreement. The agreement also stops the mezzanine lender from taking action against the developer without the bank's consent.
Formula
Calculation
For property, the combined load is measured with the combined loan-to-value ratio:
Combined loan-to-value = (Senior loan + Subordinate loan) / Property value
A property is valued at $1,000,000. The first mortgage is $600,000 and a second mortgage, which is the subordinate financing, is $150,000. The senior loan alone is $600,000 / $1,000,000 = 60%, and the combined figure is ($600,000 + $150,000) / $1,000,000 = 75%, so the second lender is exposed to the part of the value between 60% and 75%.Case study
Seen in the real world.
Cedarwood Logistics is an illustrative, fictional haulage company that wanted to buy a depot costing $5,000,000. Its bank would lend only $3,000,000, which is 60% of the price, and the owners had $1,000,000 in cash.
To close the $1,000,000 gap, Cedarwood agreed to a subordinated loan from a private lender at an interest rate 5% above the bank's. The bank required the private lender to agree that it would receive nothing until the bank had been paid in full if the business failed.
In this illustrative story, the depot raised revenue as planned, adding capacity for around 40 more deliveries a week, and the business repaid the subordinated loan early. The owners later said the higher interest was a price worth paying, because equity from a new partner would have meant giving up control of the company.
Watch out
Common mistakes.
- Assuming subordinate means unsecured, when a subordinate lender may still hold a legal claim on the same assets but ranks behind the senior lender.
- Looking only at the interest rate and ignoring fees, warrants and repayment restrictions that add to the cost.
- Forgetting that the senior lender's consent may be needed before taking on more debt.
Questions
People also ask.
Is subordinate financing the same as equity?
No, it is still debt that must be repaid with interest, but it ranks below senior debt and above equity holders in a failure.
Why would a lender accept being second in line?
The higher interest rate and fees compensate for the extra risk, and the borrower's business may be strong enough that default is unlikely.
What is an intercreditor agreement?
It is a contract between the senior and subordinate lenders that sets out payment order and each side's rights if the borrower runs into trouble.
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