What it means
Ranking is the whole point. In a liquidation the proceeds flow down a waterfall: secured senior lenders, then unsecured senior creditors, then subordinated lenders, then preference shareholders, and finally ordinary shareholders, with each level paid only once the level above is satisfied.
That extra risk is compensated by price. Where a senior secured facility might cost 6% to 8%, subordinated debt commonly costs 10% to 15%, sometimes with part of the return paid as warrants or an equity kicker rather than cash interest.
Borrowers use it to bridge a funding gap. When senior lenders will only advance three times earnings and the deal needs five, subordinated debt fills the difference without the owners selling as much equity as they otherwise would.
Lenders on both sides usually sign an intercreditor agreement setting out who gets paid when. It commonly blocks the subordinated lender from taking enforcement action or even receiving interest while the senior loan is in default, a feature known as a payment block.
There is a useful nuance for owner-managed businesses. A director's loan formally subordinated to the bank can allow the bank to treat that money as quasi-equity, improving the gearing calculation and sometimes making a facility possible that would otherwise be declined.
In practice
Real-world examples
Example 1
A management buyout of a $30,000,000 turnover business is funded with $12,000,000 of senior debt, $5,000,000 of subordinated debt at 12% and $4,000,000 of management equity. The subordinated tranche lets the managers keep a much larger share of the company than an all-equity structure would have allowed.
Example 2
A regional bank holds subordinated notes as part of its regulatory capital. The notes count towards its capital requirement precisely because holders agree to rank behind depositors and senior creditors if the bank fails.
Example 3
A family manufacturer borrows $2,000,000 from its founder to fund a new production line. The bank requires the founder to sign a deed of subordination, after which it treats the loan as quasi-equity and extends its own facility by $1,500,000.
Think of it
Imagine boarding a plane where senior lenders sit in first class and get off first during an emergency. Subordinated debt holders sit in economy; they get off later, so the airline upgrades their seats with better snacks and higher pay to make up for the wait.
Formula
Calculation
Recovery on subordinated debt = maximum of zero and (realisations - senior claims), capped at the subordinated principal
Blended cost of debt = total interest cost / total debt
A distribution business fails and its assets realise $18,000,000. It owes $12,000,000 to a senior secured lender and $8,000,000 to a subordinated lender, with shareholders behind both.
The senior lender is paid in full, taking $12,000,000. That leaves $18,000,000 - $12,000,000 = $6,000,000 for the subordinated lender against a claim of $8,000,000, a recovery of $6,000,000 / $8,000,000 = 75 cents in the dollar. Shareholders receive nothing.
The pricing reflects that exposure. While the business was trading, the senior loan carried 7% and the subordinated loan 13%, so annual interest was $12,000,000 x 7% = $840,000 plus $8,000,000 x 13% = $1,040,000, a total of $1,880,000. Across $20,000,000 of total debt that is a blended cost of $1,880,000 / $20,000,000 = 9.4%, cheaper than issuing equity for the same $8,000,000 if the owners believed the business was worth considerably more than book value.Case study
Seen in the real world
The following is an illustrative and entirely fictional example. Pallister Distribution, an invented wholesale business, financed an expansion with $12,000,000 of senior secured debt at 7% and $8,000,000 of subordinated debt at 13% from a specialist fund. The blended cost of $1,880,000 on $20,000,000 worked out at 9.4%, and the owners preferred it to selling a further quarter of the company.
For three years the structure worked. Then a major customer moved to a competitor, earnings fell by 40%, and the senior lender's covenant test was breached. The intercreditor agreement immediately blocked interest payments to the subordinated fund, which had no right to enforce while the senior facility was in default.
The business was eventually sold as a going concern for $18,000,000. The senior lender recovered its $12,000,000 in full, the subordinated fund recovered $6,000,000 against an $8,000,000 claim, or 75 cents in the dollar, and the shareholders received nothing. In this illustrative case the 13% coupon and the 75% recovery told the same story from two directions: the subordinated lender was paid a premium precisely because this outcome was always a realistic possibility.
Watch out
Common mistakes
- Treating subordinated debt as a cheaper form of equity without noticing that the interest is contractually payable in cash whether or not the business has a good year.
- Ignoring the intercreditor agreement during negotiation, when it determines whether the junior lender can be blocked from receiving anything the moment the senior facility wobbles.
- Assuming subordinated debt is always unsecured. It can hold security, but that security ranks behind the senior lender's charge over the same assets.
Questions
People also ask
What is the difference between subordinated debt and mezzanine finance?
Mezzanine is a common form of subordinated debt that adds an equity component such as warrants, so all mezzanine is subordinated but not all subordinated debt is mezzanine.
Why would a lender accept a junior ranking?
Because the higher interest rate, and often an equity upside, compensates for the risk, and because many businesses recover enough value in a sale to repay junior lenders in part or in full.
Does subordinated debt count as equity for covenant purposes?
Not usually, but a formal deed of subordination can persuade a senior lender to exclude it from gearing tests and treat it as quasi-equity.