What it means
Every dollar a business borrows sits somewhere in a repayment ranking, and subordination is the legal mechanism that fixes that ranking in writing. A subordination agreement, often called an intercreditor deed, sets out which lender gets paid first if the borrower fails.
It usually also blocks the junior lender from taking enforcement action while the senior loan is still outstanding. This matters because two loans to the same company can carry very different risk simply because one sits ahead of the other in the queue.
Lenders price that difference openly, which is why mezzanine and second lien debt typically costs several percentage points more than senior bank debt. Owners meet subordination most often when a bank insists that a director's loan or a shareholder advance be ranked behind the bank facility.
The money stays in the business, but the owner cannot be repaid until the bank is satisfied. Suppliers offering unusually long credit are sometimes asked to sign a similar undertaking.
There are two main varieties. Contractual subordination is created deliberately by an agreement between lenders, while structural subordination arises naturally when a lender sits at a holding company and the trading assets, along with their own lenders, sit one level below.
Structural subordination catches people out because nobody signs anything to create it. Subordination is also the engine behind securitisation, where cash flows are sliced into tranches and the junior tranche absorbs losses first.
The principle never changes: someone agrees to be paid last so that someone else can be paid first, and is compensated for accepting that position.
In practice
Real-world examples.
Example
A regional brewery wants to buy a rival and funds the deal with $8,000,000 of senior bank debt and $3,000,000 of mezzanine finance. The mezzanine lender signs a subordination deed accepting payment only after the bank, and charges 12% rather than the bank's 6% to reflect that position.
Example
A family owned engineering firm has lent $400,000 to its own company. When it refinances with a clearing bank, the bank requires the family loan to be subordinated and interest payments on it suspended whenever the leverage covenant is breached.
Example
A logistics group borrows at holding company level while its operating subsidiaries carry their own supplier credit and equipment finance. Nobody signed a subordination agreement, but the holding company lender is structurally subordinated, because the subsidiaries' creditors are paid from those assets first.
Think of it
“Subordination is the junior money protecting senior money-the cushion below.
Formula
Calculation
Recovery to a claim = the lower of (proceeds still available after all higher ranking claims are settled) and (the amount of the claim)
Northgate Components is wound up and the liquidator realises $9,000,000 from the assets. The senior secured lender is owed $6,000,000, a subordinated lender is owed $4,000,000, and shareholders rank last of all.
The senior lender is paid in full, taking $6,000,000 and leaving $9,000,000 - $6,000,000 = $3,000,000 in the pot. The subordinated lender receives the lower of $3,000,000 and $4,000,000, so it collects $3,000,000, a recovery rate of $3,000,000 / $4,000,000 = 75%, and writes off the remaining $1,000,000. Shareholders receive nothing, because the money runs out before their claim is reached.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Brightwater Ceramics, an invented tableware manufacturer, had grown quickly on a $5,000,000 senior facility and a $2,000,000 loan from a founding shareholder who had never asked for security or documentation. When the company needed a larger facility to fund a new kiln, the bank agreed only on condition that the shareholder loan be formally subordinated and that no repayments be made on it while the bank was owed anything.
The founder resisted at first, feeling demoted in his own business. His adviser pointed out that in a liquidation he would have ranked behind the bank in practice anyway, and that signing the deed secured cheaper money that made the whole business more valuable to him as a shareholder.
Three years later Brightwater was sold. The bank was repaid from the proceeds, the subordinated founder loan was repaid in full immediately afterwards, and the ranking never mattered because there was more than enough to go round. In this fictional case the subordination cost nothing and bought a facility the company could not otherwise have obtained.
Watch out
Common mistakes.
- Assuming a higher interest rate makes a subordinated loan safe, when the rate is compensation for a genuinely worse position rather than a cure for it.
- Forgetting that structural subordination exists even without any agreement, so lending to a parent company is not the same as lending to the trading business.
- Treating subordination as purely about repayment order, when most deeds also restrict enforcement, security and even ordinary interest payments.
Questions
People also ask.
Does subordinated debt still count as debt on the balance sheet?
Yes, it is a liability like any other borrowing, although lenders and analysts often treat it as quasi equity when assessing headroom.
Can a subordination agreement be reversed later?
Only with the consent of the senior lender, which is rarely given while its own facility remains outstanding.
Is subordinated debt the same as mezzanine finance?
Not quite, since mezzanine is one common form of subordinated debt, usually with equity style features attached such as warrants.
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