What is subordinated debt?
Subordinated debt, also known as junior debt, is a form of borrowing that ranks below senior debt in a company’s capital structure. In the event of liquidation, subordinated debt holders are only repaid after all senior debt obligations have been satisfied, but before any equity holders receive proceeds.
This lower priority means subordinated debt carries higher risk for lenders. For companies, it offers a way to raise capital without diluting ownership or giving up control.
Features of subordinated debt
Key features of subordinated debt include its junior position in the repayment hierarchy and typically unsecured (or partially secured) status. Unsecured status means that the debt is not backed by any specific collateral, such as a company's assets. In the event of a company's liquidation or bankruptcy, creditors holding unsecured debt do not have a claim to specific assets to satisfy the debt. They are paid only after secured creditors have been fully repaid.
Because of the increased risk, subordinated debt usually comes with higher interest rates (coupons) compared to senior loans. Terms are often more flexible, with fewer covenants and longer maturities. Interest payments may be fixed, floating, or payment-in-kind (PIK).
Subordinated debt is recorded as a long-term liability on the balance sheet and can impact a company’s leverage and credit rating.
Who issues and invests in subordinated debt?
Issuers | Investors |
Institutional investors |
Benefits of subordinated debt
For companies, subordinated debt provides access to additional capital without diluting common equity, a benefit it shares with senior debt. However, it's particularly useful when a company has already exhausted its capacity for senior debt. Subordinated debt sits lower on the repayment hierarchy, meaning in a liquidation, it's paid after all senior debt. This higher risk is what differentiates it. It can enhance capital structure flexibility, allowing businesses to optimize their mix of debt and equity by accessing a different tier of the capital structure.
For lenders and investors, subordinated debt offers higher yields to compensate for the increased risk. It may also include opportunities for equity participation through warrants or conversion features, giving investors a greater potential return.
Subordinated debt in private equity
In private equity and private credit investing strategies, subordinated debt is a valuable tool for structuring deals. Private funds often use this type of debt to bridge the gap between senior debt and equity, enabling sponsor-backed buyouts, growth capital investments, and recapitalizations.
In a leveraged buyout (LBO), a private equity sponsor acquires a company using a significant amount of borrowed capital. Subordinated debt plays a crucial role in these deals by filling the mezzanine layer of the capital structure, which sits between the senior debt and the equity provided by the sponsor.
This is what makes it a different and necessary tool. Typically, the senior debt provider will only finance a portion of the acquisition, based on the target company's assets and cash flow. Senior lenders want to limit their exposure and risk. When the financing needed for a deal exceeds this amount, the company has a gap to fill. While this gap could be filled with more equity, subordinated debt provides an alternative. By filling this funding gap, it allows private funds to pursue deals that would otherwise be impossible to finance with just senior debt and a reasonable amount of equity. This allows the private equity firm to reduce its own equity contribution, thereby increasing its potential return on investment.
For example, if a deal requires $100 million in financing and a senior lender is willing to provide $60 million, a private equity firm might raise $20 million in subordinated debt and contribute the remaining $20 million as equity. The subordinated debt lender is compensated for their higher risk with a higher interest rate and often a small equity stake or warrants.
