Subordinated debt is an unsecured, low-ranking type of debt that gets paid after senior debt in the event of liquidation.
Liquidation is the process of selling assets to gain spendable cash due to corporate default. Subordinated debt is also known as junior debt or subordinated debenture. Suppose a company defaults and files for bankruptcy. In that case, a bankruptcy court may order companies to repay any outstanding debts to subordinated debt holders by selling available assets, such as patents.
A subordinated loan is usually used by large corporations and business entities. Once a company has obtained the maximum amount of senior debt possible, it may seek debt financing through subordinated debt. Interested borrowers can get a subordinated bond or loan at a bank or financial institution. Subordinated loans help companies fund investments, increase capital, and gain opportunities.
What Is Senior Debt?
Senior debt is high-priority debt that a corporation must pay in full first if they default on any debt obligations. Senior debt is also referred to as unsubordinated debt.
When a corporation files for bankruptcy and has to repay its debts, senior debt is always paid before subordinated debt. Senior debt is any loan secured with collateral. For example, a mortgage loan qualifies as senior debt because the real estate property secures the loan in the event of default.
The risk is low for senior debt holders because unsubordinated debt has a higher priority. While subordinated debt has higher interest fees due to high risk, senior debt typically has lower interest rates.
What Happens When a Company Defaults?
Corporate default occurs for various reasons, such as poor cash flow management and losing control of finances. Companies and business owners that cannot repay their outstanding debts typically file for Chapter 7, 11, or 13 bankruptcy to reorganize their debts and get a clean slate.
- Chapter 7: Known as liquidation bankruptcy. A small-business owner does not have to submit to a repayment plan because assets are liquidated (sold) in order to pay existing creditors. Once secured debts are repaid, any unsecured debts get discharged.
- Chapter 11: Known as a reorganization bankruptcy. Chapter 11 is ideal for businesses that want to remain open. This debt relief option allows business entities to maintain day-to-day operations while they create a repayment plan.
- Chapter 13: Known as a wage earner bankruptcy. This type of bankruptcy is available to sole proprietors and small business owners. After filing for Chapter 13, a small debt amount gets eliminated, and the borrower can repay the remaining balance through a court-approved repayment plan. Repayment plans for Chapter 13 bankruptcy typically last three to five years.
How Does Liquidation Work?
The liquidation process occurs when a small or large company is incapable of paying back outstanding debts in a timely manner. In order to repay financial institutions, the company must sell off any assets to obtain cash for debt repayment.
There are three different types of liquidation because there are various reasons why companies go through the liquidation process.
Compulsory Liquidation
A lender instigates this type of liquidation process. When a company has not paid the financial institution for some time, the creditor can petition to liquidate. In other words, compulsory liquidation is when lenders force bankrupt companies to sell any assets to repay existing debt.
Members’ Voluntary Liquidation
A solvent business is a business that has more assets than debt. When a solvent company volunteers to liquidate, this process is known as a members’ voluntary liquidation.
Suppose the owner of a company wants to leave. Suppose 75% of the company’s members vote to liquidate. In that case, a liquidator will settle any unsubordinated and subordinate debts by selling assets.
Creditors’ Voluntary Liquidation
Suppose company directors know they cannot repay existing debts on time or realize liabilities exceed the asset value. In that case, they can appoint a liquidator to start the creditors’ voluntary liquidation process. The liquidator will settle any current legal disputes or debts the company has.
What Is Liquidation Preference?
The liquidation process has a hierarchy that dictates repayment preference in the event a company files for bankruptcy. In order of importance, repayment goes to secured creditors, unsecured creditors, and then shareholders. Secured creditors provide unsubordinated debts, while unsecured creditors provide subordinated debts and subordinated bonds.
Financial institutions that provide unsubordinated debts are paid in full during the liquidation process. In contrast, those that provide subordinated bonds are paid before equity shareholders.
What Is the Difference Between Liquidation and Bankruptcy?
Liquidation is similar to bankruptcy but entirely different. When a company files for bankruptcy, a federal court may order the company to liquidate assets to settle debts. But if a company liquidates, then the company must stop operations permanently. However, companies can continue operating if there is only a partial liquidation.
What Are Some Types of Subordinated Debt Instruments?
There are different types of subordinated debt instruments, and they all have different repayment priorities. Read about some examples of subordinated debt instruments below.
High Yield Bonds
A high-yield bond, also known as a junk bond or high-yield corporate bond or high-yield debt, is a bond that is rated below investment grade. Since the risk of default is higher, these bonds have a higher rate of interest.
Mezzanine Debt
A mezzanine debt is a type of security that is non-tradeable and is of a slightly lower rank than senior debt. Mezzanine debt also comes with features like:
- Bullet repayment
- Accrued cash return
- Attached equity warrants
The equity warrants attached to mezzanine debts allow lenders to earn interest payments on the return and exposures to equity upside as well.
Payment-in-Kind Notes
Payment-in-kind (PIK) notes are goods or services used as payment instead of cash. Many companies use payment-in-kind securities to preserve cash at the cost of higher interest assessments. PIK notes are also known as funding bonds or bartering income by the Internal Revenue Service (IRS).
Vendor Notes
A vendor note, or seller note, is a type of short-term loan a vendor makes to a customer. The loan is then secured by goods the customer buys from the vendor. Vendor notes help buyers cover part of the sale price.
How Much Subordinated Debt Can a Company Have?
Companies can only handle a certain amount of debt. There are a few measures to determine how much debt a company can successfully handle.
- Debt to EBITDA Ratio: The EBITDA margin, or revenue margin, is the profitability ratio that measures how much a company earns before interest, taxes, and other fees. The total debt to EBITDA ratio should only account for five to six times.
- Equity Funding: The company should have a maximum equity funding of 30% to 35%.
References:
Senior and Subordinated Debt│CFI Education Inc.
What Is the Difference Between Chapter 7, 11 and 13?│Bunch & Brock Law