Senior debt is often mentioned in relation to corporate lending transactions. However it’s not as complex as it often sounds: it is simply a form of debt that gets paid before more junior debt: it’s unsubordinated and ranks ahead of unsecured and unsubordinated debt on the insolvency of the borrower. It's often secured by collateral of the borrower and a company will repay it completely before repaying subordinated debt.
Here we’ll be covering the fundamentals in the UK, including:
- What is senior debt?
- Who issues it?
- How is it issued?
- Structural subordination
- Contractual subordination
- Is senior debt safe?
- Is debt senior to equity?
- Is senior debt always secured?
- Can senior debt be consolidated?
What is senior debt?
Senior debt is money borrowed by a company that it must repay first if it goes out of business. If a company becomes insolvent, then senior debt is prioritised for repayment on the distribution of the company’s assets. This means that it will be paid back before more junior debt.
Senior debt has the highest protection in insolvency, so it typically requires lower interest rates from a borrower.
Who issues it?
Senior debt is normally held by banks or noteholders. For example, a bank extending a revolving credit facility to a company will normally be more senior than other lenders. When a bank offers a company a revolving credit facility, it will want to make sure that this is a senior debt. This seniority means that a bank is more likely to be paid back if something goes wrong with the company.
How is it issued?
The seniority of debt is normally determined by agreement between creditors through a process known as subordination. Subordination determines the rank of one creditor to another.
The main forms of subordination are:
- Structural subordination
- Contractual subordination
- Assignment of junior debt
- Granting security to senior creditors
Subordination arrangements will normally be documented in a subordination or intercreditor agreement.
Structural subordination gives priority to one creditor over another by lending to different entities within a corporate group. Typically this involves a group of companies and one creditor lending to a company further up the corporate chain than another lender.
For example, if senior lender A makes a loan to the parent company while senior lender B makes a loan directly to the parent company’s subsidiary, then senior lender A will be subordinated to senior lender B. This is because, in the event of insolvency, the creditors of the subsidiary will be paid before money is paid to the parent company. Only if the parent company receives a distribution from the liquidator of the subsidiary, will it be able to repay senior lender A. By contrast, senior lender B is a creditor of the company and will receive payment directly from the liquidator.
Lending to a parent company where the parent is a non-trading company and has few direct assets is considered particularly risky. It is quite common for a lender that wishes to avoid being structurally subordinated to require subsidiary companies to guarantee a parent company’s loan. This allows a lender to participate in the insolvency of the subsidiary more directly.
Contractual subordination is where creditors enter into a contract to ensure that one creditor is paid before another. There are four main types of contractual subordination. They are:
- Contingent debt subordination
- Simple contractual subordination
- Turnover subordination
- Trust subordination
What is contingent debt subordination?
Contingent debt subordination is where a junior creditor agrees that its debt is contingent on the senior debt being paid in full. This means that the junior debt is not payable until after payment of the senior debt in full.
Junior lenders should be aware that subordinating their debt to a senior lender under a contingent debt subordination or simple contractual subordination will automatically subordinate their debt to any other creditor ranking alongside the senior lender. Junior lenders will want to ensure that a borrower is not able to obtain additional senior debt in the future without their permission. Otherwise, a junior lender runs the risk of being subordinated to more and more lenders.
What is simple contractual subordination?
Contractual subordination is where a junior creditor gives an undertaking not to collect its debt until a senior lender is paid in full. This undertaking gives the senior lender a personal right against the junior creditor, if it collects repayment before the senior lender has been repaid.
Contractual subordination may be complete or partial. Under a complete subordination, no payments are to be made on the junior debt until the senior debt is paid in full. Under partial subordination, payments of interest and instalments on the principal may be permitted so long as no event of default has occurred.
What is turnover subordination?
Turnover subordination is where a junior creditor agrees to pay (“turn over”) money received to the senior creditor up to a specified amount or until the senior debt is repaid. The advantage of turnover subordination is that the junior lender is only subordinated to the senior lender. This is contrast to contractual and contingent subordination, where a junior creditor is subordinated to all creditors ranking equally with the senior lender.
The advantage for a senior lender is that it will have the benefit of both its claim and the junior lender’s claim on the winding up of the borrower. The disadvantage for the senior lender is that ultimately depends on the credit risk of the junior lender and, more particularly, on it remaining solvent.
What is trust subordination?
Trust subordination is where a trust is created to hold the proceeds, dividends or payments received by a junior lender or where a junior lender promises to pay sums to a senior lender. Trust subordination provides a senior lender with a proprietary interest in the proceeds received by a junior lender.
Trust subordination requires the junior lender to declare itself trustee of any sums received in respect of the junior debt. The terms of trust will require that these sums must be applied to repay the senior debt.
Is senior debt safe?
Many lenders consider it as a safe investment. The seniority of the debt helps to ensure that if a borrower gets into financial difficulty then senior lenders are more likely to be repaid than more junior lenders or shareholders.
Senior debt is accessible to a wide range of businesses and interest rates are generally lower than more junior debt. In order to minimise the cost of servicing debt, a company should seek to fund itself with senior debt before turning to other forms of debt.
Is debt senior to equity?
In an insolvency, all debt is to be paid back before equity (shares). The term ‘senior’ or ‘seniority’ is used to refer to the ranking of different classes of debt/creditor. This means it ranks ahead of junior debt and shareholders.
Is senior debt always secured?
No, it isn't always secured, although it is common for senior lenders to take some form of security for their loan. By contrast, junior debt is more commonly unsecured.
Can senior debt be consolidated?
Yes, it can be consolidated or restructured with the agreement of the senior lenders. Common forms of restructuring include reducing interest rates, swapping debt for equity and moving debt from the private sector to public sector institutions.