The Difference Between Senior Debt and Subordinated Debt: A Guide to Understanding Capital Structure

Tom Siska

Last Modified : Sep 18, 2024

Reviewed by: Bruce Sayer

Debt plays a crucial role in funding business operations, expansions, acquisitions, and more. However, not all debt is created equal, and understanding the distinctions between different types of debt can help both businesses and investors make informed decisions. Two primary categories of debt that often come up in discussions of capital structure are senior debt and subordinated debt. Each serves a distinct purpose and comes with different levels of risk, priority, and interest rates.

In this article, we’ll explore the key differences between senior debt and subordinated debt, their implications for businesses and investors, and how they fit into a company’s overall financing strategy.

What is Senior Debt?

Senior debt refers to loans or other forms of borrowing that take priority over other debt instruments in the event of a company’s liquidation or bankruptcy (often referred to from lenders as “taking first position”). Simply put, if a company goes under, senior debt holders are first in line to be repaid from the company’s assets before other creditors, such as subordinated debt holders or equity investors.

Key Characteristics of Senior Debt:

1. Priority in Repayment: In the event of liquidation or default, senior debt holders are paid before any other debt or equity holders. This makes senior debt less risky from a lender’s perspective.
2. Lower Interest Rates: Because senior debt is safer for lenders, it generally comes with lower interest rates compared to subordinated debt. Borrowers may find it more affordable due to this lower cost of capital.
3. Collateralized: Senior debt is often secured by the company’s assets, such as property, inventory, or receivables. This further reduces the lender’s risk.
4. Covenants: Lenders of senior debt typically impose strict covenants—agreements that the borrower must comply with to maintain the loan. These covenants may relate to financial metrics like debt-to-equity ratios, liquidity requirements, or operational restrictions.

Senior debt is typically issued by banks, alternative lenders, institutional lenders, or through public bonds. It is often used by businesses for large, asset-heavy investments or to finance acquisitions.

What is Subordinated Debt?

Subordinated debt, also known as junior debt, is a type of borrowing that ranks below senior debt in terms of repayment priority. If a company defaults, subordinated debt holders are paid after senior debt holders and may not recover their investment if the company’s assets are insufficient to cover all obligations.

Key Characteristics of Subordinated Debt:

1. Lower Priority in Repayment: Subordinated debt holders are repaid only after all senior debt obligations have been fulfilled. This higher level of risk is reflected in its ranking below senior debt.
2. Higher Interest Rates: To compensate for the increased risk, subordinated debt typically carries higher interest rates. For borrowers, this means higher financing costs.
3. Unsecured: Subordinated debt is often unsecured, meaning it is not backed by specific company assets. This further increases the lender’s risk, as they have fewer claims on the company’s resources in case of a default.
4. Flexibility: Subordinated debt is generally more flexible for borrowers in terms of covenants and terms. Lenders of subordinated debt may impose fewer restrictions compared to senior lenders, giving the company more freedom in its operations.

Subordinated debt is commonly issued to fill funding gaps when senior lenders will not provide the full amount required by the borrower. It is often used in mergers and acquisitions, leveraged buyouts, or when a company seeks to increase its leverage without compromising its relationship with senior lenders.

Senior vs. Subordinated Debt: Key Differences

1. Repayment Priority

The most significant difference between senior and subordinated debt is repayment priority. In the event of liquidation or bankruptcy, senior debt holders have the first claim on a company’s assets. Subordinated debt holders, on the other hand, are only repaid once senior obligations are fully settled. This makes subordinated debt inherently riskier for lenders.

2. Interest Rates

Because senior debt carries less risk due to its priority in repayment and is often secured by assets, it typically comes with lower interest rates. Subordinated debt, facing greater risk, commands higher interest rates to compensate lenders for the additional exposure.

3. Collateral

Senior debt is often secured by collateral, which serves as a guarantee of repayment in the event of default. If the company fails to make its debt payments, senior lenders can seize and liquidate the collateral. Subordinated debt, by contrast, is often unsecured, meaning the lender has no direct claim on any company assets, further elevating the risk level.

4. Covenants

Senior debt agreements usually contain more restrictive covenants, designed to protect the lender’s investment. These covenants may limit how much additional debt the company can take on or set financial performance targets. Subordinated debt typically comes with fewer covenants, giving companies more flexibility but increasing the lender’s risk.

5. Purpose

Senior debt is often used to fund long-term, large-scale investments like real estate purchases, equipment, or acquisitions. Subordinated debt, on the other hand, is frequently used to complement senior financing or to support growth initiatives that require additional leverage.

Which Type of Debt is Right for Your Business?

For businesses, the choice between senior and subordinated debt often depends on their specific financial needs, risk tolerance, and existing capital structure. Senior debt is typically the first option due to its lower cost and more favorable terms. However, when companies need additional funding beyond what senior lenders are willing to provide, subordinated debt becomes a useful tool to fill the gap.

Senior Debt May Be Ideal If:

• You have significant collateral to offer.
• You need lower-cost capital and are willing to comply with stricter covenants.
• You are seeking long-term financing for stable, asset-backed investments.

Subordinated Debt May Be Ideal If:

• You need additional leverage and can’t raise more senior debt.
• You are willing to pay higher interest rates in exchange for more operational flexibility.
• You are involved in a leveraged buyout or acquisition where subordinated debt is commonly used to bridge financing gaps.

Conclusion

Understanding the differences between senior debt and subordinated debt is critical for businesses looking to optimize their capital structure and for investors evaluating potential risks and returns. Senior debt offers lower risk and cost but comes with more restrictions and collateral requirements. Subordinated debt, while riskier and more expensive, provides businesses with greater flexibility and access to additional financing when needed. Together, these types of debt help form a balanced capital structure that supports both growth and financial stability.

Tom Siska

Tom‘s impressive career includes transformative successes, solidifying his stature in the financial sector. Notably, he drove impactful Sales & Marketing strategies at Sterling Commercial Credit LLC, culminating in a game-changing acquisition.

At Grasshopper Bank NA, he played a pivotal role in establishing a thriving commercial and asset-based lending group and his skill in integrating and overseeing acquisitions at North Mill Capital underlined his strategic acumen.

His talent for nurturing winning teams and delivering transformative outcomes has yielded an impressive $100MM in stakeholder value across diverse startup and turnaround ventures.