A Subordinated Term Loan is a type of loan that ranks below other debts in terms of repayment priority in the event of a borrower’s liquidation or bankruptcy. This means that in case of financial distress or insolvency, the subordinated loan will be repaid only after all higher-priority debts, such as senior loans or secured loans, have been satisfied. Subordinated loans are also known as junior debt or mezzanine debt.

Because of their lower repayment priority, subordinated term loans carry a higher risk for lenders, and as a result, they typically come with higher interest rates to compensate for this increased risk. These loans are often used in corporate finance, particularly in leveraged buyouts, recapitalizations, or growth financing, where companies need additional capital but may already have significant senior debt.

Key Features of a Subordinated Term Loan:

1. Subordination in Repayment:
   • The primary characteristic of a subordinated term loan is its position in the repayment hierarchy. In the event of liquidation or bankruptcy, subordinated loans are repaid only after all senior debts (secured loans, senior term loans, or revolving credit facilities) have been fully settled. This makes subordinated loans riskier for lenders.
2. Fixed Maturity and Payment Schedule:
   • Like other term loans, a subordinated loan has a set repayment schedule, typically with fixed monthly or quarterly payments over a defined period (often 3 to 7 years). However, repayment of principal may be deferred or structured with interest-only periods in some cases.
3. Higher Interest Rates:
   • Subordinated loans carry higher interest rates compared to senior debt because of the increased risk for lenders. The interest rate compensates the lender for the lower priority in the repayment structure and the potential loss if the borrower defaults.
4. Unsecured or Lightly Secured:
   • Subordinated term loans are usually unsecured, meaning they are not backed by specific collateral. In cases where they are secured, the security is often considered “light,” or secondary to the collateral backing senior debt. This further increases the risk for lenders and contributes to the higher interest rates.
5. Flexible Use of Funds:
   • Subordinated term loans are often used for flexible purposes, such as funding business expansions, acquisitions, recapitalizations, or restructuring existing debt. They provide additional capital when senior financing options are limited.
6. Covenants and Restrictions:
   • While subordinated loans often have fewer covenants or less restrictive terms compared to senior debt, lenders may still impose certain covenants to protect their investment. These can include limits on additional borrowing, restrictions on dividend payments, or requirements for financial reporting.
7. Subordination Agreement:
   • A subordination agreement is usually required when there is a combination of senior and subordinated debt. This agreement outlines the order of priority in case of default or liquidation, specifying that the senior debt will be paid first.

Applications of Subordinated Term Loans:

1. Growth Financing:
   • Businesses may use subordinated loans to fund expansion projects when they need capital but already have senior debt. The subordinated loan provides an additional layer of funding without requiring senior lenders to provide more capital.
2. Leveraged Buyouts (LBOs):
   • In leveraged buyouts, subordinated loans are often used to finance the acquisition of a company. The senior lender (e.g., a bank) typically provides the majority of the financing, while subordinated loans are used to fill any remaining financing gap.
3. Business Recapitalization:
   • Companies may use subordinated loans to restructure their balance sheets, pay down existing debt, or finance dividend payouts to shareholders. In recapitalization, subordinated loans help manage capital structure while maintaining the flexibility to use senior debt for operational needs.
4. Bridging Finance Gaps:
   • Subordinated loans can bridge financing gaps when a company requires more capital than its senior debt allows. They provide a way to secure additional financing without diluting equity or issuing shares.

Benefits of a Subordinated Term Loan:

1. Access to Additional Capital:
   • Subordinated loans allow businesses to secure financing even when they already have senior debt, providing a way to access extra capital for growth, acquisitions, or restructuring.
2. Less Restrictive Covenants:
   • Compared to senior loans, subordinated loans often have fewer or less stringent financial covenants. This gives businesses more flexibility in how they manage their operations and use the funds.
3. Flexible Structuring:
   • Subordinated loans can be structured with varying terms, such as deferred payments or interest-only periods, allowing companies to tailor repayment schedules to suit their cash flow needs.
4. No Immediate Dilution of Equity:
   • By using subordinated loans instead of equity financing, businesses can raise capital without diluting ownership or control. This is particularly useful for companies that want to maintain ownership while still raising funds.

Risks and Challenges:

1. Higher Interest Rates:
   • Due to the higher risk associated with subordinated loans, they carry higher interest rates, which can increase the overall cost of borrowing for the business. Companies must ensure they can generate sufficient cash flow to meet these higher debt obligations.
2. Repayment Subordination:
   • Subordinated loans rank lower in repayment priority, meaning the lender may face significant losses in the event of the borrower’s insolvency or liquidation. This subordination increases risk for both the lender and the borrower.
3. Potential for Default:
   • If a company’s financial situation deteriorates, it may have difficulty meeting the higher interest payments associated with subordinated loans, increasing the likelihood of default.
4. Limited Collateral or Unsecured:
   • Subordinated loans are typically unsecured or have limited collateral, which means the lender has less security in case the borrower defaults. For the borrower, this can mean more exposure to aggressive collection actions if they face financial trouble.

Example of a Subordinated Term Loan:

• Scenario: A growing technology company wants to acquire a smaller competitor for $10 million. The company has already secured $7 million in senior debt from a bank but needs an additional $3 million to complete the acquisition. The company opts for a subordinated term loan to cover the remaining $3 million. The loan has a 10% interest rate, significantly higher than the senior loan’s 5%, but it allows the company to complete the acquisition without issuing more equity or seeking other costly financing alternatives.

Subordinated Term Loan vs. Senior Debt:

• Repayment Priority: Senior debt takes precedence over subordinated debt in case of liquidation or bankruptcy, meaning senior debt holders are repaid first. Subordinated debt holders are repaid after all senior debt obligations are satisfied.
• Collateral: Senior loans are often secured by specific collateral, while subordinated loans may be unsecured or backed by secondary collateral.
• Interest Rates: Subordinated loans have higher interest rates due to the higher risk for lenders.
• Covenants: Senior loans tend to have more stringent covenants and restrictions compared to subordinated loans, giving the borrower less flexibility.

A Subordinated Term Loan is a useful financing tool for businesses seeking additional capital beyond their senior debt capacity. By offering higher risk and higher reward to lenders, subordinated loans provide a way for companies to fund growth, acquisitions, or recapitalization efforts without diluting equity or over-leveraging with senior debt. However, the higher interest rates and repayment subordination make these loans riskier for both lenders and borrowers, so careful consideration is needed to ensure they align with the company’s financial strategy.