Senior Debt
What is Senior Debt?
What Is Senior Debt?
When you work in finance, debt is one of the most important financial terms you learn about. However, you don't need an experienced financier to understand debt. Debt is the amount of money that one party (the debtor) borrowed from another (the creditor).
Many individuals use debt as additional financial support. It allows them to make purchases they couldn't afford otherwise.
In the world of corporations, this rule also applies. Many other factors can explain the relationships between debt instruments and companies.
In this article, we will shed more light on one particular type of debt: senior debt. As a general rule, there are two major types of debt:
- Senior debt or Senior note
- Junior or subordinated debt
The principal difference between them is their seniority. Seniority refers to the priority status of the creditor's claims against the borrower.
One creditor is senior to another when a borrower has a contractual obligation to reimburse him before any payment can be made to the second creditor.
Key Takeaways
- Debt is the amount of money that one party (the debtor) borrowed from another (the creditor).
- Senior debt and junior or subordinated debt are the two major types of debt. The difference between them is their seniority or the priority status of the creditor's claims against the borrower.
- Seniority is achieved through contractual or structural subordination.
- Certain debts are prioritized over others in contractual subordination, as determined by the subordination provisions in the indenture. Senior creditors are paid first before junior creditors.
- In structural subordination, debt instruments in a company are prioritized based on their legal entities and the support they receive from other entities.
- Senior debt holders have priority status over other debt holders. They are the first to be paid back in the event of bankruptcy.
- Senior debt is often secured by collateral and guaranteed through covenants that govern a company's actions.
- Revolving Credit Facilities (RCF) and Term Loans are typical examples of senior debt. RCF can be a cash flow RCF or an asset-based lending (ABL) facility, while term loans can be Term Loan A, B, or C.
How Senior Debt Works
Imagine a company filing for bankruptcy. The capital structure of this company contains a senior note and some other subordinated debt instruments. This company has an obligation to pay back its debt holders.
However, owners of a senior note have priority status over other debt holders. They are the first to be paid back. Every penny can only go to the pocket of subordinated creditors if the senior debt is fully repaid.
Often, senior debt is also secured. Security means that a borrower grants a creditor a pledge of or lien on collateral. Collateral refers to accounts receivable, inventories, intellectual property, property, plant, equipment (PPE), and securities that will change ownership in the event of liquidation.
For creditors, it is a surety. If a company cannot pay its debt, creditors will sell collateral to get their money back. Different collateralization levels are required depending on the volatility of cash flows.
The more cash flows are unpredictable and fluctuating, the more risky a company is. Hence, a higher collateral level will be demanded.
Note
Seniority is often achieved through contractual or structural subordination.
Contractual subordination means prioritizing certain debts over others within the same legal entity. This is usually determined by the subordination provisions, which state that senior creditors must be paid first before junior creditors can receive any payment.
If we're talking about the subordinated bonds, the subordination provisions are outlined in the indenture. They are used by senior creditors as a way to ensure that they get paid before anyone else.
When you have senior secured debt and senior unsecured debt, both have contractually equal debt claims. Yet, senior secured debt would be "effectively" senior due to the extent of the value of its collateral. Thus, senior unsecured debt can be considered "effectively subordinated" to senior secured debt.
Structural subordination refers to the priority status of debt instruments within a company but at two legal entities.
Imagine debt in an operating company (OpCo) and a holding company (HoldCo). The company's assets are located at the level of OpCo, so its debt is considered more important than the debt at HoldCo. It is valid as long as HoldCo's debt has no support from OpCo.
This support can take the form of a guarantee. OpCo, with actual operations and assets, can agree to use its cash and assets to pay off debt obligations on behalf of HoldCo.
In any other scenario, if OpCo goes bust, its debts should be fully paid back before any money could be given to HoldCo, its shareholder.
Example of Senior Debt
Revolving Credit Facility (RCF) and Term Loans are typical examples of senior debt or secured facilities.
Within the revolving credit facility, we have two subsets:
- Cash Flow RCF
- Asset-based lending (ABL) facility
In turn, term loans can take the form of different tranches:
- Term Loan A
- Term Loan B
- Term Loan C
Senior debt (bank debt) uses restrictive covenants. It is an additional layer to guarantee security for debt holders.
Covenants govern various actions a company has or doesn't have a right to do. A company also has specific financial ratios and provisions they have to respect.
Bank debt is financial debt (interest-bearing). Borrowers have regular interest payments (monthly, quarterly, or yearly).
The interest is often comprised of Base Rate plus a spread. The spread depends on the borrower's creditworthiness or the quality of pledged assets (if ABL). The Base Rate is a forward rate calculated daily. In the US, it is SOFR, while in Europe, €STR.
Revolving Credit Facility
RCF is the first-lien-secured debt instrument. Therefore, it is considered to be the least risky among all debts. For this reason, it also has the least cost.
1. Cash Flow Revolving Credit Facility
This is a common credit line granted by a bank or a group of banks to a company. A borrower can draw any amount up to the authorized limit whenever he wants.
A group of banks is also called a pool. A pool of banks often finances significant credit lines. It allows them to redistribute risks and facilitate financing processes.
The amount borrowed can be freely repaid and borrowed unlimited times during the effective period of RCF. This credit line is commonly used to finance working capital needs, capital expenditures, letters of credit, and other corporate purposes. It is also sometimes seen as a means to finance a portion of an LBO transaction.
RCF is a secured instrument and is often the least expensive funding source. Lenders generally require a priority on the borrower's or its subsidiaries' assets (tangible and intangible assets or capital stock).
A revolver can be guaranteed and not-guaranteed. A guaranteed revolver is one that a bank commits. Whatever happens, a bank must make funds available for you if requested.
On the contrary, a non-guaranteed revolver is not committed. A bank can refuse to fund you if deemed necessary.
2. Asset-Based Lending Facility
Another type of revolving credit facility is an ABL facility. This facility is available to companies intensive in current assets. For example, asset-based borrowing is secured through current assets like inventories, accounts receivable, and sometimes PP&E.
For instance, ABL facility is commonly used by manufacturers, retailers, or rental equipment businesses. ABL loans have limits on how much money can be borrowed.
An ABL borrowing base determines the maximum amount that can be borrowed. The limit is based on "eligible" accounts receivable, inventories, and other fixed assets pledged as collateral.
ABL borrowing base = 80% * Eligible Accounts Receivable + 80% * Eligible Inventory
Note
Note that this is an indicative formula.
Generally, the biggest amount of money available for borrowing is capped by the size of the borrowing base or the committed amount of the facility. Whichever is less is how much you get.
ABL facilities offer lenders extra safeguards not typically included in the standard cash flow revolvers. These protections could consist of regular reports on the collateral and appraisals.
Additionally, the assets that back ABLs (such as inventory and accounts receivable) are usually easier to convert into cash in the event of bankruptcy. Thanks to these added benefits, the ABL facilities generally have lower interest rates than the cash flow revolvers for the same level of credit.
Term Loans
Along with RCF, Term Loans are also first-lien debt instruments. They are, however, slightly less secure and benefit from a lower priority over RCF.
1. Term Loan A (TLA)
A company borrowing money can opt for the first type of loan, called a "Term Loan A" or "TLA." Term loan A is amortized throughout its life.
This is why it is also known as an "amortizing term loan." Amortization means that a borrower must repay a portion of a loan every contractualized period.
For instance, imagine a company borrowing $100M for five years. This amortizing term loan will be repaid yearly. The annual amount to be returned to investors would be $20M ($100M/5).
Lenders prefer TLAs because they are less risky than loans with minimal required principal payments. As a result, TLAs are often the most affordable type of term loan.
Note
Commercial banks and finance companies syndicate or distribute TLAs along with a revolving line of credit. This type of loan is often called a "pro rata" tranche because lenders typically commit to equal percentages of the revolving line of credit and TLA during syndication.
2. Term Loan B (TLB)
Term Loan B is another type of loan. TLBs are usually bigger than TLAs and are sold to institutional investors, often the same investors that purchase high-yield bonds (junior debt).
Institutional investors prefer loans that don't require regular repayments (non-amortizing) with longer repayment periods and higher interest rates.
Therefore, TLBs typically have a lower repayment rate and require a lump sum payment at the end of the loan term. It is called bullet debt.
A bullet loan is one in which the borrower only makes interest payments throughout the loan term. The principal amount is due in a single payment or "bullet" at the end of the loan term.
TLBs are designed to have a more extended repayment period than the revolver and TLA because banks prefer that their debts be paid before TLBs.
3. Term Loan C (TLC)
Term Loan C (TLC) can be given by financial institutions such as banks, private equity firms, and hedge funds. However, it typically comes with a higher interest rate than TLB.
TLC can be set up as an amortizing loan or a bullet loan. Companies usually use TLC to fund their growth plans or to restructure their debt. If set up as a bullet loan, TLC would have a slightly longer maturity of one to two years compared to TLB.
The interest rates for Term Loan B (TLB) and Term Loan C (TLC) differ. Several factors influence them. It includes market conditions, the borrower's creditworthiness, loan size, and maturity.
Generally, TLB loans have lower interest rates than TLC loans. The potentially weaker collateral of TLC explains it. TLB interest rates can range from 3% to 10%, depending on the above factors.
On the other hand, TLC loans typically have higher interest rates than TLB loans. TLC interest rates can range from 5% to 15%. Bear in mind that these interest rate ranges are not unchangeable.
Senior Debt on Demand
When a debt market is strong, it is common to see second-lien term loans being used to finance companies and LBOs (Leveraged Buyouts). These types of loans are collateralized. They also have a lower priority than first-lien loans.
Unlike first-lien term loans, second-lien term loans generally do not require repayment over time. Instead, they have longer terms than first-lien loans to ensure that the first-lien lenders are repaid before the second-lien lenders.
Second-lien-term loans are an alternative option offered to borrowers of traditional junior debt instruments such as high-yield bonds and mezzanine debt.
Second-lien-term loans provide borrowers with better prepayment options than high-yield bonds. They can also be issued in smaller sizes than high-yield bonds.
This debt instrument can also reduce the cost of capital under favorable market conditions for companies with a low-risk profile. However, they usually come with financial covenants, which are moderately less restrictive than first-lien debt.
Investors like hedge funds and CDOs (collateralized debt obligation investors) prefer second-lien term loans. This is because they offer less risk due to their secured status while paying a higher coupon than first-lien debt.
If the borrower fails to repay the loan, the second-lien lenders may be unable to be recovered. This is because the first-lien lenders have priority over them regarding repayment.
The risk of interest rate fluctuations or economic downturns should also be considered. For example, debtors can have more difficulties repaying interests during high-interest rate periods or when the downward economy trims revenues.
Note
Debt instruments are at the core of many LBO analyses. Thus, their workings must be understood to model leverage buyout transactions successfully. Different types of debt present different challenges and approaches to deal with them.
Researched & Authored by Illia Shliapuhin | LinkedIn
Reviewed and Edited by Raghav Dharmarajan
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