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Case StudiesSubordinated Debt
Subordinated debt is a synonym for mezzanine debt. It is junior debt that is unsecured or has a lesser priority than that of an additional debt claim on the same asset. This means that if the party that issued the debt defaults on it, people holding subordinated debt gets paid after the holders of the “senior debt”. A subordinated debt therefore carries more risk than a normal debt.
Subordinated debt is used in acquisition and buyout transactions where there is a need for extra funding that the senior lender cannot provide. In a standard acquisition transaction, an equity investor provides 20% to 35% in equity and the senior lender provides senior debt in accordance with an EBITDA multiple. If the senior lender can only provide 40% and the equity investor provides 25%, there is a gap in the amount of 35% that the subordinated debt lender or mezzanine lender will fill. The subordinated debt resides in the middle layer of the transaction structure, below the senior loan layer and above the equity layer. They are junior to the senior lender but senior to the equity investor with respect to priority. Most subordinated debt loans do not have hard collateral as security as that is usually taken by the senior lender.
How Subordinated Debt Enhances Acquisition Structures With Cash-Flow-Driven Financing
Subordinated debt is structured upon on debt service and leverage multiple ratios calculated upon historical and projected cash flow. Subordinated debt principal repayment requirements are back-ended allowing for senior loan repayment throughout the term. The pricing on subordinated debt is higher than senior loans due to the lack of collateral and term risk. Subordinated debt, if structured properly, is a form of “cheap equity” as it can replace more expensive equity investment in an acquisition deal structure. Its superpower is being able to quantify a debt structure based on cash flow and overall equity valuation, rather than conventional collateral. While it is commonly called upon to fund any capital gap, it is more powerfully utilized in a direct lending structure where it funds an acquisition or buyout of a founder-owned company with no cash equity.
Frequently Asked Question
It is generally an interest rate of 10% to 13% with an additional equity kicker for the lender to realize total return of 15% from both the interest rate and equity kicker.
Most middle market lenders start at a loan size of $10 million. This translates into company size of $20 million revenue and $3 million in EBITDA for minimum levels.
Growth stories are extremely important and drive the enthusiasm level of the lender to pursue your deal.
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