A-Z of banking and finance: J is for junior debt

A-Z of banking and finance: J is for junior debt

Banking and finance bulletin - September 2022

Junior debt – sometimes referred to as subordinated debt, occasionally talked about as mezzanine debt – is referred to as such because it ranks behind other, more senior, debt owing by the same borrower. Junior creditors can come in many different shapes and sizes and can include shareholder lenders and specialist debt investors or funds.

Junior debt can be an attractive proposition for investors as it often carries a better return (i.e. an attractive interest rate or other fees making it more expensive debt). But with enhanced returns often come greater risk: more senior-ranking debt will typically get paid out first before the borrower makes any payments to junior creditors. This usually means that junior creditors occupy a more vulnerable position than senior creditors in the event of a borrower’s insolvency. An understanding of these different creditor interests is crucial both for businesses seeking debt funding and for investors looking to allocate their capital effectively.

Structural vs. contractual subordination

The ranking of junior debt compared to a borrower’s other indebtedness, and the circumstances in which junior creditors can expect to receive repayment, can be dealt with in different ways. Sometimes people talk about structural subordination, where senior debt is advanced at a “lower” (meaning close to the operating entities) level in a corporate group structure, and guarantees and security are taken from and over the assets of the operating vehicles in that corporate group. The junior (or subordinated) debt by contrast will be advanced at a “higher” level in that corporate structure to a holding vehicle (i.e. a company that does not trade and whose only assets are its interest in the operating subsidiaries) and without the benefit of guarantees from and security over the assets of the operating entities. In this scenario, the junior creditor(s) have claims against the holding company to which the junior debt is advanced alone, which will be dependent upon distributions from its subsidiary/ies or repayments of intercompany loans owing by those subsidiary/ies to obtain the funds necessary to repay the junior debt. The senior creditor(s) by contrast have claims against, and security from, companies lower in the corporate structure including, crucially, the asset-owning and income-generating operating companies. In short, in a distressed or insolvency situation, the senior creditors stand a much better prospect of recovering amounts owing to them.

In more complicated financings, lenders are rarely prepared to rely upon structural subordination where there is any junior debt in the mix and will also want an element of contractual subordination – a contract under which different lenders agree to a specific order of priority in which their debts will rank. Such contracts may be referred to as subordination agreements, or as deeds of priority, or as intercreditor agreements. To read more about intercreditor agreements, please see our previous article here. For the purposes of this note, suffice to say that if you’re a junior creditor and asked to enter any such subordination arrangement, then you should expect to find yourself deeply subordinated – in other words, waiting patiently behind the senior creditor(s) until the senior debt is repaid in full before you can do much with your junior debt.

Relevant considerations for junior creditors

It’s beyond the scope of this article to cover all the different points that a junior creditor might want to consider when senior creditor(s) start imposing contractual subordination arrangements, but relevant considerations for junior creditors might include the following:

  • How should the repayment profile (including for principal, fees and any interest) for the junior debt be impacted whilst the junior debt remains outstanding? If all payments (including in respect of interest) on the junior debt are suspended until the senior debt has been repaid in full, will interest on the junior debt capitalise in the meantime?
  • To what extent can the junior creditor(s) take guarantees and/or security over the assets of the borrower and its affiliates by way of collateral for the junior debt?
  • If the junior debt is secured and/or guaranteed, to what extent can the junior creditor(s) enforce those security and guarantee interests whilst the senior debt is outstanding? If the senior creditors impose a “standstill period” during which the junior creditor(s) are unable to enforce those security and guarantee interests, how long should that standstill period last? Should the senior lender(s) have to consult with the junior creditor(s) about any enforcement action they might take in the meantime?
  • What restrictions should be placed on any amendments or waivers to the junior loan documents whilst the senior debt is outstanding? Equally, to what extent should amendments to the senior debt documents (for example to increase the size of the senior loan or to change the repayment profile) be restricted? Similarly, to what extent are transfers of the junior debt regulated?
  • How does all of this play out if the borrower enters any kind of insolvency situation?

In summary

To summarise, junior debt will typically:

  • carry a higher risk for the junior lender, compensated for by higher interest rates and possibly additional fees;
  • rank behind senior debt in the ordinary course repayment hierarchy and in a borrower’s insolvency; and
  • be regulated by an overarching agreement such as a subordination agreement, deed of priority or intercreditor agreement.

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