What is 'Subordinate Financing'

Subordinate financing is debt financing that is ranked behind that held by secured lenders in terms of the order in which the debt is repaid. "Subordinate" financing implies that the debt ranks behind the first secured lender, and means that the secured lenders will be paid back before subordinate debt holders.

BREAKING DOWN 'Subordinate Financing'

The lender's risk in subordinate financing is higher than that of senior lenders because the claim on assets is lower. As a result, subordinate financing can be made up of a mix of debt and equity financing. This allows the lender involved to look for an equity component, such as warrants or options, to provide additional yield and compensate for the higher risk.

Risks of Subordinate Financing

If a company has to file for bankruptcy or faces liquidation with both subordinate financing and senior debt on the books, then the unsubordinated debt is paid back first before the subordinated debt. Once the unsubordinated debt is completely paid back, the company then repays the subordinated debt.

For example, assume a company has secured senior debt of $60 million and subordinate financing that totals $40 million. If a company liquidates all of its assets in a bankruptcy for $80 million, it first needs to pay off the $60 million amount of its debt held by secured lenders. The remaining subordinated debt is only half repaid for $20 million due to the lack of liquidated funds.

It's important for potential lenders or debt investors to be aware of a company's outlook for solvency, other debt obligations and total assets when reviewing an issued bond. While this type of debt is riskier for lenders, it's still paid out ahead of equity holders. Subordinate financing usually offers higher rates of interest to compensate for the potential risk of default.

Types of Subordinate Financing

Subordinated bonds can be found largely in bonds issued by major banks.

Asset-backed securities are another type of subordinated debt. These collateralized types of securities are usually issued in different types of classes, also known as tranches – each with different levels of risk, interest rates, and maturities.

Another type of subordinated financing is a mezzanine debt. These are often issued as either preferred stock or unsecured debt and are generally only senior to common stock. Mezzanine debt acts as a hybrid security.

RELATED TERMS
  1. Subordination Agreement

    Subordination agreement is a legal agreement which establishes ...
  2. Effective Net Worth

    Effective net worth is shareholders' equity plus subordinated ...
  3. Convertible Subordinate Note

    A convertible subordinate note is a short-term debt security ...
  4. Senior Debt

    Senior debt is borrowed money that a company must repay first ...
  5. Retail Note

    Retail notes can be purchased directly from the issuer at par ...
  6. Preferred Debt

    Preferred debt refers to debt obligations that must be repaid ...
Related Articles
  1. Investing

    Understand the Security Types of Corporate Bonds

    Any investor should be aware of the different security types regarding corporate bonds as well as the direct correlation to potential recovery rates.
  2. Investing

    Will Corporate Debt Drag Your Stock Down?

    Corporate debt can mean a leg up for firms, or the boot for investors. How to tell the difference.
  3. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  4. Small Business

    Small Business Financing: Debt Or Equity?

    There are two sources of financing for small businesses: debt and equity financing. This article explains both.
  5. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  6. Financial Advisor

    The 4 Best Debt Reduction Services

    It can be tricky to find the best debt reduction services for your financial situation. These top 4 debt consolidation firms help make the process easier.
  7. Insights

    How Countries Deal With Debt

    For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly.
  8. Personal Finance

    Sizing Up Debt

    Ever wonder if the different types of debt are good or bad? Read on and we'll tell you.
RELATED FAQS
  1. What is the difference between subordinated debt and senior debt?

    Understand the difference between subordinated debt and senior debt. Learn what a company is required to do in case of bankruptcy. Read Answer >>
  2. Is debt a relatively cheaper form of finance than equity?

    When financing a company, the cost of obtaining capital comes through debt or equity. Find out which method generally provides ... Read Answer >>
  3. What is the difference between secured and unsecured debts?

    Learn about the differences between secured and unsecured debt — and how banks buffer risks associated with each type of ... Read Answer >>
  4. What are the main categories of debt?

    Learn about the different types of debt available for consumers including secured debt, unsecured debt, revolving debt and ... Read Answer >>
Trading Center