Subordinate Financing

Subordinate Financing

Investopedia / Nez Riaz

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.

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