Subordinated Debt can be defined as the class of debt that does not get preference on the claim of assets until the senior debtholder’s claims are not satisfied. Structuring of the debt defines the priority of claims for general payment as well as in case of liquidation.
In this article, we discuss subordinated debts in detail –
- Overview of Credit
- What is Subordination Debt?
- Credit facilities
- Secured vs Unsecured Subordination Debt
- Types of Subordination Debt
- #1 – Collateral Subordination Debt
- #2 – Structural Subordination Debt
- #3 – Contractual Subordination Debt
- Non-investment grade borrowers
- External ratings
- Facility ratings
Overview of Credit
With the growing levels of corporate defaults in the current sluggish macroeconomic scenario, banks are becoming increasingly cautious about their money lent. The lender banks have tightened their credit norms to limit the impact on their balance sheet in case of default scenarios. Consequently, the debt facilities that are extended to the client are only processed after meticulously drafting the credit documentation, termed as a “Credit Agreement”. A credit agreement is a legal contract between a lender and a borrower outlining the key terms of the debt facility in the transaction such as maturity, interest rate, amortization schedule (or the loan servicing plan), covenants, course of action during events of default, as well as the priority of the lending.
What is Subordination Debt?
The priority of the lending i.e. the structuring of the debt in the overall capitalization profile primarily determines the priority of each liability in case of general repayment from the regular cash flows as well as liquidation of a company’s assets in case of an extreme scenario. The debt lower in the priority is said to be “subordinated” compared to the debt higher in the rank. In a liquidation scenario, the subordinated lenders can not call for default until the more senior debt has been repaid by the borrower. Of course, since the subordinated debt creditors take on more credit risk than the senior debt lenders, they are compensated by the borrower with a higher interest rate. Nevertheless, even the most subordinated debt is paid before the equity holders.
We note that the credit facilities primarily taken by the corporates from the banks and other financial institutions fall under the following categories:
- Term loan “TL” facility; which are repaid in set amortization schedule or in the bullet,
- Revolving credit “RC” facility; which are used for working capital purposes, and can be drawn down (and repaid) any numbers of times up to the maximum facility amount,
- Working capital loans used for daily operations; such as overdrafts and letters of credit. Also, checkout working capital ratios
- Structured credit facilities, such as mezzanine debt, which have both debt and equity-like characteristics. This type of debt typically ranks lower in the debt structure.
The companies could also raise debt from the capital markets in the form of commercial paper (typically issued for short term purposes) as well as bonds and debentures (typically issued for long term investments).
Secured vs Unsecured Subordination Debt
Each of the above-mentioned debt structures could be secured or unsecured in nature, and subordination may vary depending on the right over the assets during a liquidation scenario (as shown below). A second lien secured loan has a second priority on the assets of the borrower and guarantor. We note that the security grants lender the right to sell the secured assets and be repaid from the proceeds. Hypothetically, if all the shares of a company are pledged as security, the lender may sell the company entirely through this arrangement to another lender and get repaid.
Types of Subordination Debt
The importance of subordination increases when the debtor owes more than one creditor and the total value of assets remains insufficient to pay all the liabilities at the time of default. Broadly, there are three types of subordinations:
- Collateral subordination
- Structural subordination
- Contractual subordination
Let us understand the first two types with the help of an example. A conglomerate “ABC Ltd” has 4 operating subsidiaries, OS1, OS2, OS3, and OS4. The amount of debt and assets at the parent and its subsidiaries is shown below:
#1 – Collateral Subordination Debt
In this example, the priority order of claims of various debt facilities on the assets of the standalone parent ABC in descending order would be: 1) $5 mm Secured Revolving credit, 2) $10 mm Unsecured Term loan, and 3) $10 mm Junior Unsecured Bonds. Hence, the $10 mm of Bonds is collaterally subordinated compared to the RC and TL, whereas the TL is collaterally subordinated to the RC. This is based on the priority of these debt structures over the assets of the standalone parent assuming a liquidation scenario. Likewise, at OS3 the $5 mm Unsecured Bonds are collaterally subordinated to the $5 mm Secured TL. Thus, in a credit tranche, ranging from senior secured to junior subordinated, the subordinated tranche could act as protective layers for the senior tranche which usually remains unaffected.
Elimination of collateral subordination risk
The most common way to avoid collateral subordination risk is over-collateralization, which means the amount of debt issued is limited to a smaller portion of the fair value of the underlying assets. In this case, a decline in the value of the assets could still leave enough cushion for the secured debt to get repaid.
#2 – Structural Subordination Debt
We note that the operating subsidiaries OS1-OS4 are typically expected to service their own debt from their operating cash flows, and then upstream only the remaining portion (likely in the form of dividends) to its parent entity. This is intuitive as the equity shareholders (i.e the parent) are most subordinated of all the liabilities. Hence, considering the consolidated entity, in a typical scenario, the liability at the parent is structurally subordinated to the debt at OS1-OS4. We note that out of the total consolidated debt of $60 mm, $35 mm (or 58% of the total consolidated debt) is structurally senior to the debt at a standalone entity. This can impact the LGD (or the loss given default) of the debt at the parent level, considering that the assets at the parent were insufficient to service its own debt.
The extreme scenarios where the operating subsidiaries are financially independent of the parent are termed as ring-fencing. This can be ensured through covenants at ring-fenced assets, and limit on dividend and inter-company cash transfers from the operating subsidiaries to the parent. This arrangement is typically done for regulatory reasons and taxation purposes. One example of a ring-fenced entity is a public utility business that is required to be separated from a parent company in a non-regulated business. This is done mainly to protect the customers of the basic services from financial instability in the parent business. As a matter of fact, the 2008 financial crisis highlighted the fact that the banks should ring-fence their retail operations so as to protect the retail deposits from the meltdown of the corporations.
Conversely, the debt at the operating subsidiaries could be non-recourse in nature, which means that the lender to the operating subsidiary OS2 cannot claim the parent’s assets in a default scenario, in case OS2’s assets are insufficient to fund its liabilities. However, in the majority of cases, if a business (represented by the operating subsidiary) goes through a difficult time (leading to suppressed cash flows for a long time) due to its cyclical nature, the parent may come to rescue its operating subsidiary. This is more the case when the subsidiary is of strategic importance for the parent, shares the name of the parent, and when the parent’s reputation is at stake which could impact the stakeholders’ confidence. For instance, an L’Oreal India entity shares the name with the L’Oreal brand – the French parent and is also a strategically important subsidiary for L’Oreal considering its presence in a high growth emerging country India. These scenarios are usually documented in the credit agreement in the form of parent support – verbal or written. In a parent support clause, verbal support shows the parent’s intention to support the capital needs of its subsidiary in an implicit way, without having a legal obligation. In this case, a parent may also help its subsidiary in the form of equity injection. Written support is a stronger form of support, which could set a legal obligation on the parent to rescue its subsidiaries, leading to improved confidence of the lenders to lend to the operating subsidiary.
Elimination of structural subordination risk
We note that the debt at an operating subsidiary can become pari-passu (i.e at equal priority) with the debt at the parent when the operating subsidiary provides an upstream guarantee to the parent. An upstream guarantee is one of the ways to tackle structural subordination and fetch better financing terms for the Company. For instance, if the $15 mm Unsecured TL at OS2 is bundled in the same financing package with the $10 mm Unsecured TL to the parent along with upstream guarantees from the subsidiaries OS2 and OS4, the total debt at parent, OS2, and OS4 would be $40 mm against the total assets of $50 mm, which would place parent at a more favorable position by the creditors. Of course, the creditors would restrict future borrowings at the operating subsidiaries, so as to avoid weakening of the guarantees. Various international firms with international operations are inclined to undertake debt locally at its operating subsidiaries, and then have the foreign subsidiaries guarantee the debt of the parent. The upstream guarantee could also be given in different financing packages at various levels such as below:
An alternate way to remove structural subordination risk involves the use of inter-company loans, under which the debt and assets at a consolidated level would still add upto the same. In this case, ABC (i.e. the parent) would act both as a creditor as well as a shareholder to its subsidiaries. This arrangement could look like below:
#3 – Contractual Subordination Debt
This type of subordination arises when there is an explicit contractual agreement between a group of creditors, where a certain group of creditors (who are subordinated) wilfully provide protection to another group (senior) in the event of bankruptcy. In this case, the senior creditors are entitled to receive the bankruptcy distributions before the subordinated group. The subordinated group, which could be the existing creditors or corporate insiders (such as management) may be motivated to do so to gain higher risk-return (in case of IPO/FPO), as well as attract financing during a corporate restructuring. In a more regular scenario, the liabilities (related to working capital), as well as payments to employees, could have priority in the payment waterfall.
Non-investment grade borrowers
As mentioned above, one of the ways to eliminate structural collateral subordination risk is to aggregate most of the loans at the parent and allow inter-company loans to the subsidiaries. In case of a non-investment grade however, a creditor may take a slightly different approach. The banks may require the borrowings to take place closer to the assets (i.e borrow at operating subsidiaries level) and then demand higher security (with a larger portion of assets), stringent covenants, and guarantee from the borrower.
It is important to note that the external credit rating of a company is independent of the type of subordination of its facilities, although it does get affected by the support of a parent. For instance, let us assume that the L’Oreal India entity is rated at a non-investment grade rating on a standalone basis, due to its smaller scale and reach of its products as well as high competition. However, owing to the parent support from the French parent L’Oreal, which is at a strong net cash position, the L’Oreal India entity would be rated at an investment-grade level, based on the level of parent support. Stronger the support, closer would be the external rating of the Indian entity to the parent.
While external ratings of a company are independent of the subordination story, the individual facilities very well depend on the structural and collateral subordination, as well as the guarantees on those facilities. This is derived based on two factors: 1) Credit rating of the
This is derived based on two factors:
1) A credit rating of the company, and
2) LGD of the facilities.
The LGD of the facility would, in turn, be based on the level of the recovery rate of the individual facilities, which are dependent on the subordination criteria. The below figure shows the facility ratings for a German healthcare player Fresenius SE & Co. KGaA “FSE” and its diabetes products division (its major subsidiary) Fresenius Medical Care ”FMC”. We note that the Senior Secured Bank Credit facility (with exposure at both FSE and FMC) are both pari-passu in nature between FSE and FMC, and rated at Baa3. The unsecured facilities at FSE are rated the same as the secured facilities owing to guarantees from its subsidiaries, whereas the unsecured facilities at FMC are rated lower owing to the lower entity rating.