Subordinate financing is an investment made in the form of debt. In other words, it’s debt financing with equity characteristics.
This type of financing has the following attributes:
• It consists of a committed, long-term facility.
• The borrower has the obligation to repay the loan according to a predetermined schedule, like regular debt financing. However, the repayment is flexible, structured to match future cash flows.
• The loan is subordinated to senior debt, which consists of the borrower’s term loans and/or working capital facilities. This means that security and debt service rank behind the senior lender.
• The size of the loan that is acceptable to the financier is primarily determined by the borrower’s historical cash flows, not by the borrower’s capitalization. In other words, it is not leverage but a form of company valuation that establishes the loan size. This approach resembles equity financing.
• The return comes from scheduled interest payments (a debt characteristic) and some sort of kicker (a variable component), such as warrants to purchase shares in the borrower at a discount, royalties on revenues or EBITDA, or bonus payments on the borrower’s equity value or EBITDA. Through these kickers, the financier has the opportunity to participate in the borrower’s upside (an equity characteristic).
Subordinate financing is typically used in the context of ownership changes (management buyouts), acquisitions (leveraged buyouts) and where growth or expansion capital is required. Subordinate financing comes into play where conventional debt financing is unavailable or limited, or as an alternative to equity.
Subordinate financing has the following benefits:
• It offers a range of customized financing structures designed to provide sufficient residual cash flow for growth during the term of the investment.
• It allows for an investment in intangible assets, making debt financing possible where there are no hard assets available to serve as security.
• It is treated as equity by senior lenders (subject to its deep subordination), which also improves financial ratios and creates leverage with senior lenders.
In addition, subordinate financing has the following advantages over equity financing:
• It limits shareholder dilution.
• It takes less control.
• It is less expensive.
• It is a more tax-effective instrument, as interest is tax-deductible.
• It offers more flexibility in light of a customized repayment schedule.
• It requires no shareholder agreement.
For more detailed information on this topic, see the book I wrote: The Decision-Maker’s Guide to Long-Term Financing – available at www.guidetolongtermfinancing.com.