Subordinated Debt

Intercreditor Terms That Matter

• Payment blockage. How long the senior lender can stop payments to junior holders after a default.

• Standstill period. How long the junior lender must wait before taking enforcement action.

• Amendment limits. Caps on how much the senior lender can increase its loan or change terms without junior consent.

• Purchase option. The junior lender's right to buy out the senior loan at par in a default, giving it more control over the outcome.

These terms decide how much room the company has in a downturn. This is a general overview, not legal advice. Have experienced counsel review any subordination or intercreditor agreement.

When It Makes Sense

A junior layer works best when a company has steady cash flow, a clear use for the money and a senior lender that has reached its comfortable limit. It can be cheaper than selling equity, since owners keep control and most of the upside. For example, if a senior lender will fund $15 million toward a hypothetical $20 million purchase and the buyer brings $3 million of equity, $2 million of subordinated debt could close the remaining gap.

It is a poor fit when cash flow is thin or volatile. Adding junior debt raises total leverage, and if earnings fall, both lenders will be watching closely.

Frequently Asked Questions

Is junior debt the same as mezzanine financing?
Mezzanine financing is one type of junior capital. The broader category also includes second lien term loans, seller notes and subordinated shareholder loans.

Does a second lien loan always get paid after the first lien?
From collateral proceeds, yes. For regular interest payments, not necessarily. Many second lien facilities pay interest alongside the first lien until a default or enforcement event.

Will my senior lender allow subordinated borrowing?
Only on its terms. Most senior credit agreements limit additional debt, so any junior financing needs senior lender consent and an intercreditor agreement.

Explore Ways to Fill Your Funding Gap

When senior lending falls short of what a deal or growth plan needs, a junior layer can close the gap without giving up ownership. Weigh the cost against equity and other structures, then explore the subordinated debt and financing options that fit your company.

Subordinated debt is borrowing that ranks behind a company's senior loans, so it gets paid only after the senior lender's claims are satisfied. Because it carries more risk, it costs more than senior borrowing, but it can provide capital that a bank will not, without the ownership dilution of selling equity.

Companies use this layer to fill the gap between what a senior lender will advance and what a deal or growth plan actually requires. It shows up in acquisitions, shareholder buyouts, recapitalizations and expansion projects, usually alongside a senior facility rather than on its own.

How Subordination Works

Subordination is created by contract. The junior lender signs a subordination or intercreditor agreement with the senior lender that spells out who gets paid first, when the junior lender can receive payments, and what it may do if the borrower defaults.

These agreements carry weight in bankruptcy. Under Section 510(a) of the U.S. Bankruptcy Code, a subordination agreement is enforceable in a bankruptcy case to the same extent it is enforceable under applicable nonbankruptcy law.

Debt can also be subordinated by structure. A loan made to a parent company that owns operating subsidiaries ranks behind the subsidiaries' own creditors in practice, because it can be repaid only from what is left after those creditors are paid.

Payment Subordination vs. Lien Subordination

Not all subordinated debt is junior in the same way, and the difference matters.

• Payment subordination. The junior lender agrees not to be paid until the senior lender is paid, or to stop receiving payments when the senior loan is in default. Traditional mezzanine notes work this way and are often unsecured.

• Lien subordination. The junior lender holds a security interest in the same collateral, but its lien ranks second. A second lien loan is the main example. Outside of enforcement, second lien lenders often receive regular interest payments side by side with the first lien lender. The subordination matters mainly when collateral is sold or the company fails.

Common Forms of Junior Capital

• Mezzanine notes. Unsecured or lightly secured notes, often paired with warrants that give the lender a small equity stake.

• Second lien term loans. Secured loans ranking behind a first lien facility, common in larger private equity deals.

• Seller notes. Part of an acquisition price paid over time by the buyer, usually subordinated to the buyer's bank loan.

• SBIC loans. Small Business Investment Companies, which are licensed and regulated by the U.S. Small Business Administration, often provide long-term subordinated loans to smaller companies.

• Shareholder loans. Funds advanced by owners, which senior lenders almost always require to be subordinated.

What It Costs

Junior lenders price for their position. Expect a higher interest rate than senior debt, and often a mix of cash interest and paid-in-kind (PIK) interest, which is added to the loan balance instead of paid in cash.

Here is a hypothetical example. A company borrows $5 million on a subordinated note at 12% cash interest plus 2% PIK. It pays $600,000 a year in cash interest. The PIK portion adds $100,000 to the balance in the first year, so the company owes $5.1 million at the start of year two, and PIK interest then accrues on the larger balance.

Other common features include prepayment premiums in the early years, warrants or other equity participation, and fees at closing. Compare total expected return to the lender, not just the stated rate.