Subordinated debt has a variety of implications for growing businesses. Also known as junior debt, it can be used to fund expansions, acquisitions, and other projects like customer outreach and employee recruitment.
Every business owner knows growth is essential to success. In a rapidly changing market, standing still often means falling behind — a lesson best exemplified by once-profitable companies that failed to adapt to advances in technology, shifts in consumer demands, or increased competition in their field.
Of course, all growth in the business world requires financial support. Investors, shareholders, lenders, and others can help a business thrive by providing resources at pivotal moments in time. For small-to-medium sized enterprises, opportunities for growth are abundant if key capital is in supply. But SMEs are regularly turned away from traditional lending institutions like big banks. Since the 2008-09 financial crisis and the regulatory changes resulting from it, many banks have focused solely on large-scale, established companies when offering loans. In this environment, small businesses with less consistent cash flow struggle to prove themselves.
Alternative lenders, including business development companies (BDCs) like Saratoga Investment Corp., have evolved to meet the needs of these businesses. An alternative lender takes a more holistic view of a company’s situation and is willing to take risks on promising enterprises. One of the many instruments used by lenders to fuel an SME’s growth is subordinated debt.
In the “new normal” brought on by the COVID-19 pandemic, subordinated debt has become an increasingly common method for businesses looking to survive unforeseen hardships and continue to evolve.
What Is Subordinated Debt?
The subordinated debt definition is quite simple: an unsecured loan that ranks below senior loans or securities. It can take several forms, such as mezzanine debt, asset-backed securities, and bonds, which are described in detail further down this page.
When it comes time for a business to repay its loans, senior debt (including liens secured by collateral) is prioritized over subordinated or junior debt. In the event a company goes bankrupt, subordinated debt is fulfilled after senior debt but before common stockholders.
For lenders, the nature of subordinated debt makes it riskier than secured debt, and thus the interest rates on these loans is typically high. Subordinated debt gained popularity as a way for lenders to self-discipline concerning the risks they take. A 1999 Federal Reserve report recommended subordinated debt as a financing option that encourages banks and alternative lenders alike to thoroughly assess the companies to which they consider issuing loans.
Businesses That Often Take Subordinated Debt
New businesses, no matter how in-demand they are, lack the reputations of established companies. This makes it tricky to demonstrate long-term success or consistent cash flow when asking for a loan. So it makes sense that the majority of organizations that request subordinated debt are SMEs.
Two of the main businesses that seek financing from alternative lenders are software-as-a-service companies and tech companies. While the future of every economic sector relies on the innovation brought by these startups, investors take a risk by supporting them. Still, the rise of many young and profitable tech-based companies in the past thirty years demonstrates that the rewards are often worth the risk.
At Saratoga Investment Corp., our professionals regularly support SaaS businesses making waves and revolutionizing the way people live, work, and play. The same goes for tech businesses disrupting a myriad of industries. Most often, Saratoga works with companies in education, finance, healthcare, hospitality, specialty chemical, and media and communications.
Subordinated Debt Examples
As mentioned above, subordinated debt serves as an umbrella term for a series of financing methods with specific benefits and drawbacks. The following are a few examples of subordinated debentures.
Mezzanine debt — Considered a hybrid of debt and equity, mezzanine debt acts as an intermediary that bridges the gap between senior debt and equity. It is based on historic and projected cash flows, making it ideal for growing businesses. The appeal of Mezzanine debt fills the void left by senior lenders unable to provide all the capital needed by a business.
Asset-backed securities — Often issued in tranches or portions, an asset-backed security refers to financing secured by one or more of a company’s holdings. One common example is a mortgage-backed security, in which a business leverages its existing property to obtain a loan.
Bank-issued bonds — An SME is unlikely to secure a bank-issued bond for the reasons explained earlier, but it is considered a form of subordinated debt. A bank can issue bonds to companies it finds especially promising with the knowledge their repayment is low-priority compared to first liens.
Advantages of Subordinated Debentures
Subordinated debt can allow businesses to invest in growth on their own terms. Whether it be a new office space, initiatives to attract more customers, or funds to greenlight a new product, such financing opens the door to exciting opportunities. While high interest rates are associated with subordinated debt, it is still less costly than seeking equity investments from outside sources.
Furthermore, subordinated debt does not dilute existing stockholders’ capital nor confer voting rights on lenders. It has a minimum maturity of five years and a lender cannot accelerate the repayment period except under extremely specific circumstances. Its flexibility and simple terms are an added bonus.
Working with the right alternative lender means a business will have someone in its corner throughout the financing journey. When researching potential alternative lenders, owners should keep these questions in mind:
- Does my business meet the qualifications for subordinated financing?
- Is the lender’s application process clear? Is their approval rate high?
- What are the typical interest rates and terms for this kind of loan?
- Is it easy to get into contact with a real person at the lending company?
- How transparent is the repayment process?
Final Considerations
No two businesses take the exact same path to success, but every one needs to grow in order to thrive in today’s economy. As the pandemic reminded the world, major disruption can happen at any time. Businesses need to be able to adapt at a moment’s notice. One way to do that is by taking advantage of subordinated debt financing from reputable lenders.
As a business development company, Saratoga Investment Corp. embraces a partnership approach to working with small-to-medium sized enterprises ready to evolve. Our professionals use their decades of expertise to assist business owners and management teams as they execute their business plans.
Those interested in pursuing junior debt options can consult Saratoga’s in-depth investment profile to determine if their company might be a good fit for our services.