Junior debt is an increasingly popular means for small to medium-sized enterprises (SMEs) interested in growth initiatives. Also referred to as subordinated debt, junior debt allows business owners to focus on the future of their companies.
Despite setbacks related to the pandemic, the current market offers businesses unique ways to expand their products, services, and staff. For instance, the necessity of social distancing created a boost for e-commerce sales throughout various industries. On a similar note, the rise and extension of remote work has improved the efficiency of the labor force, in part by eliminating commutes and providing new digital ways to connect with colleagues and clients.
While there are reasons to remain cautious in the current environment — such as rising inflation, future COVID-19 variants, and geopolitical events — businesses can also take this time to reinvent and achieve new growth. Often, such economic and social disruption inadvertently lead to innovation and opportunity.
Growth in business is not only good, but necessary. Standing still as the world changes can mean getting left behind. The past few years have made clear that modern consumers appreciate individualized shopping experiences, whether online or in-person. Furthermore, more young professionals are seeking transparent workplaces with strong corporate cultures and values. Across the board, people are interested in an economy that is flexible, sustainable, and robust.
For SMEs, being attuned to these shifting attitudes means making necessary changes as the years go by. Businesses pursuing growth will require financing, which is where junior debt can come into play. In the past five years alone, nearly $35 billion in junior debt has been issued, with a particular uptick seen in 2020.
As many small and new business owners know, banks tend to gravitate toward larger corporations when issuing loans. Fortunately, alternative lenders, such as business development companies (BDCs) like Saratoga Investment Corp., are willing to support smaller scale companies. Alternative lenders also offer flexibility, speed, and transparency to companies. Keep reading to learn more about junior debt and business financing options.
What Is Junior Debt?
When a company takes out a loan, it does so via unsubordinated or subordinated debt. Junior bonds are considered a form of the latter, meaning that in the event of a default, they are repaid after all forms of senior debt.
These circumstances mean lenders are taking on more risk by offering junior debt, and thus the interest rates are typically higher for such financing. Unlike most senior bonds, junior debt is usually an unsecured debt not backed by collateral.
Junior debt first became a popular method for financing in 1999. That year, the Federal Reserve released a study that recommended institutions offer subordinated debt as a way for lenders to self-discipline their risk levels. Titled “Using Subordinated Debt as an Instrument of Market Discipline,” the report encourages lenders to develop a well-rounded understanding of the risks associated with solvency, debt obligations, and other considerations when choosing which businesses to support. The result of this due diligence can benefit borrowers and issuers alike.
Example Of How This Financing Is Structured
Junior debt can be structured in a variety of ways. However, 95 percent of junior bonds involve a 10-year maturity, with a fixed rate for the first five years. Below are a few ways this type of loan can manifest.
Bank loan: Since interest payments on junior debt are tax-deductible, a bank may issue such a loan despite the associated risks. However, a majority of these loans go to larger, well-established organizations.
Mezzanine debt: Also known as hybrid debt, mezzanine financing can serve as a bridge or intermediary level between other loans. It is considered a form of subordinated debt.
Asset-backed security: If a loan request can be backed by a mortgage or similar asset, a lender may issue junior debt in “tranches” or portions. The senior tranches must be paid back first in this case.
Common stock preference: Another form of junior debt is the common stock preference. A lender may take out shares in a company, which must be repaid prior to repaying other shareholders.
There are a variety of financing plans out there, and it’s easy to get overwhelmed. A supportive lender will take the time to walk a borrower through all their options when considering junior debt financing.
Benefits & Uses For Borrowers
Junior debt can open a doorway to ambitious growth opportunities. Small and growing businesses seeking to take steps like acquiring new technology, reaching new clientele, or expanding their staff can take advantage of junior bonds to do so.
As many small business owners know, accessing certain forms of financing is difficult when getting started. Without a track record of success or leverageable assets, few loans are available. Frequently, traditional banks and institutions shy away from newer companies. But alternative lenders are willing to take a chance on newcomers and help them bring their visions to life.
When considering the benefits of working with a specific lender, it helps to ask yourself the following questions.
- Is the application process simple and streamlined?
- Are the interest rates fair for the loan I’m considering?
- Does the lender have a proven record of supporting businesses like mine?
- How transparent and communicative has the lender been throughout the process?
With these in mind, finding the right, hands-on lender is possible. At the end of the day, there’s no need to settle for a loan that fails to meet your specific needs.
Conclusion
Growing a small business requires patience, dedication, and grit. Achieving sustainable growth means constantly evolving to survive economic realities, aggressive competition, and unexpected issues. To reach its full potential, every company requires financing at some point, and more often than not, junior debt holds the key to building a lasting organization.
Business development companies like Saratoga Investment Corp. are here to help small and medium-sized businesses secure reliable funding to reach their goals. Whether growth looks like hiring more staff, strengthening your e-commerce department, creating new products, or acquiring larger office space, financing can help keep your business focused on the future.
Those interested in pursuing their junior debt options should consult Saratoga’s investment profile to see if your company might be a good fit for our services.