Every business owner understands the importance of growth. Whether expanding a customer base, creating a new product line, acquiring assets, or transitioning to a larger office space, growth allows businesses to flourish. A constantly evolving business can endure unstable markets and meet challenges as they arise.
For companies ready to evolve, digitally or otherwise, business loans, like senior subordinated debt (often called mezzanine debt), can boost growth and allow for creative solutions to existing issues. Business development companies like Saratoga Investment Corp. are capable of meeting the needs of small and mid-sized enterprises (SMEs) typically turned away from bigger banks. That’s because traditional lenders, often gravitate toward bigger companies with consistent cash flow and favorable debt-to-income ratios. Alternative lenders, such as BDCs, are an appealing choice for SMEs in need of flexibility, speed, transparency, and a simple application process.
What Is Senior Subordinated Debt?
Senior subordinated debt is essentially a hybrid of senior debt and equity financing based on an enterprise’s historic and projected cash flows. This differs from similar financing, which is backed by the current value of an enterprise’s assets, making it far more attainable for smaller companies and those without many material assets.
Borrowers often seek senior debt and equity first, but after securing these funds, many businesses find they are still missing a chunk of necessary financing. This occurs because banks and other institutions have leverage limitations, meaning they can only loan a certain amount of senior debt to any single company. Senior subordinated debt can bridge this gap.
However, it’s also important to note that experts consider mezzanine debt to be one of the most high-risk forms of debt. Compared to senior loans, it yields very high returns, generating rates between 12 and 20 percent per year.
Senior subordinated debt is frequently used in mergers, acquisitions, and leveraged buyouts. For instance, a company looking to acquire another for $50 million may receive a senior loan for only $40 million from its primary lender. Rather than put up $10 million of its own capital or bet on equity, the business owner can apply for a senior subordinated loan from an alternative lender to make up the difference.
How This Financing Works
The structure of subordinated debt is fairly unique. It contains a “coupon,” or current return component, which is the sum of the interest rate the borrower pays plus some deferred return. These coupons can range from 12-14 percent and sometimes includes a deferred interest component. The deferred interest rate hovers around 2-4 percent (this is called the Paid in Kind, or PIK, interest). The latter is not paid immediately, but becomes part of the principal and is fulfilled at a later time.
The relatively high return rates of subordinated loans mentioned above are still lower than those of equity financing, which can range from 25-50 percent. Mezzanine investors rely on high returns because their payments are made after a senior lender’s payments. Additionally, senior lenders have first rights to a company’s assets if bankruptcy occurs, whereas the subordinated lender rarely does. Subordinated debt has earned the nickname “patient capital” due to these conditions.
Benefits For Investors in Senior Subordinated Debt
Investors have much to gain from offering senior subordinated debt to clients. The high returns alone are valuable enough, but subordinated debt arrangements also enable an investor to reap further benefits when a company meets the financial goals it laid out when applying for the loan.
Subordinated debts are low risk for investors and their structure (the coupon component) reduces potential volatility. Mezzanine investors are paid before those that lend equity and can expect consistent repayments, which are made on a quarterly basis, unaffected by fluctuating market conditions. Furthermore, requested financing for subordinated debt is often lower than the requests made of primary or senior investors, meaning new investors have a greater chance of thriving.
Benefits For Borrowers of Senior Subordinated Debt
Senior subordinated debt can be favorable to all parties involved. Borrowers will appreciate that it is based on historic and projected cash flow, rather than collateral. It is also relatively inexpensive and flexible despite high interest rates.
Investors that offer senior subordinated debt are committed for the long haul, so there’s little risk in working with an alternative lender to secure this type of financing. When compared to equity, the long-term nature of subordinated debt gives borrowers time to execute ambitious expansion and growth plans while steadily repaying their loan. The potential for total loss on the investor’s part (in the event of bankruptcy) means they are truly committed to a borrower’s success. These investors are usually eager to provide guidance and support as their clients navigate the complexities of the modern economy.
Mezzanine financing of any kind is often the last piece of the puzzle needed for a borrower to succeed in their field.
Is Senior Subordinated Debt Right for Your Company?
As noted, senior subordinated debt can bridge the gap for businesses interested in growth, including changes like a pivot to digital sales, an impressive acquisition, or new hires. Its nature as an intermediary between equity and senior debt makes it one of the most flexible forms of alternative funding currently available.
For companies with proven records of profitability and clear goals, senior subordinated debt could pave the path between an innovative expansion plan and its fully realized completion. But that doesn’t mean it is the perfect option for every company. Take time to consider your specific requirements and obligations to determine if such a loan is right for your organization.
No matter which financing method works for you, the following are helpful questions to ask yourself about any lender:
- How communicative and transparent is the investor?
- Is the application process clear and simple?
- What is their approval rate?
- Are their proposed interest rates reasonable?
- What is their reputation and track record with previous clients?
If you’re ready to speak with a business development company (BDC) that can provide the sort of flexible, borrower-friendly loan agreements mentioned here, check out Saratoga’s investment profile to see if your company might be a good fit. At Saratoga, our team members have decades of experience helping SMEs meet their growth goals.