The role of subordinated debt in financing.
What is Subordinated Debt?
The popularity in the public market of high yield, or junk, bonds in the 1980s made finance professionals realize that even small, privately held companies could benefit from this type of financing. Today, the subordinated debt market is very sophisticated and its structure is limited only by the creativity of the people involved in structuring the mezzanine loan.
The capital offered by mezzanine lenders is particularly useful if a company's bank borrowings have exceeded the bank's comfort level, but the company has sufficient cash flow to service more debt. Subordinated lenders can bridge the gap a senior lender (such as a bank, commercial finance company, or insurance company) is unwilling to fill because subordinated lenders do not view a company's collateral as a possible exit option available to them. Instead, mezzanine debt is solely dependent on a company's ability to generate cash flow.
Typically, subordinated debt is an unsecured loan that is junior to either an unsecured or secured loan provided by a senior lender. In virtually all instances, privately held companies will find that the payback on the loan usually starts in the third to fifth year, with final payment due in the seventh to ninth year. Whereas senior lenders may be collateralized, mezzanine lenders are not. In return for their increased risk, subordinated lenders receive interest on the loan as well as additional yield enhancements, such as stock warrants that allow the debt investor to acquire common stock of the company and have a stake in its upside potential. When it exercises the warrants, the company must buy back the stock or stock warrants and cash the subordinated lender out of the deal.
Using Subordinated Debt as Part of a Company's Capital Structure
It will become readily apparent to a company that subordinated debt may be an appropriate financing strategy when their senior lender advises them that they are unwilling to advance funds sufficient for its overall needs. For example, suppose a company needs $3 million to acquire another company, expand its plant, generate working capital, pay a dividend, or acquire outstanding shares of common stock. Also assume that its senior lender is willing to advance only a portion of the funds needed. At this point, business owners or chief financial officers should determine if raising subordinated debt is a viable alternative.
In contrast to two years ago, today senior lenders have become much more aggressive. Nevertheless, even if a company is performing well financially, senior lenders are unwilling to advance funds substantially in excess of the company's collateral position. On the other hand, because the primary concern of a subordinated lender is a company's ability to generate cash, if it is anticipated that the business' cash flow is sufficient to repay the loan, it is quite likely subordinated debt can be used.
Advantages of Subordinated Debt in a Company's Capital Structure
Subordinated debt is an extremely flexible form of financing. Because they are more concerned than senior lenders about their overall yield, mezzanine lenders are very liberal in tailoring their investment to meet the financial, operating, and long-term cash flow needs of the borrower. As long as the subordinated lender's anticipated yield is satisfied, they can be flexible as to the amortization of the loan and the interest rate.
From the senior lender's perspective, subordinated debt looks like equity. It is unsecured and subordinated to their loan and, thus, is viewed as long-term capital. As a result, a senior lender may consider the company to have strengthened its capital position as additional capital has been raised that is junior to their loan.
Whereas many true equity investors are only desirous of a controlling ownership interest, another advantage of subordinated debt is that such investors do not seek this type of control. Mezzanine lenders, however, will want a seat on the company's board of directors.
While closely held companies are extremely reluctant to open themselves up to outsiders, subordinated debt advisors often bring fresh insights to businesses because they are financially sophisticated and have a great deal of experience developing strategies to maximize long-term value.
Disadvantages of Subordinated Debt in a Company's Capital Structure
As valuable as subordinated debt can be to a company, it is not without its disadvantages. First, the company must give up some equity ownership to an outside group. Although it is unlikely the subordinated lenders will have control of the board, the lender will have a vote and the ability to take more severe actions if the company does not meet its projections and does not perform well financially.
In addition, owners of closely held businesses may not be able to pay above market salaries to officers, and other perks may need to be limited. They may have to reduce their own compensation to the level of a non-owner/manager and lower dividend payouts as well. However, the wealth of the existing shareholders should increase even though there is a decrease in their ownership interests. For example, if a company's value is $10 million, adding $3 million of subordinated debt would raise the worth of the business to $13 million. If the shareholders' ownership interests decrease from 100 percent of $10 million to 90 percent of $13 million, the shareholder has seen the value of his holdings increase by $1.7 million ($11.7 million vs. $10 million).
Another disadvantage of subordinated debt is that it is significantly more expensive than senior debt. Today, the current interest coupon on mezzanine debt approximates the 10-year treasury rate plus 5 percent, or roughly 13 to 14 percent. Adding the required yield enhancement, usually warrants, creates an increase in the returns to between 20 percent to 30 percent.
Difference Between Private and Public Subordinated Debt
Adding to the confusion of the subordinated debt market for privately held companies are the dramatic differences between the private and public subordinated debt markets. With public mezzanine debt, also known as high yield or junk bonds, an investor receives an interest rate return and usually does not obtain yield enhancements or warrants. Public subordinated debt transactions must be registered with the Securities and Exchange Commission and, as such, the issue cost is greater than that obtained in the private market. Moreover, whereas private subordinated debt carries potentially significant restriction, remedies, and covenants, public mezzanine debt has very few. Lastly, although it is usually difficult to take public any subordinated debt transaction that would be smaller than $15 million to $20 million, private mezzanine debt funds will consider borrowings for as little as $500,000.
Key Negotiating Points
The very nature of subordinated debt and the introduction of another creditor into a relationship creates a more complex capital structure and complicates the negotiations between a senior lender, borrower, and subordinated lender. While subordinated lenders are much more yield-driven than senior lenders, when it comes to documentation they are very concerned with protecting their investment. Complicating the situation is the fact that it is more difficult for subordinated lenders to exit a privately held company and exercise warrants in order to generate targeted yields. Therefore, during the course of negotiations, some trouble spots tend to arise.
The Size of the Warrant Position and Exercise Price
Usually, the size of a lender's position is inversely related to the interest rate: The higher the interest, the fewer the warrants required by a subordinated lender. Mezzanine lenders typically have warrants equal to 5 percent to 20 percent of the company and the price of the warrant will be a pre-set multiple of operating income or a price that might be paid for a public company in a similar business. The borrower will want the lender to exercise its warrant within five to 10 years, delaying the obligation to buy back the stock. Of course, the lender will want the option of exercising them as soon as possible. One option may be for the borrower to agree to an earlier exercise date, and spread the payments over three years if there is insufficient cash to buy back all the stock at once. Lastly, the lender will want the ability to register the warrants and sell the underlying shares should the company go public.
Covenants and Inter-Creditor Issues
The subordinated lender will attach a variety of covenants to the loan, delineating the conditions and financial ratios that must be met to prevent default. With some of these, such as the cash-flow level and debt-to-equity ratio, the borrower can become actively involved in negotiating with the lenders to protect his company's interests. However, the senior and junior lenders also will negotiate separately to spell out certain points, such as their relative collateral positions, and to define their remedies in the event of default.
In spite of the obstacles, subordinated debt is an alternative worth exploring. If a company's debt-servicing capacity exceeds a bank's comfort level, securing a mezzanine loan may be favored over a more costly equity investment.
Lawrence M. Levine is a managing director in the Corporate Finance Services Department of Altschuler, Melvoin and Glasser LLP, a national accounting and consulting firm., Northbrook, Ill.
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|Author:||Levine, Lawrence M.|
|Date:||May 1, 1995|
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