The role of subordinated debt in financing.

In spite of its recent growth, subordinated or mezzanine debt is an often used and frequently misunderstood term in corporate finance. To some degree, this is because subordinated debt can be tailored to meet precisely a company's financial requirements and it comes in all shapes, sizes, and forms.

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.