Do you know your subordination?
One of the topics we cover in our Leveraged Finance Covenant Training course is “subordination”, legalese for “one lender will be paid after another lender”.
There are several ways that subordination can be embedded in a capital structure and covenant package, and given how important it is to knowhow much debt can potentially be repaid ahead of you, this blog explains three different types of subordination and how to find them.
Contractual Subordination
Contractual subordination, as its name suggests, arises when one lender agrees by contract to be paid after another lender.
This can happen in a couple of ways in the typical capital structure: through the presence of a super senior RCF, or where senior notes are issued alongside senior secured notes.
In the case of the super senior RCF, the relevant contractual provisions are embedded in the intercreditor agreement, and the covenants for a typical high yield bond or leveraged loan grant permission for this subordination to take place through the “Permitted Collateral Lien” definition.
Though they’re called “senior notes”, subordination arises by virtue of the guarantees being contractually subordinated to the senior secured notes and any senior facilities debt. Most deals marketed with the label “senior notes” are supported by subordinated guarantees – check the Notes Guarantees section of the prospectus to find this out.
Effective Subordination
Effective subordination is caused when one lender has security over assets that another lender does not have security over, and is governed by the Permitted Liens definition.
Permitted Liens themselves will allow specified categories of debt to be secured, and in this case, you’re looking for cross-references to the Debt covenant’s Permitted Debt Baskets, in addition to the General Permitted Liens basket (hint: it’s the one with a number – usually a fixed amount and EBITDA grower).
Structural Subordination
Structural subordination arises when one lender has a debt claim at a subsidiary that another lender does not have a debt claim at.
This can arise either because debt is borrowed directly at that subsidiary or because that subsidiary provides a guarantee of another subsidiary’s debt.
Remember that equity always ranks junior to debt, so unless you have a guarantee from a subsidiary of the issuer, that subsidiary could borrow from another lender, causing structural subordination to the extent of the amount of debt at that subsidiary.
To find out the potential risk of structural subordination in your deal, check for the amount of debt can that be incurred by non-guarantors. In a structure with low guarantor coverage, the risk of structural subordination is higher.
If you’re still scratching your head about this concept, or have any follow up questions, send us an email.