If you work with leveraged finance contracts, understanding how capital structures work and how different types of subordination affect lending relationships is crucial. In this blog, I break down these concepts and explore how they shape agreements in leveraged finance.
The Hierarchy of Capital Structure
Capital structure isn't just about organizing debt and equity - it's about engineering financial relationships to reflect the intentions of all parties involved. At its core, capital structure is a delicate balance between risk and reward, where different lenders have varying appetites for risk.
Key Stakeholder Objectives:
- Equity holders seek return on investment and operational flexibility
- Borrowers aim to manage capital costs and optimize maturity profiles
- Subordinated lenders want to maintain priority and protection
- Senior lenders prioritize protection against value loss and enforcement processes
Types of Subordination
These priorities are reflected in the contract using different types of subordination, a legalese term for "you get paid before me." Below are four types of subordination and how they arise.
1. Contractual Subordination
This occurs through formal agreements specifying payment priorities, such as super senior RCF arrangements or subordinated guarantees.
2. Structural Subordination
Based on the fundamental principle that equity ranks behind debt in priority. This highlights the importance of obtaining guarantees from as many subsidiaries as possible.
3. Effective Subordination
This happens when certain lenders have security over specific assets that others don't - think of it as having "dibs" on particular collateral.
4. Temporal Subordination
Simply relates to the timing of repayment, where earlier maturing debt naturally gets paid before later-maturing obligations.
Practical Application
When analyzing a capital structure, it is essential to map out the following - this is your "Point A":
- The size of the initial equity investment
- The identity of the other lenders in the structure
- What comprises your collateral
- The level of your guarantor coverage
- Day-one subordination levels
The Role of Intercreditor Agreements
Particularly important in European markets, these agreements memorialize the priorities above in the event that the borrower falls into stress and cannot repay its obligations as they come due. They will:
- Govern payment priorities
- Establish enforcement processes
- Define security interest rankings
- Set rules for payment stops and standstills
Future-Proofing Your Position
Smart lenders think beyond day-one positions (Point A) and consider how their standing might change over time (Point B). This involves analyzing:
- Debt capacity
- Secured debt thresholds
- Non-guarantor debt limits
- Covenant calculation flexibility
Understanding these elements helps stakeholders navigate complex financial structures and protect their interests throughout the lifecycle of their investment.
This comprehensive approach to capital structure and subordination isn't just academic - it's essential for anyone involved in leveraged lending, from private equity sponsors to senior lenders and everyone in between. This is exactly what Fox Legal Training equips our clients to do.
Remember: The key to successful financial engineering ies in properly aligning all parties' intentions while maintaining appropriate protections for each level of the capital structure.