Subordinated debt

Debt is subordinated when its repayment depends on the prior repayment of other creditors, whether preferred or unsecured. In return for this additional risk, the subordinated creditor demands a higher interest rate than the other creditors. Contractual subordination results from a stipulation in the contract. For securities, article L. 228-97 of the French Commercial Code allows the issuer of debt securities to provide, at issuance, that these securities will be repaid only after the other creditors have been paid in full, and to organise an order of payment priority between classes. For loans, an intercreditor agreement sets the ranking of each tranche, the payments permitted to the junior debt while the senior debt remains outstanding and the period during which the junior creditor refrains from taking action against the borrower. Contractual subordination differs from structural subordination, which follows from the borrower’s position in the group structure. In corporate financing, mezzanine debt and shareholder loans are subordinated to senior or unitranche debt. For the borrower, subordinated debt increases the total amount raised without diluting the shareholders. Its cost exceeds that of senior debt and its payment terms depend on the intercreditor agreement.

A group finances a €200m acquisition with €120m of senior debt, €30m of subordinated mezzanine debt and €50m of equity. The intercreditor agreement blocks the payment of mezzanine interest in the event of a default on the senior debt. In a liquidation, the mezzanine holders are repaid after the €120m of senior debt has been repaid in full.

• The ranking of each tranche in the intercreditor agreement
• The payments permitted to the subordinated debt while the senior debt is outstanding
• The length of the standstill imposed on the subordinated creditor
• The interest rate gap between subordinated debt and senior debt