Subordinated indebtedness: Overview, definition, and example
What is subordinated indebtedness?
Subordinated indebtedness refers to debt that ranks below other debts in terms of repayment priority if a borrower defaults or declares bankruptcy. This means that subordinated creditors are paid only after senior debts have been fully repaid. Subordinated debt is often used in corporate financing, mergers, and leveraged buyouts to raise capital while prioritizing repayment of more critical obligations.
For example, a company may issue subordinated bonds to investors, which will only be repaid after senior bondholders and bank loans have been satisfied in the event of liquidation.
Why is subordinated indebtedness important?
Subordinated indebtedness is crucial in financial structuring because it allows businesses to access additional capital while protecting senior creditors. Investors in subordinated debt typically accept higher risk in exchange for higher interest rates since they stand behind senior lenders in the repayment hierarchy.
For businesses, subordinated debt can provide flexible financing options without affecting senior lenders' security, making it a valuable tool in structured financing. However, borrowers must clearly define repayment terms and risk levels to attract investors while maintaining financial stability.
Understanding subordinated indebtedness through an example
Imagine a manufacturing company secures a $10 million senior loan from a bank to fund operations. To raise additional funds, the company also issues $3 million in subordinated notes to private investors.
If the company declares bankruptcy, the bank loan (senior debt) must be fully repaid before any payments are made to subordinated noteholders. If there are insufficient remaining funds, subordinated creditors may recover only part of their investment—or nothing at all.
In another scenario, a private equity firm acquires a company using a mix of bank loans (senior debt) and subordinated debt. The senior lenders have first priority over cash flows and assets, while subordinated lenders take on greater risk but receive higher interest payments as compensation.
An example of a subordinated indebtedness clause
Here’s how a subordinated indebtedness clause might appear in a loan agreement:
“The Borrower agrees that any Subordinated Indebtedness shall be subordinate in right of payment to all Senior Debt. In the event of default or liquidation, no payments shall be made on Subordinated Indebtedness until all outstanding obligations under the Senior Debt have been satisfied in full.”
Conclusion
Subordinated indebtedness is a lower-priority debt that is repaid only after senior debts are settled. It plays a key role in corporate finance, leveraged buyouts, and investment strategies, allowing companies to access capital while protecting senior lenders.
By clearly defining subordination terms in financing agreements, businesses can structure debt effectively, attract investors, and balance financial risk.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.