Written bySubordination is an agreement that ranks one debt behind another, so the subordinated lender is paid only after the senior lender has been repaid.
Also known as: subordinated debt, deed of subordination, subordination agreement
Key points
- A deed of subordination sets the order: the senior lender is repaid first, and the junior lender takes what is left.
- Because it carries more risk, subordinated debt such as mezzanine finance is priced above senior debt.
- Directors' loans are often subordinated so shareholder money stays in the business while the bank's facility is running.
- It changes who is paid first, not who holds security over the assets, unless the deed says so.
How subordination works
The order is agreed in writing, usually in a deed signed by the borrower, the senior lender and the junior lender. The deed says the junior debt is not repaid until the senior debt is cleared, or only within limits. Interest on the junior debt is often allowed while the business trades normally, with payments stopping if there is a default.
The order really bites on enforcement. In a liquidation the liquidator still distributes under the statutory order, and the deed binds the junior lender instead, typically requiring it to hold anything it receives on trust for the senior lender until the senior debt is cleared. Where both hold security over the same assets, the deed also sets out who can enforce and when.
Where subordination is used
Three situations cover most of it. A second financier fills the gap where the senior lender will only go so far, funding a purchase or an expansion for a higher return. A bank asks a director or a related company to rank their loan account behind the bank, so that money cannot be pulled out first. On a refinance an incoming financier wants the existing one to step back rather than be repaid, and in each case the covenants in the senior facility usually require the deed to be signed before any money moves.
What it means for each lender
The senior lender gets certainty. It knows it is repaid first, and that the junior lender cannot demand repayment, take security or enforce without its agreement.
The junior lender takes more credit risk and is paid for it, through a higher rate, fees or an equity stake. It also gives up control, because a standstill clause can stop it acting for a set period after a default. For the borrower, subordination can raise more total finance than one lender would provide alone, though the combined cost is higher and the documents take longer to negotiate.
Example
A manufacturer needs $2 million to buy a competitor. Its bank will lend $1.4 million against the assets and cashflow, and no more. A second financier puts in the remaining $600,000 on subordinated terms. All three sign a deed: the bank is repaid first, the second financier receives interest while the business meets its covenants, and it agrees not to enforce for a set period if something goes wrong. The second financier charges more for sitting behind, and the owner funds the purchase without selling equity.
Not to be confused with
- Mezzanine finance
- mezzanine finance is a common form of subordinated debt, while subordination is the ranking itself
- Security (collateral)
- security decides which assets a lender can claim, while subordination decides who is paid first
Frequently asked questions
How does subordination work?
The lenders and the borrower sign a deed setting the order of repayment. The senior lender is paid first, and the junior lender waits. The deed usually also limits when the junior lender can demand payment, take security or enforce against the borrower.
What is subordinated debt?
Debt that ranks behind other debt for repayment. If the borrower fails, subordinated lenders are paid only after senior lenders are satisfied, so they often recover little. In exchange they charge more, and sometimes take warrants or a share of equity as well.
Why would a lender agree to be subordinated?
Because it is paid for the position. A junior lender accepts a lower ranking in return for a higher rate, fees or equity. Directors and related parties usually agree for a different reason: the bank makes it a condition of providing or keeping the main facility.
What is a deed of subordination?
The document that records the arrangement. It names the senior and junior debts, says what the junior lender may receive and when, sets out any standstill period after a default, and explains how enforcement proceeds are shared. Borrowers usually sign it alongside the senior facility.
Is subordinated debt riskier?
Yes, for the lender. Being last in line means a higher chance of a partial recovery or none at all if the business fails. That risk is reflected in the pricing and in tighter conditions, which is why subordinated finance costs a business more than senior lending.
Related terms
Mezzanine finance
Mezzanine finance is a hybrid layer of capital that sits between senior debt and equity, ranking behind the senior lender and often carrying equity-style upside for the financier.
Read definitionSecurity (collateral)
Security (collateral) is an asset or legal interest a borrower grants a lender, which the lender can take and sell to recover the debt if the borrower defaults.
Read definitionLiquidation
Liquidation is the process of winding up a company: a liquidator takes control, sells its assets, pays creditors in a set order of priority and the company is deregistered.
Read definitionCovenants
Covenants are promises, obligations or restrictions written into a contract or recorded on land title that bind the parties, such as a borrower's promise to maintain minimum interest cover.
Read definitionCredit risk
Credit risk is the possibility that a borrower or counterparty will default on their contractual repayments, leaving the lender or investor with a loss.
Read definitionFacility letter
A facility letter is a lender's written confirmation of the terms on which it proposes to provide a loan or other finance facility to a borrower.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.