Senior debt is a loan that a company must repay first if it gets into financial trouble. It is the most common form of lending and carries a low-interest rate, usually from a bank. Such debt is more secure than any other type of debt as it usually is collateralized by assets. It means that such lenders have a first lien claim on the company’s assets.
There are several types of financing options, and each has a different priority level when it comes to repayment. If a company is going out of business, then it has to repay senior debt first. Next on the priority list are the junior debt holder, preferred stockholders, and then common stockholders.
Also, not all senior debt holders may enjoy equal priority. If there is more than one senior debt holder, then the first lien debt holders are paid back first. A lien gives the creditor a legal right to confiscate the property of the defaulting borrower. Common types of senior debt are Revolving Credit Facility or Senior Term Debt.
Features of Senior Debt
- Usually based on the collateral and/or the cash flows.
- Such debt is usually amortized, or come with an option for a bullet repayment.
- These carry low-interest rate and are usually granted in tranches.
Importance to Companies
A senior debt can help the borrower save a lot of money as they carry a low-interest rate. For instance, assume Company A needs $1 million to start a business, which after five years will be at its peak. So, in such a case, whether you secure funding from a bank or any junior lender, the expected result would be the same.
So, if you borrow the money from a bank at 5%, you will have to pay $250,000 (assuming you pay just the interest. But, if you borrow at 12% from a junior lender, then the total amount that you will have to pay is around $600,000. In this case, the saving is $350,000 if you go for a senior loan. Now, you can assume how much will be the difference if you borrow a much bigger amount, say 10 times the current amount.
Advantages of Senior Debt
Senior debt offers the following benefits to the lender and borrowers:
- It carries a lesser risk for the bank as it is secure and is paid off first in the case of bankruptcy.
- Senior lenders also enjoy an advantage in negotiations, like with junior lenders. Senior lenders can dictate terms of the agreement, like how much should the borrower repay to the junior lenders, and more.
- Since they carry a low-interest rate, it makes them attractive to the borrowers. Moreover, borrowers can benefit from the floating rate coupons during the rising interest rate scenario. This helps to address the inflation risk.
- Owing to less volatility in the senior loans interest rate, borrowers use them in the company’s capital structure. This helps them to make the capital structure look more efficient.
- Helps a company to optimize and protect shareholder returns.
- It also helps in optimizing the capital cost of debt to a company. Since companies collateralize their assets to get the loan; it helps them lock better interest rate for the loan.
Disadvantages of Senior Debt
- If a company defaults on the payment, then it may lose the asset used as collateral for the loan.
- Since its a liability, it raises the expenses and financial burden for the company.
- Sometimes, senior lenders may put too many restrictions on the company’s capital expenditure, dividends, and acquisitions.
- Companies taking senior debt must also maintain certain defined financial ratios.
How it’s Different from Mezzanine Debt?
In Mezzanine debt, lenders use different criteria for approving the loans. For senior debt lenders, being paid back is the most important thing. The providers of the mezzanine debt care for the profitability and future of the company.
Along with the EBITDA (earnings before interest, tax, depreciation, and amortization), mezzanine debt lenders also consider the quality of the business’s leaders. However, the interest rate under Mezzanine debt is comparatively higher, and lenders also get warrants as part of the deal.
How it’s Different from Subordinated Debt?
Difference between the senior and subordinated debt is mainly of the priority in which a firm pays the debt claims. If a company files for bankruptcy and has both types of debt on its balance sheet, it first pays the senior debt. After paying the senior debt, it can repay the subordinated debt.
Therefore, the subordinated debt holders are at risk, like if a company does not have enough money after paying the senior debt. For instance, suppose Company A has a loan of $100 million from Bank A and $50 million from Bank B. If Company A files for bankruptcy and has assets worth $120 million, then $100 million of assets are used to pay the senior loan, and only $20 million will be left for the subordinated debt.
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