What is a Subordinated Loan?

A subordinated loan is an important tool for businesses trying to seek capital. As a loan, it presents higher risks but potentially higher returns, for subordinated lender. They are positioned such that they are repaid only after senior debt has been settled.

These kinds of loans are an essential aspect of corporate and structured finance. They allow companies to secure funding without diluting ownership stakes.

In this article, we will delve deeper into what subordinated loans are, their features, risks and benefits. 

How Do Subordinated Loans Work?

Subordinated loans are a form of debt that ranks below senior or first mortgage loans in that they are only paid back after senior debt loans are fully repaid.

For example, if there is a default, creditors with seniority are paid out first from available assets. Only after these senior creditors are paid out do holders of subordinated loans receive payment. This makes this kind of loan riskier. However, they do promise higher returns thanks to higher interest rates.

These kinds of loans are often used by developers to achieve a balanced capital structure to support growth without giving away equity on their projects. However, they do need careful consideration due to their lower repayment priority.

Key Features of Subordinated Loans

Here are three key components of subordinated loans.

Ranking and Priority in Repayment

Senior debt is money that must be repaid first if a company goes out of business. Often the owners of senior debt are banks or bondholders. Senior debt is often secured by collateral, making it less risky than subordinated debt.

Subordinate debt ranks below senior debt and is only repaid once holders of senior debt have been paid. It is an unsecured loan, hence riskier than senior debt.

Interest Rates and Risk Assessment

The high interest rates applied to subordinated loans reflect the increased risks lenders take on board due to the lower priority of repayment if a business defaults.

This higher return on such a loan is designed to offset the higher risk in the financial landscape.

Terms and Conditions Flexibility

Often there are flexible terms and conditions associated with subordinated loans due to their risky nature. These can include lenient repayment schedules and covenants. It is this flexibility that can be so attractive to borrowers seeking a tailored solution to their financial situations. 

The Importance of Subordinated Loans in Finance

While it may seem unusual to have high risk financing options, subordinated loans do have their place in the financial landscape of today.

Supporting Business Growth and Development

A DeveloperBusiness looking to expand and needing capital to spread across their projectsto generate finance can apply for a subordinated loan. This enables them to get into multiple projectsgenerate capital without the need for raising further equity from investors who would take shares in their profits.more shareholders wanting a piece of the business should they default.

The flexibility of the terms and conditions can also mean repayments can be delayed.

Enhancing Loan Structures and Attracting Investment

Subordinate loans offer a varied risk-return profile, so it enriches the loan structure a developer can undertake. It diversifies the financing options and solutions and offers appealing investment opportunities from different investor segments.

Balancing Risk and Return for Lenders

Being a subordinated loan means, that if the worst was to happen to a project, they would be paid out only once senior loans were fully paid out. You risk not getting any return on your investment.

This is why the interest rates are higher, so if you do get a return, it is higher than a regular kind of loan or investment opportunity.

Comparing Subordinated Loans and Senior Loans

Subordinated pans are different to senior loans in three key ways.

1. Risk Level
   Subordinate loans are a riskier financial option due to their lower priority on the repayment ladder.
2. Interest Rates
   Due to their high-risk nature, they come with a higher interest rate. This potentially higher ROI accounts for the higher risk level.
3. Repayment Priority
   Subordinate loans are below senior loans in the hierarchy of repayment. If a business goes bust, the senior loan holders must be repaid in full before any repayments are made to the holders of subordinated debt.

Potential Risks and Benefits

Subordinated lenders have the benefit of higher returns than on a senior loan, due to the high interest rates.

However, this high interest brings with it a risk that the lender will not be repaid if the business goes into default.

A lender must conduct thorough due diligence on the business they intend to lend to, to reduce potential risks.

Who Should Consider a Subordinated Loan?

Large business entities are generally the most common borrowers of subordinated loans. It allows them quick access to capital, and generally they have the heft to guarantee repayment.

Software as a Service (SaaS) and tech companies are often the biggest sectors that seek alternative financing, such as subordinated loans.

New businesses, with very little financial track record that can guarantee long-term repayments, also seek subordinated loans.

Contact Us Today!

All financial investments come with risk and reward. As long as you understand this principle and go into subordinated finance after doing thorough due diligence, and can handle the risk, then it can be an appealing investment option for you.

If you would like to understand more about subordinated debt, get in touch with us today.