The subordination of debt (finance) is a technique that consists of making the repayment of a debt to one or more others. The general principle is that when there is not enough money to repay all the debts, the subordinated debt will be paid after the other debts. These will be classified as ordinary or senior debts .
Balance Sheet Management Tool
Used as a balance sheet management tool , subordinated debt is somewhere between ordinary debt and capital . In case of problems, the subordinated creditor will be reimbursed after the ordinary creditors, but before the shareholders .
This management tool has been used particularly by banks , subject to minimum capital requirements to cover their credit risks .
In this case, one often distinguishes between ordinary subordination and deep subordination.
In the case of ordinary subordination, the subordinated debt is normally paid on its interest and principal maturities , the subordination only having effect at the moment when the creditor undertaking enters into liquidation or any other equivalent liquidation mode. in a foreign law.
In the case of deep subordination, the payment of subordinated debt may also be suspended or suspended if certain events occur in relation to the financial structure of the enterprise, such as the deterioration of its income statement .
Structured Financing Tool
As a structured financing tool, subordination is particularly useful in the context of project financing or securitization .
In both cases, the concept is based on the financing of assets (such as the construction of a power plant or the purchase of a loan portfolio) by debts that will be repaid by the future financial flows generated by these assets. assets.
If we consider these future financial flows, we can for example classify them as certain, probable, and uncertain flows.
The project will then be financed by:
- a “senior” debt that will be repaid by the certain flows and the amount of which will depend on the ability of these certain flows to repay it.
- an intermediate subordinated debt (so-called ” mezzanine debt “) which will be repaid by the probable flows and the amount of which will depend on the capacity of these probable flows to repay it.
- a subordinated debt to the two previous ones (so-called “Junior”) which will be reimbursed by the uncertain flows and the amount of which will depend on the capacity of these uncertain flows to repay it.
By this technique, the risk of loss for the senior lender has been minimized, since project losses will first impact subordinated and mezzanine level lenders.
Each debt will bear an interest rate that will depend on the risk of non-repayment. Senior debt with a relatively low interest rate due to risk minimization. This technique helps minimize funding costs.