Subordinated or mezzanine debt is a useful tool in corporate finance because it can be negotiated and structured to precisely meet the financial requirements of a company. The subordinated debt market is very sophisticated, and the loan structuring possibilities are limited only by the creativity of the negotiators.

The capital offered by subordinated lenders is useful for a company that has sufficient cash flow to service more debt but has already borrowed beyond the comfort level of the bank. Subordinated debt is an unsecured loan that is junior to an unsecured or secured loan provided by a senior lender. Subordinated lenders can bridge the gap a senior lender is unwilling to fill because the subordinated lender does not view a company's collateral as a possible exit option. This debt is solely dependent on a company's ability to generate current and future cash flow.

In most instances, privately held companies find that the payback on the loan starts in the third to fifth year, with final payment due in the seventh to ninth year. Since the loan is unsecured and has protracted payments to meet the needs of the company; subordinated lenders receive interest on the loan as well as additional yield enhancements in return for their increased risk. Such yield enhancements can include stock warrants that allow the debt investor to acquire common stock of the company and to have a stake in its upside.

When the lender exercises the warrants, the company must buy back the stock or stock warrants and cash the subordinated lender out of the deal. The borrower will often want the lender to exercise its warrant after five to ten years, delaying the obligation to buy back the stock. The price of the warrant can take various forms, such as a pre-set multiple of operating income or a price that might be paid for a public company in a similar business. The size of a lender's warrant position is usually inversely related to the interest rate. The higher the interest, the fewer the warrants required by a subordinated lender.

As valuable as subordinated debt can be to a company, it also has disadvantages. The company must give up some equity ownership to an outside group. In order to protect their investment, the lender gets a vote on the board and has the ability to take action in the event that the company does not perform well financially.

In spite of the obstacles, subordinated debt is an alternative worth exploring. From the senior lender's perspective, subordinated debt looks like equity. It is unsecured and subordinated to their loan; it is viewed as long-term capital. As a result, a senior lender may consider the company to have strengthened its capital position by raising additional capital that is junior to their loan. In maximizing a company's long-term value, a subordinated loan may be favored over a more costly equity investment.

October 2000

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