Meaning of senior debt
Senior debt is the first-tier debt or liabilities of the company. It is a secure debit and is secured by a lien against the collateral property. The company provides regular principal and interest payments to lenders based on a preset schedule. Senior debt is generally funded by banks.
The banks take the lower risk senior status in the repayment order because they can generally afford to accept a lower rate given their low-cost source of funding from deposit and savings accounts. If the company becomes insolvent, carrying too much debt may mean the business cannot pay all of its creditors. For this reason, senior debt holders typically want to keep other debt at a minimum. Secured senior debt is backed by an asset that was pledged as collateral.
For example, lenders may place liens against equipment, vehicles or homes when issuing loans. If the loan goes into default, the asset may be sold to cover the debt. On the other hand, unsecured debt is not backed by an asset pledged as collateral. If a business becomes insolvent, unsecured debt holders file claims against the company’s general assets.
Features of senior debt
- Senior debts are secured against lien on some assets. Rarely, it is secured by the lien on projected cash flows.
- Senior debts are usually amortized and come with option for a bullet repayment.
- Senior debts have collateral security. Hence, they carry low-interest rate and are usually granted in tranches.
Importance of senior debt to companies
Senior debt helps the borrower to save a lot of money as it carries low interest rate due to reason being secured liabilities. For example, Sinra Inc needs $1 million to start a business, which after 3 years will be at its peak. If the borrower secures funding from bank, the result would be same.
So, a borrower borrows from the bank at 5% and has to pay $ 250,000 as interest. But if the company borrows from the junior lender at 12%, the interest payment would likely be $ 600,000. Hence, if the saving is $ 350,000 the borrower shall go for senior debt and save lots of money in interest payment.
Advantages of senior debt
- Cost – Senior debt capital is a cost-effective way to finance a company. It is less risky from a lenders point of view, making it the cheapest form of funding for a business. If a company takes on low-cost debt and reinvests it into relatively high return capital projects, they are going to create more value for the business.
- Potential for Growth – Senior debt capital allows a company to invest in its business in excess of cash-on-hand. bringing on a senior debt capital partner can enable companies to pursue growth opportunities that they may not otherwise be able to, such as making an acquisition.
- Control – As opposed to taking on equity, senior debt capital allows a business owner to invest in their business, continue to grow and add value to their business, while also maintaining ownership.
- Flexibility – Senior debt capital has the flexibility to be sourced and placed on standby for the unexpected, whether it’s in the form of a revolving credit facility or a shelf facility. It is important for companies to maintain liquidity for the known and for the unknown.
Disadvantages of senior debt
- If the company defaults the payment, it can lose the asset it has put in as collateral for the loan
- As it is a liability, it raises the expenses and financial burden for the company.
- Generally, senior debt comes with complications of too many restrictions related to expenditure, dividends and acquisitions.
- The companies who agree to take senior debt has to maintain certain defined financial ratios.
Senior vs Subordinated Debt
The primary difference between subordinated debt and senior debt is the priority in which the debt claims are paid by a firm in bankruptcy or liquidation. If a company has both subordinated debt and senior debt and has to file for bankruptcy or face liquidation, the senior debt is prioritized first and the company goes back to pay subordinated debt later on. Hence, if a company files for bankruptcy, senior debt claims are paid first. All other debt is subordinated.
Collateral from an asset-backed debt may be sold to pay off senior secured debt. Senior unsecured debt is then paid using other company assets. If any assets remain, subordinated debt is paid. For this reason, subordinated creditors may lose some or all of the principal and interest payments that they are owed.