Subordinated debt is a term that is most important when a business becomes incapable of continuing to run its revenue-earning operations, thus necessitating it to either go into bankruptcy or go into liquidation. Like its name suggests, subordinated debt is less than other kinds of debt in the sense that it receives lesser priority than other kinds of debt when it comes to repayment. This makes subordinated debt the opposite to senior debt, which is debt that is “superior” in the sense that it must be paid off before the rest.
Regardless, the result is that subordinated debt is considered to be riskier than other kinds of debt. After all, if the borrower is forced to either go into bankruptcy or go into liquidation, the lender of subordinated debt will get paid after the lenders of other kinds of debt. Effectively, this means that they have a lower expected outcome because their outcome is that much worse should be the borrower become incapable of running their revenue-earning operations.
How Does Subordinated Debt Affect Bankruptcies and Liquidations?
For those who are curious, when a business becomes incapable of running its revenue-earning operations, it will see its assets entrusted to an outsider who will be responsible in using them to pay off as much of its outstanding obligations as possible. Since debt is what the business owes to other parties while equity is the percentage of the owners’ stake in the business’s total value, this means that debtors get paid before the owners, whether those owners are actually called owners or partners or shareholders.
As stated, there are different kinds of debt, with some kinds of debt getting paid off before others. However, it is interesting to note that there can be both secured and unsecured debt as well, meaning whether it has had collateral put up for it or not. Generally speaking, collateral means that the lender will just recoup as much of their losses as possible by claiming whatever it was that was put up for collateral in the first place, meaning that secured debt tends to be seen as being somewhat less risky than its unsecured counterpart.
With that said, it is important to note that these normal rules are somewhat unreliable when it comes to subordinated debt that has been secured through the process of collateralization because it is possible that the borrower won’t actually be able to collect whatever it was that had been put up as collateral. Something that happens so long as the contract makes it very clear that the subordination applies even to the collateral. Due to this, while secured subordinated debt is less risky than unsecured subordinated debt, it is by no means perfect protection, which is something that interested parties will want to take into consideration whenever they make relevant choices.
Regardless, the owners don’t get to recover their investments until the creditors have been paid off. As a result, there is a very real chance that the owners won’t be paid at all because there is no guarantee that the business’s assets will be able to cover all of its outstanding obligations. After all, an asset’s book value is not necessarily an asset’s fair market value when one considers issues such as accumulated depreciation and the limited window of time in which to get a good sale price, meaning that it is not uncommon for a business’s assets to fall short of their book price.
It’s a Riskier Kind of Debt
Summed up, subordinated debt is a riskier kind of debt, which is something that both sides will want to take into consideration when making their choices. For example, businesses tend to be reluctant to issue subordinated debt because they need to offer higher than normal interest rates for the purpose of attracting the attention of interested parties. Meanwhile, lenders need to remember that the nature of subordinated debt increases their chances of being unpaid should something go seriously wrong with the business’s revenue-earning operations. With that said, so long as everyone understands exactly what they are getting into as well as what they can expect, they should be able to make use of subordinate debt while keeping the potential issues down to a minimum.