Senior Debt in a Company’s Capital Structure

Companies are often required to raise capital in the form of equity capital and debt capital. This unique composition makes up a company’s capital structure.

The three types of equity capital generally include common equity, preferred equity, and retained earnings. Debt capital, however, is characterized by the seniority ranking on interest payments and the claim on assets in the event of default.

Within a company’s capital structure, senior debt is the highest-ranking security, meaning senior debtholders are usually the first to receive their money back.

In return for seeking a priority claim on assets, senior debtholders have lower risk and thus receive a lower rate on interest payments.

Ranking of Senior Debt

Source: Corporate Finance Institute, November 2022. ”Senior Debt”

Senior debt is the highest-ranking security in a company’s capital structure and is borrowed money that is likely to be repaid first if the company goes out of business.

Lenders are often attracted to senior debt because it carries a lower risk and higher priority for repayment, compared to other types of debt.

Covenants

A defining feature of senior debt is the covenants or restrictions that lenders put on lending agreements to limit the actions of the borrower. Debt covenants are not supposed to be used to place unnecessary burdens, but to ensure that the interest between the lender and the borrower are aligned.

Positive covenants are requirements that a borrower must do, including maintaining certain financial metrics such as the Debt-to-Equity ratio and providing audited financial statements.

Negative covenants, however, are actions that borrowers are restricted from taking and may include restricting the company from borrowing more debt or selling certain assets.

Oftentimes, borrowers will concede certain restrictions from lenders to secure a lower cost of borrowing.

Senior Secured Debt

Another distinguishing feature of senior debt is that it can be secured by collateral, making it relatively less risky. When senior debt is backed by pledged assets from the borrower, it is called senior secured debt.

Senior secured debt is often divided between first and second-lien debt with first lien debt having the first claim on collateral and second lien debt having the second priority.

Notably, the difference between first and second-lien debt refers only to the lien subordination as they generally have equal rights to principal and interest payments.

Senior Unsecured Debt

Senior unsecured debt differs from senior secured debt in that it is not secured by collateral. Instead, debtholders have only a general claim against company assets.

If the company goes bankrupt, senior unsecured debtholders are the first tranche to be paid using company assets not held for senior secured debtholders.

Senior vs. Subordinated Debt

Like first and second-lien debt, the difference between senior and subordinated debt is the priority in which the debt claims are paid in bankruptcy or liquidation.

Subordinated, or junior debtholders are only paid out after the senior debtholders are made whole.

If the company’s liquidation value falls below the amount of outstanding debt, subordinated creditors may lose some or all the principal and interest payments that they are owed.

In return for the subordinated debt position, they are generally compensated with a higher interest rate than the senior debtholders.

Senior debt is subject to certain investment risks including credit risk and interest rate risk. Credit risk is the likelihood that an issuer will default on the principal and/or interest obligations, while interest rate risk is the risk that changes in interest rates could negatively affect the value of debt investments.

While the probability of issuer default is a critical consideration, lenders should be aware that absent default, they may still be subject to untimely payment of principal and interest as there is no assurance of the amount and timing of payments.

Moreover, the factors affecting an issuer’s first lien loans, and its overall capital structure, are complex. Even with senior debt being the highest-ranking security in a company’s capital structure, it may not have priority over all other debt of an issuer.

Lastly, although senior secured debt is generally backed by collateral with a value greater than the borrowed amount, the collateral itself, or the liquidation value, may fall below the amount owed to senior debtholders.

Senior debt is the highest-ranking security in a company’s capital structure and is borrowed money that is likely to be repaid first if the company goes out of business.

Like all forms of investment, senior debt is subject to risks including credit risk, interest rate risk, and the risk that pledged collateral is insufficient to make secured debtholders whole.

As such, it requires thorough credit analysis to understand a company’s capital structure, the expected probability of default, and the nature of the pledged collateral.

Sources:
Financial Edge, March 2022. "First Lien/Second Lien Debt"
Investopedia, April 2022. "Second-Lien Debt"
Analyst Prep, September 2019. "Seniority Rankings of Corporate Debt"
Livermore Investments. "Overview of Senior Secured Loans"
Investopedia, November 2020. "Unitranche Debt"
Investopedia, November 2020. "Senior Debt"
Investopedia, June 2022. "Capital Structure Definition, Types, Importance, and Examples"
Corporate Finance Institute, May 2021. "Senior Debt"
Corporate Finance Institute, October 2022. "Debt Covenants"
Corporate Finance Institute, November 2022. "Senior Debt"
Investopedia, September 2022. "Interest Rate Risk Definition and Impact on Bond Prices"
Investopedia, May 2022. "Prepayment Risk"
Investopedia, March 2022. "Credit Risk: Definition, Role of Ratings, and Examples"
Home Bankers' Club. "P2P Lending Risk vs Return Ratio: How Platforms Assess Borrowers and Loans"