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Senior Debt

Guide to Understanding Senior Debt

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Senior Debt

Senior Debt Facility Financing Terms

Senior debt represents the most prevalent form of debt raised by corporates seeking to fund their operations and reinvestments, namely capital expenditures.

Senior debt financing – which is often referred to as a “senior term loan” – is traditionally provided by institutional commercial banks, a syndicate of commercial banks, or a group of institutional investors.

Notably, senior debt is secured, meaning that the debt issuance is backed by collateral, i.e. the lender now has a lien (i.e. claim) on the assets pledged by the borrower.

The protection provided by the collateral reduces the risk and potential losses incurred by the lender substantially, making senior debt facility terms more favorable to the borrower.

By virtue of possessing the highest claim on the company’s assets – i.e. being placed at the very top of the capital structure – senior debt carries the least risk.

Hypothetically, in the event of bankruptcy (or liquidation), senior debt lenders hold seniority above all other stakeholders (including other lenders) – hence, senior lenders are the most likely to receive full recovery of the original capital provided.

Senior Debt Interest Rate

Usually, senior debt is priced at the lowest interest rate.

Like most financing instruments, the borrower is contractually obligated to pay interest to the lender periodically across the borrowing term, as well as repay the entire principal amount on the date of maturity.

  • Secured Debt → Lower Interest Rate + Favorable Lending Terms
  • Unsecured Debt → Higher Interest Rate + Less Favorable Lending Terms

Since the financing is secured by the borrower’s assets, the collateral can be seized by the lender in the case of default (i.e. due to a missed interest payment or if the borrower cannot repay principal) or a covenant breach.

The drawback, however, is that traditional bank lenders tend to be the most risk-averse (and there is a limitation as to how much senior debt can be raised).

Moreover, the interest expense owed on senior debt is most often priced at a floating rate against a specified benchmark rate such as SOFR (formerly LIBOR), as opposed to a fixed rate.

  • If interest rates are expected to fall in the near-term future, investors prefer fixed interest rates.
  • If interest rates are expected to increase, investors would prefer floating interest rates.

Types of Senior Debt – Terms Loans and Revolver

The chart below describes the most common types of senior debt.

Senior Debt Tranches Description
Revolving Credit Facility (Revolver)
  • A revolving credit facility is normally offered as a “deal sweetener” packaged alongside the term loan(s) to make an overall financing package more attractive
  • The revolver functions as a “corporate credit card”, which the borrower can draw from in periods of liquidity shortages (i.e. to fund short-term working capital needs)
  • The interest on a revolver is only charged on the drawn amount, and there is typically only a minor annual commitment fee for the unused portion of the facility
Term Loan A (TLA)
  • TLAs are characterized by straight-line amortization, i.e. equal repayments across the borrowing term until the principal reaches a balance of zero at maturity
  • TLAs are normally structured with shorter borrowing terms relative to TLBs (and come with no prepayment penalty)
  • The most frequent lender of TLAs are commercial bank lenders
Term Loan B (TLB)
  • TLBs, contrary to TLAs, have minimal amortization requirements (i.e. 1% to 5% per year) followed by a bullet repayment on the date of maturity
  • TLBs tend to be structured with longer borrowing terms, with no prepayment penalty (or a very minimal amount)
  • TLBs are normally loans syndicated to institutional investors such as hedge funds, credit funds, mutual funds, etc.

Senior Debt vs. Subordinated Debt (and Mezzanine Financing)

The pricing of debt – i.e. the interest rate charged – is a byproduct of its capital structure placement.

The difference between senior and subordinated debt is that the former takes precedence in the event of default (or bankruptcy), as its claims are more senior.

In such scenarios, such as bankruptcies, the senior claims recoup their losses before the subordinated claims can be paid back.

As such, senior debt is perceived as the cheapest source of financing because of the secured nature of the financing, i.e. senior debt carries the lowest cost of debt relative to “riskier” tranches of debt.

While the interests of senior lenders are protected by the pledged collateral, unsecured lenders are not afforded the same type of protection (and thereby, the recoveries in the event of default are lower).

Unlike senior lenders, subordinate lenders that provide riskier types of financing, such as mezzanine financing, charge higher interest rates, which are generally priced at a fixed rate. Since they bear higher risk, they are compensated via higher returns (i.e. interest rates).

  • Subordinated Lenders: A fixed rate is established to ensure the lender receives a sufficient return (i.e. a target yield is met).
  • Senior Lenders: In comparison, senior debt lenders such as traditional banks prioritize capital preservation and minimizing losses above all else.

Further, senior debt can usually be paid back early with no (or minimal) prepayment fees, while subordinated lenders charge higher penalties in the case of prepayment.

The chart below summarizes the differences between senior and subordinated debt.

Senior Debt vs. Subordinated Debt Chart

Senior Loans and Covenants

We’ll wrap up by discussing covenants, which are implemented in the loan agreement by senior lenders to further protect their downside risk.

Debt covenants are legally binding obligations agreed upon by all relevant parties that require the borrower to be in compliance with a specific rule or when taking a specific action (and historically have been tied to senior lenders more than subordinate lenders).

  • Affirmative Covenants → Affirmative covenants, or positive debt covenants, state certain obligations that the borrower must fulfill in order to remain in good standing with loan agreement terms.
  • Restrictive Covenants → Restrictive covenants, or negative debt covenants, are provisionary measures intended to prevent borrowers from taking high-risk actions that place repayment at risk without prior approval.
  • Financial Covenants → Financial covenants are pre-determined credit ratios and operating metrics that the borrower must not breach, such as a minimum leverage ratio.

Financial covenants can be separated into two distinct types:

  • Maintenance Covenants → Maintenance covenants, as implied by the name, require the borrower to maintain certain credit ratios and metrics to avoid violating the covenant, e.g. Leverage Ratio < 5.0x, Senior Leverage Ratio < 3.0x, Interest Coverage Ratio > 3.0x
  • Incurrence Covenants → Incurrence covenants are tested for compliance only if the borrower has taken a specific action, i.e. a “triggering” event, rather than being tested regularly.

Covenants can be a significant drawback to borrowers as they can be restrictive in terms of limiting a company’s ability to perform (or not perform) certain actions.

Covenants tend to reduce operating flexibility.

Senior lenders have, however, become more lenient on debt covenants and now the term “covenant-lite” has become common, which stems in part from the low-interest rate environment and increased competition in the lending market, i.e. the number of lenders in the market has increased due to the entrance of direct lenders (and the emergence of unitranche terms loans).

Given current market conditions, i.e. high risk of an economic contraction, long-lasting recession, record high inflation, etc., more strict covenants could soon return to the credit markets.

Senior Financing Filing Confidentiality

One distinct feature of senior debt is that it is raised in a private transaction between the borrower and lender(s).

In contrast, debt securities like corporate bonds are issued to institutional investors in public transactions formally registered with the SEC, and those corporate bonds can be traded freely on the secondary bond market.

The confidential aspect of senior financings can be favorable to borrowers that want to limit the amount of information disclosed to the public.

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