As lenders, we focus on having a first lien position on any collateral we take to secure a loan. In other words, if we are going to lend money for a house, a car, or a business asset; then we want to have the first right to foreclose and liquidate that collateral we have securing our loans.
When lenders have a first lien, it means they have priority over any other lender who may claim that asset as collateral. Sometimes, we call the loan with priority claim the “senior” debt, and any other loans secured by this collateral are considered “junior” debt, or it has a “junior” lien.
Think of a borrower who has a first mortgage on their house, and also has a second mortgage that is a home equity line of credit (HELOC). The HELOC is junior debt and has a junior lien on the house. That junior lien is “subordinate” to the senior lien. As you can probably infer, subordinate debt is synonymous to junior debt.
In the world of business lending, we see subordinated debt play a role in various situations. Just like a member might have a HELOC on their home, business owners might have a second mortgage on their commercial real estate to tap into equity for renovations or another big purchase.
Sometimes a potential real estate buyer does not have quite enough equity to purchase a property. Say the credit union will make 75% loan-to-value mortgage on a property purchase of $500,000. This means the credit union will provide a loan of $375,000, and the borrower is expected to come up with $125,000. Perhaps the member can only provide $80,000. If the seller is motivated or flexible, they may provide the remaining $45,000 in financing as subordinated debt. That debt is subordinated to the credit union’s first lien interest in the $375,000.
The arrangement described above can be both good and bad. It may be good, because it assures the credit union has a loan-to-value at or below 75%. Notice, the junior debt has an effective loan to value of ($45,000 + $375,000) / $500,000 equaling 84%. The junior lender (the seller in this case) will need to pay off the credit union’s mortgage before he can foreclose on his $45,000 second lien position. The bad part about this arrangement is now the effective debt on the property is $420,000. Now the borrower has two mortgages to pay, meaning less money is available should anything go wrong.
Subordinated debt can also play a positive role in a business buy-out situation. Sometimes a business is sold for its intangible worth, such as its reputation or client list. In this case, the credit union will probably take something outside the business as collateral; although, it may be desirable not to pay the seller 100% of the purchase price, but force them to provide some of the financing as subordinated debt. This is sometimes called seller financing or seller carryback. In this situation, the seller will only realize their full purchase price if the business continues to operate successfully into the future. In this case, the seller may be incentivized to stay involved in some way or leave the business in good operating condition to the benefit of themselves, and thus everyone else in the transaction.