Types of Debt Flashcards
What are two primary types of debt financing?
Senior and subordinate debt.
What are the characteristics of the capital stack?
Senior debt is at the top, followed by subordinate debt, preferred equity, and finally common equity on the bottom.
First, senior debt creditors will be paid first in the event of financial distress, while shareholders will divide what remains after all creditors are paid. Secondly, the return profile of debt and equity is inverse to the priority list. Shareholders with an equity stake have the highest return profile, whereas senior debt creditors have the lowest.
What are the characteristics of senior debt?
The entire senior debt portion commonly accounts for 50% of funding in an acquisition, which roughly equates to two to three times debt to EBITDA or twice the interest coverage. For example, if a company’s EBITDA is stable and reliable, perhaps banks would lend the company two to three times its EBITDA for its senior debt. Another example would require the company to generate sufficient cash flow to cover the interest expense of senior debt twice over.
Common senior debt lenders include commercial banks, credit companies, and insurance companies.
What are the characteristics of subordinated debt?
Subordinated debt is considered as any type of debt that will not be paid until all senior debt is paid in full. However, even within subordinated debt, there are various types of loans with different priorities. Types of subordinated debt include high yield bonds, mezzanine with and without warrants, Payment in Kind (PIK) notes, and vendor notes, ordering from the highest to the lowest priorities, respectively.
How does leverage affect returns?
As the business grows and expands, the equity piece will grow significantly over the next three to five years. The subordinated debt piece will remain the same, while the senior debt piece will shrink, as its principal has been repaid over its amortization period. Hence, the value of the business has grown, but the majority of that growth has only been transferred to shareholders.
Why do companies use subordinated debt?
Although sub-debt may seem expensive at 18-22% return, it is less expensive than equity which can demand 25%-50% returns. As a lower cost equity alternative, there are several applications and uses of this form of capital. Transactions that need additional capital to satisfy Sellers’ need for cash at closing, senior bank capital demands, or capital for growth are the most common reasons for a company to borrow subordinated debt. Whereas senior banks may cap leverage rates at 3x EBITDA, subordinated lenders are generally willing to go as high as 4x EBITDA because they are compensated for their risk. Additionally, because the sub-debt is generally structured as interest-only, the payments of that debt are easier to make as the lender allows the senior debt to be paid first and waits for its money until maturity – which is also why sub-debt can be called “patient capital”.
What is mezzanine debt?
Mezzanine debt is a non-tradeable security, which is subordinated to senior debt. It often has a bullet repayment, accrued cash return, and can have equity warrants attached. Equity warrants provide lenders exposures to equity upside on top of the expected return on the actual interest payments.
Also, mezzanine debt includes convertible loan stocks, which can be converted entirely into equity, or convertible preferred shares, which can be converted entirely into preferred shares.
Debt with warrants, convertible loan stocks, and convertible preference shares all have equity exposures built into the debt security.
How are mezzanine debts repaid and what are the average IRRs?
Mezzanine lenders typically target an Internal Rate of Return (IRR) of 15% to 20%. The IRR consists of several components. The first is the cash interest that is paid by the company to the investor. The second piece is the accrued interest, which is interest accrued to be repaid with the principal. These two components comprise the contractual returns that the company owes to the creditors. The final component is the upside equity exposure from warrants. These warrants are typically 3% to 10% of the post-exit value of the business, which significantly increases the IRR of a debt investor.
