Subordinated debt is a term that is most significant when a business becomes not capable 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 sorts of debt when it comes to repayment. This will make subordinated debt the opposite to senior debt, that is debt that is “superior” in the sense it must be paid off before the rest.
Regardless, as a result 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 get into liquidation, the lender of subordinated debt can get paid after the lenders of other sorts of debt. Effectively, this means that there is a lower expected outcome as their outcome is that much worse ought to be the borrower become incapable of running their revenue-earning operations.
How Does Subordinated Debt Affect Bankruptcies and Liquidations?
For those people who are curious, when a business becomes not capable of running its revenue-earning operations, it'll see its assets entrusted for an outsider who will be responsible in using these to pay off as much of its outstanding obligations as you possibly can. Since debt is what the business owes to other parties while equity may be the percentage of the owners’ stake in the business’s total value, which means that debtors get paid before the owners, whether those owners are in fact 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's interesting to note that there can be both secured and unsecured debt as well, meaning whether it has already established collateral put up for it or otherwise. 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 having said that, it is important to note that these normal rules are somewhat unreliable when it comes to subordinated debt that has been secured with the process of collateralization because it is possible that the borrower won’t actually be able to collect whatever it had been that had been put up as collateral. Something which happens so long as the contract causes it to be very clear that the subordination applies even going to the collateral. Due to this, while secured subordinated debts are less risky than unsecured subordinated debt, it's by no means perfect protection, that 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 before the creditors have been paid off. As a result, there is a very real chance the owners won’t be paid at all because there is no guarantee that the business’s assets can cover all of its outstanding obligations. After all, an asset’s book value is not necessarily an asset’s fair market price when one considers issues such as accumulated depreciation and the limited window of your 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 type of debt, which is something that both sides will want to take into consideration when making their choices. For instance, businesses tend to be reluctant to issue subordinated debt simply because they need to offer higher than normal interest rates for the purpose of attracting the attention of your customers. Meanwhile, lenders need to keep in mind 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 engaging in as well as what they can expect, they should be able to make use of subordinate debt while keeping the potential issues down to the absolute minimum.