In the wake of the recent financial crisis
debt has taken on a new pertinence. Both businesses and individuals may have witnessed first-hand and struggled to cope with multiple types of debt.
Larger companies, for example, will find that they are involved in many different types of financial transactions and have a number of varying forms of debt with different investors.
As such, companies will have different grades of debt, which means that determining how the types of various debts are treated by the company becomes very important. Senior debt is the most important type of debt in the eyes of the borrower.
Definition of Senior Debt
Financially speaking, senior debt should be viewed as money owed that has a higher priority than other unsecured debt outstanding from the issuer.
Senior debt has greater importance in the issuer's capital structure than subordinated debt. This form of debt will often be secured or backed by collateral on which the lender has put in place. Traditionally, this covers all the assets of a corporation and is often used for revolving credit lines.
It is a class of corporate debt that has priority with respect to interest and principal over other classes of debt and over all classes of equity by the same issuer.
And in the event the issuer goes bankrupt, senior debt must be repaid before other creditors receive any payment.
Conversely, debts that are considered 'less important' and are not paid off first are known as junior debts. These could be supplemental loans, credit card debt or other types of funds from different companies.
Risk and Interest
Because there remains a high chance that senior debt will be repaid even in the event that a company goes bankrupt, it can be considered as relatively low risk. As a result, lenders and investors tend to be more willing to part with their money to finance senior debt.
It also tends to mean that it is available with lower interest rates, making the loan easier for the borrower to secure.
Senior debt financing can be categorised in several ways, including secured versus unsecured and cash flow versus asset-based. With each option, there are differences in pricing and in ongoing covenant requirements.
Senior debt financing
is available to anyone, although the guidelines to obtaining it tend to be very strict. Primarily, it centres on a company or individual having an asset that can be used as collateral should they encounter any problems.
Lenders will also typically study a company's cash flow to ensure that it is capable of keeping up with the necessary financial repayments.
Once all things have been considered, lenders will determine the interest rate that will be applied to the senior debt. A borrower can get a high interest rate if the lender perceives a high risk of not being paid on time. However, interest rates can also be as low as one point below prime if the borrower can show a strong cash flow history.
Managing Senior Debt
Different organisations adopt a number of approaches to dealing with and managing senior debt.
Some will set aside and allocate specific resources in a senior debt fund - essentially storing cash and other assets which can be used to pay the debt in the event of a financial or economic downturn.
Alternatively, businesses take advantage of a senior debt ratings system which will automatically prioritise and pay all debts in this class. This method can help companies to establish a schedule for making regular payments.
The exact processes used by a given company will often depend on the regulations and standards that hold sway in the country where the business is incorporated and primarily conducts its business.
- Friday 04 February 2011