Dear XXXXXXXXXX,
Subordinated debt is also called mezannine debt.Today, the subordinated debt market is very sophisticated and its structure is limited only by the creativity of the people involved in structuring the mezzanine loan. The capital offered by mezzanine lenders is particularly useful if a company's bank borrowings have exceeded the bank's comfort level, but the company has sufficient cash flow to service more debt. Subordinated lenders can bridge the gap a senior lender (such as a bank, commercial finance company, or insurance company) is unwilling to fill because subordinated lenders do not view a company's collateral as a possible exit option available to them. Instead, mezzanine debt is solely dependent on a company's ability to generate cash flow.
Advantages:
Subordinated debt is an extremely flexible form of financing. Because they are more concerned than senior lenders about their overall yield, mezzanine lenders are very liberal in tailoring their investment to meet the financial, operating, and long-term cash flow needs of the borrower. As long as the subordinated lender's anticipated yield is satisfied, they can be flexible as to the amortization of the loan and the interest rate.
From the senior lender's perspective, subordinated debt looks like equity. It is unsecured and subordinated to their loan and, thus, is viewed as long-term capital. As a result, a senior lender may consider the company to have strengthened its capital position as additional capital has been raised that is junior to their loan.
Disadvantages
First, the company must give up some equity ownership to an outside group. Although it is unlikely the subordinated lenders will have control of the board, the lender will have a vote and the ability to take more severe actions if the company does not meet its projections and does not perform well financially.
In addition, owners of closely held businesses may not be able to pay above market salaries to officers, and other perks may need to be limited. They may have to reduce their own compensation to the level of a non-owner/manager and lower dividend payouts as well. However, the wealth of the existing shareholders should increase even though there is a decrease in their ownership interests. For example, if a company's value is $10 million, adding $3 million of subordinated debt would raise the worth of the business to $13 million. If the shareholders' ownership interests decrease from 100 percent of $10 million to 90 percent of $13 million, the shareholder has seen the value of his holdings increase by $1.7 million ($11.7 million vs. $10 million).
Another disadvantage of subordinated debt is that it is significantly more expensive than senior debt. Today, the current interest coupon on mezzanine debt approximates the 10-year treasury rate plus 5 percent, or roughly 13 to 14 percent. Adding the required yield enhancement, usually warrants, creates an increase in the returns to between 20 percent to 30 percent.
References:
http://linkinghub.elsevier.com/retrieve/pii/S0377221703009111
http://www.allbusiness.com/business-finance/business-loans-business-credit/499709-1.html
http://www.britannica.com/bps/additionalcontent/18/35601944/THE-EFFECT-OF-SENIOR-DEBT-ON-SUBORDINATED-BOND-CREDIT-YIELD-SPREADS
http://www.google.co.in/url?q=http://docs.google.com/gview%3Fa%3Dv%26q%3Dcache:cy8bjleThaAJ:www.fanniemae.com /markets/debt/pdf/subordinated_debt_program.pdf%2Bsubordinated%2Bdebt%2Badvantageous%2Bto%2Bsenior%2Bdebt%2Bholders%26hl%3Den%26gl%3Din%26pid%3Dbl%26srcid%3DADGEESi0mPTb6cAOPcf3XVUVKxKQ_vH5vC19US-45PW318gKh3BosY4gkmTMYcKdv-oGFDLOjjSN5ViZIPILr-LRbKtsMrSuOWiqYEu52hQo5cj5GmULtd8i6BR9YWxeMowfyqpp2CAz%26sig%3DAFQjCNFFAxta0Yt5553Gc3JHdWW9DIeO7Q&ei=c2HoSqzlOYO4swP6toydBQ&sa=X&oi=gview&resnum=5&ct=other&ved=0CBcQxQEwBA&usg=AFQjCNHMTy8meWbRvsATffatiBeg50fy3Q
http://74.125.155.132/search?q=cache:0IYx29nXqlQJ:dsp-psd.pwgsc.gc.ca/Collection/FB3-2-105-40E.pdf+subordinated+debt+advantageous+to+senior+debt+holders&cd=8&hl=en&ct=clnk&gl=in
I hope the above helps...
Regards,
Financial Advisor
Technical Analyst in Financial Markets -- Experience of more than 10 years in consulting