Senior Debt Capital Sources
With senior debt capital, there are more choices and variations than meet the eye.
Senior debt capital is the least expensive and most common way for companies to obtain substantial amounts of capital. However, what many CEOs and CFOs may not know about it is the variety of options available to them, in how senior debt capital can be sourced, securities as well as the ways it can be structured.
Just as it sounds, senior debt capital assumes priority over other forms of capital and is generally repaid first. It can be secured or unsecured, asset-based or cash-flow based, depending on the size and strength of a company. The term (short or long) for the senior debt capital will be dictated based on the nature of the funding need and the company’s credit quality. Senior debt capital is also available from multiple lending markets.
Senior Debt Capital Sources
Companies primarily source senior debt capital from these three markets:
- Bank Market – Typically shorter-term (3-5 years), secured or unsecured, and revolving or term based. For smaller or asset-based businesses, companies can utilize secured, asset-based bank loans (such as ABL revolvers or finance leases) with borrowing capacity determined based on the size and quality of the assets. Larger businesses (typically investment grade) can access bank funding on a fully unsecured basis. As bank loans are shorter-term in nature and can be drawn and repaid as needed, they are better-suited to help finance working capital needs, smaller capital projects and other ongoing operational expenses. Bank loans also usually have floating interest rates, and sometimes companies will artificially ‘fix’ these floating rates with a financing derivative, such as a swap.
- Private Placement Market – A private placement is a private sale, or ‘issue’ of corporate debt or equity securities by a company, to a select number of investors. The most common type of private placement is long-term, fixed-rate senior debt capital that sits equally (or ‘pari-passu’) with other senior debt. Due to the nature of the investor, or lender base, private placements can be flexible in tenors(between 5-30 years, depending on financing need and credit quality) as well assize (as low as $15MM with a single investor to $2.5B in a ‘mega’-syndicated transaction)
Traditionally, companies issue private placements with institutional investors, such as large insurance companies. A private placement issuance is a way for institutional investors to lend with a ‘buy-and-hold’ approach, and with no required rating or public disclosures. Private placements are typically fixed rate, offering interest rate protection to the issuer over the term of its debt. This is a more intimate, relationship-based market where borrowers will commonly get to know the private placement lenders well, similar to their banks.
- Public Bond Market – Companies will often issue a corporate bond in the public bond market to raise long-term senior debt capital; the preparation process can be time consuming due to the time and resources required to create the necessary prospectus and register with the Securities and Exchange Commission (SEC). With bond issuances, ratings and minimum issuance size are typically required. Amounts raised in the public bond markets are often more than $300MM (to qualify for index-eligibility), and in many instances, public bonds are issued by a company with publicly traded stock. Like private placements, the purchasers of the public bonds also include institutional investors, but unlike private placements, public debt is more likely to be traded and the investor composition more opaque. A benefit of the public bond market is that covenants are typically much looser than bank and private placement debt, who are typically aligned.
Businesses are not limited to any one of these markets but can obtain senior debt capital with differing structures from multiple sources. For example, companies can achieve structural parity when combining private placement and bank loans as well as other benefits.
Senior Debt Capital Security: Secured vs. Unsecured
Depending on a company’s scale and track record, the senior debt capital they obtain will either be ‘secured,’ via an asset-based loan, or ‘unsecured,’ like most cash-flow-based loans. Here are the main differences between asset-based versus cash-flow based loans:
Secured – To strengthen their credit quality, increase borrowing capacity or reduce their cost of capital, a company can pledge certain business assets to support a loan, making it secured.
Secured loans can be in the form of ‘all assets,’ where the investor has a lien on effectively all assets of the company in support of the debt issued. Where multiple investors are involved, they may share in the security on a ‘pari-passu’ basis.
A borrower can also pledge different types of collateral from their operating business, accounts receivable and inventory to specific plants/facilities or equipment on an ‘asset-specific’ basis. Asset-specific loans often require appraisals, and the ‘loan to value’ can vary based upon the type and age of the collateral.
Unsecured – Unsecured, cash-flow-based loans are typically utilized once a middle-market company demonstrates meaningful scale and stability over an extended period. As a general rule of thumb, companies may graduate from secured, asset-based loans to unsecured, cash-flow based facilities once they are considered ‘investment grade.’ The determination of investment grade status is often based on the amount of sustained revenue and earnings a company can demonstrate, and the amount of debt that is already in place as a claim against that cash flow. Unsecured, cash-flow-based loans are typically governed by a suite of financial covenants, and can provide additional flexibility for the business as compared with senior secured financing.
Senior Debt Capital Structures: Revolver vs. Term Debt
Senior debt capital is most commonly structured as either a ‘revolver’ or a ‘term loan,’ which differ as follows:
Revolver – Revolving loans, or lines of credit, are used by companies to maintain a steady flow of cash. What is ‘revolving’ about this type of loan is the amount of the loan itself, with balances that are able to be drawn down and repaid on an as-needed basis, often daily.
- Principally used to fund short-term working capital needs
- Term is usually 5 years or less
- Typically priced on a floating-rate basis
- Can be secured or unsecured
- If secured, are typically secured by inventory and accounts-receivable but can include fixed assets (machinery, facilities, real-estate, etc.)
Term Debt – Term Debt does not ‘revolve,’ and instead has a set term of 3, 5, 7 years (typically provided by banks), or longer 5-25+ years (provided by institutional investor markets) during which time, interest is paid. Thus, it is often used by companies to finance the purchase of machinery or equipment, acquisitions or other growth initiatives. Term debt can amortize, requiring repayment of some or all of the principal during the term, or can be non-amortizing and have a single balloon payment at the end of the term.
- Principally used to fund longer-term investments in a business, like fixed assets, or term out a portion of ‘core’ revolving debt that’s always outstanding
- Terms range from ‘bridge financing’ of ~2 years out to 25+ years mortgages, projects or large/stable companies
- Either fixed or floating rate
- Can be secured or unsecured
- If secured and asset based, they are typically secured by all fixed assets of the company, or a specific fixed asset (like a machine or ship)
Senior Debt Capital Variations
Now that we have discussed markets, securities and structures, here are the senior debt capital markets with the variations they offer:
There are various senior debt capital options available to companies, however, you are not beholden to borrowing just one type of senior debt capital from one provider. It is prudent to find the right balance and mix of long-term versus short-term, revolving versus term, and floating versus fixed rate to match your business profile; the distinct types can easily be combined to suit your business needs. No matter which type or combination of senior debt capital you choose, it is the most cost-effective way to finance your company when using leverage on your balance sheet.