Corporate entities are increasingly switching from preferred equity to subordinated debt to finance sales and other transactions.  Subordinated debt is perceived as providing better assurances of payments regardless of whether corporate earnings are positive or negative. Moreover, certain subordinated debt notes will have higher valuations than preferred stock in resale transactions, and even subordinated debt will take precedence over holders of corporate equity if a corporation needs to be liquidated due to insolvency. 

Banc Star Financial’s subordinated debt advisors focus on these and other considerations in advising clients on the benefits and risks of subordinated debt. Where, for example, a corporation would benefit from a tax-advantaged financing transaction, our advisors will focus on corporate debt, which (unlike preferred stock dividends) provides interest payments that are tax deductible. In the current tax environment, if a company maintains S-corporation status, it can take advantage of pass-throughs if the subordinated debt does not have reclassification provisions that envision conversion of debt to equity.

Banc Star Financial’s subordinated debt advisors take a unique approach to reclassification and conversion features. When S-corporation status is a secondary concern, we might structure a subordinated debt transaction with preferred stock that converts to debt upon occurrence of certain conditions, such as achieving cash flow targets, pay-down of debt to senior lender, or meeting other defined financial ratios.

Other investment or merchant banks might fall back on standard structures for subordinated debt transactions, with a corresponding attempt to fit the transaction into a pre-defined financing facility. Banc Star Financial rejects a one-size-fits-all approach. We begin every subordinated debt financing engagement with an in-depth analysis of the client’s capitalization and stock, its future earnings potential, its presence in its industry and in applicable markets, and its needs for risk mitigation and tax advantages.

In many cases, subordinated debt assumes a status between traditional commercial bank debt or lines of credit and a company’s equity structures. This middle stance has given rise to a mezzanine financing specialty among many investment and merchant banks. Rather than forming internal teams of advisors and consultants around semantic labels, Banc Star Financial’s specialists develop unique subordinated debt solutions that factor in the higher risk levels of that debt with optimum financing terms and conditions that meet the client’s needs first.

Subordinated debt structures are often combined with warrants that give a lender an option to procure equity as a discounted strike price. If the lender does not exercise those warrants, the buyer might then repurchase them at an appreciated value. Banc Star Financial has also been a pioneering industry participant in the use of success fees that give lenders additional fixed payments with caps on returns.

We simplify corporate debt decisions by preparing our analyses to show the relative costs of subordinated debt in comparison to equity. Although subordinated debt interest rates are high, the returns of that debt are typically lower than equity, which can demand returns that are up to twice as high as subordinated debt. Subordinated debt lenders are often willing to accept greater leverage. Even though a highly leveraged transaction will impose a larger interest burden on the borrower, subordinated debt is more readily structured with interest-only payments and a balloon principal payment at the end of a defined term.

Banc Star Financial specifically perceives subordinated debt to be an ideal financing alternative for companies that emphasize a services-based earnings environment (e.g. distributors, logistics companies, etc.) over collateral that can be used to secure debt financing. In every situation, our subordinated debt advisory team works with our clients to weigh the risks and advantages of subordinated debt within the client’s capital structure in view of expected outcomes and returns available in any transaction. With proper capital planning, a corporate entity can use subordinated debt to boost shareholder returns without risking cash flow that needs to be used for payments on senior debt.