Senior and junior debt providers frequently work together within a borrower’s capital structure, so a harmonious relationship between the lending parties is the key to a beneficial outcome. Jeri Harman of Avante Capital Partners and Alan Chen and Kate Jenks of Caltius Structured Capital provide a refresher course on the difference between the two types of lending and important considerations to ensure a successful partnership. They also share their thoughts on how the COVID-19 pandemic has shifted the market and the outlook for junior debt providers.
There is more than one way for a business to obtain financing and that can frequently lead to working with more than one type of debt or capital provider. While unitranche structures with a single lender can be the right option in some instances, more varied capital structures that include pieces of senior and junior debt can provide additional benefits in the right situations.
The relationship between senior and junior lenders is not entirely straightforward and requires flexibility and an understanding of the different approaches and ultimate goals of each side. But before we can jump into how senior and junior debt providers work together, it’s important to understand the differences between them. For many in the asset-based lending space, these differences are common knowledge, but these basic tenets play a major role in influencing the relationship between the two types of providers when working on a deal together.
Back to Basics
There are certainly the basic differences. Junior lenders have lower priority in the capital structure than senior lenders, who will get paid back first during a liquidation, default or sale. In addition,
senior and junior lenders differ in the structures and terms they provide. According to Alan Chen, vice president of Caltius Structured Capital, and Kate Jenks, an analyst at Caltius Structured Capital, junior lenders do not require scheduled paydowns like senior lenders, but they charge a higher interest rate, usually falling in the low teens compared with the low single-digit rates from their senior counterparts. On top of that, junior lenders frequently require an “equity kicker” such as a minority equity co-investment.
“Junior debt is more expensive and riskier, particularly because instead of basing lending amounts on assets, junior lenders make those decisions based on historical and projected cash flows,” Chen says.
“Junior debt does not require personal guarantees, contractual paydowns and assets to determine the amount and features of a loan,” Jenks says. “Junior debt is longer-term, partner-like capital that is structured to be flexible for the company to comfortably operate during periods of stability or investing for growth.”
By serving in more of a “partner-like” role, junior capital providers can be more invested in the borrower’s long-term success, while also putting themselves at greater risk in pursuit of a greater payoff.
“Junior capital providers are more focused on the long term and growth opportunities of the business and willing to take more risk,” Jeri Harman, founder and chairman of Avante Capital Partners, says. “Of course, with more risk, they expect more return in the form of higher interest and the equity component.”
A variance in risk tolerance is at the heart of the divide between senior and junior lenders. Senior lenders are inherently more conservative in their approach, particularly since many are at the mercy of regulators, according to Harman, who notes that senior lenders are generally focused on a timely return. In addition, she says that different considerations should be made when working with senior cash flow lenders compared with senior asset-based lenders. Regardless of the type of senior lender, however, the bottom line remains the same.
“Senior lenders expect to get out first. Period,” Harman says.
From the borrower perspective, the differences between these types of lenders must be factored into the decision-making process when selecting the right capital provider or providers.
“Borrowers should have … a sense for how much capital they need, the amount of senior and junior debt that their business could support and the level of flexibility needed for the company to comfortably operate and execute on its growth plans,” Chen says.
Factors to Consider
Despite the many differences between them, senior and junior lenders can work together to provide the capital necessary for businesses to succeed and grow. According to Chen and Jenks, most of these relationships form either when a junior lender begins working with a company with an established senior lender or when a senior lender and junior lender partner on an investment opportunity. As the terms are being settled, the two parties will consummate the rules of their relationship in the form of an intercreditor agreement or an agreement amongst lenders. While these agreements will help outline the governance specifically, Chen and Jenks say there are four important factors to consider when a junior lender begins a partnership with a senior lender: capacity, the relationship, flexibility, and terms and economics.
Evaluating capacity means determining whether the senior lender will be able to “provide additional capital for growth initiatives,” according to Jenks. The relationship factor speaks to whether there is a prior history of cooperation between the senior and junior lender. When it comes to flexibility, a junior lender must determine how a senior lender will react during challenging times. Lastly, looking at the terms and economics of the combined capital/debt will determine how beneficial such a combination will be for the borrower as well as the providers themselves.
Chen, Jenks and Harman all agree that once a partnership is formed, the most critical key to success is communication between the senior and junior lenders.
“Like everything, senior/junior lender relationships work best when there is substantial and frequent communication from the initial loan evaluation through exit/repayment,” Harman says. “It is especially important when things don’t go as expected. The ability of the senior and junior lenders to work together constructively on a unified front to combat the issues will generally work in both of their favors.”
This level of communication underscores the need for a junior lender to continually understand the position of the senior lender, who, as noted earlier, will be more risk-averse than those on the junior side.
“Junior lenders have to keep in mind that the senior lenders are not being paid to take more risk and will be very focused on anything that increases the credit or business risk and could impact the company’s ability to pay back the senior debt,” Harman says.
Junior Lenders and COVID-19
The COVID-19 pandemic has dramatically shifted the marketplace for businesses and the capital providers who serve them. For junior lenders, this means changes in perspective, credit appetite and the types of businesses that will be given consideration.
“I expect junior capital providers will continue lending to companies and end markets that have been able to remain stable-to-growing in the COVID-19 environment to date and that are also well positioned for continued success in the post-COVID-19 environment,“ Chen says. “Due to general uncertainty around the lasting impacts from COVID-19, I expect junior capital providers will take a conservative approach to proposed economics/terms.”
Conservatism will not just be felt in deal terms but on the credit evaluation side, as junior lenders employ greater scrutiny when evaluating potential opportunities.
“I think both senior and junior lenders are being more cautious in the types of credits they will do and the terms upon which they will do them,” Harman says, noting that this could lead to less leverage and higher pricing.
However, this environment may be increasing the appetite of borrowers for junior capital solutions, which is being driven at least partially by the private equity community.
“There also seems to be more weight placed by private equity sponsors on the importance of relationship and a longer term perspective, which has shifted their focus to using more junior capital in the capital structure and working with lenders that have proved to be good partners in tough times — not just going to the most aggressive unitranche or other provider,” Harman says.