Meaning of the subordinated loan

A subordinated loan is a credit that is treated as subordinate in the event of insolvency. It is positioned between the senior (first-ranking) loan and equity. Before subordinated loans can be paid out in the event of insolvency, the repayment of the senior loans is required. However, subordinated loans are paid out before any equity is returned to the original owner.

Advantages and disadvantages of subordinated loans

For the borrower, subordinated loans are a quick and flexible instrument to bridge liquidity shortages. They are often used in construction projects when it becomes apparent that the original loan amount is not sufficient. Since they are considered an "extraordinary loan", they are neither subject to prospectus requirements nor covered by a distribution restriction under § 32 Kreditwesengesetz.

In corporate financing, subordinated loans offer particular advantages for both parties: For the borrower, taking out a subordinated loan does not mean losing their entrepreneurial decision-making freedom. Subordinated loans do not entitle lenders to influence ongoing business operations. At the same time, they do not constitute an equity stake in the sense of a limited partnership (KG). This means this form of credit is exempt from any obligation of additional liability. No further funds need to be contributed if the company encounters further liquidity problems.

A drawback for the lender of a subordinated loan is the increased default risk. In the event of insolvency, their claim is explicitly "subordinated." This means they only receive their money after all other "priority" creditors have been satisfied in full. Since seizure and auction of an insolvency estate rarely suffice to fully compensate senior creditors, providers of subordinated loans often come away empty-handed. This risk is in most cases compensated by a significantly higher interest rate.

Subordinated loans are therefore a quick way to obtain fresh funds. They are also a convenient way to put dormant capital to work very lucratively. However, the interest rate must be commensurate with the default risk. Both lenders and borrowers must be aware of this in advance.

Communication builds trust with subordinated loans

Lenders of subordinated loans are not involved in the borrower's entrepreneurial decisions. As a rule, however, they still require constant and extremely detailed information about current business development.

Given the risk that providers of subordinated loans take on, this is understandable. Communication is the decisive trust-building instrument for any type of loan. This is even more important when taking out subordinated loans. Sensible measures by the borrower include weekly newsletters, accountability reports, or regular personal meetings.

For lenders, subordinated loans are a particularly interesting product for lucrative returns on unused capital due to the higher interest rates. Therefore, in the context of sound business practice, it is generally unproblematic to receive an offer for a subordinated loan. Since lenders of senior and subordinated loans are often based at the same institution, an in-depth insight into the company's setup is usually guaranteed from the outset.

There may be reasons for borrowers to look for a subordinated loan outside their house bank. In particular, the high returns of this type of investment make a comparison of offers generally advisable. In loan negotiations, however, one must be prepared for the question of why the house bank is not a suitable lender for the subordinated loan. Therefore, a discussion with an external provider must be particularly well prepared.

Poor argumentation can lead to a rejection or a substantial increase in the cost of the loan. This is especially true if the prospective lender gets the impression that the house bank is already observing a threat of insolvency and therefore refuses further loans.

Well-prepared and well-argued negotiations can, however, generate significantly better conditions for the borrower even with external providers. It is by no means impossible that the subordinated loans offered by the house bank are disproportionately highly priced, so that third parties with better offers may in fact be the more attractive lenders.

Increased risk of over-indebtedness due to subordinated loans?

Subordinated loans can close financing gaps. However, they are loans that not only have to be repaid but are often subject to particularly high interest rates. Therefore, it requires especially precise calculation whether and how such a loan should be used. More than with any other form of financing, the return on investment must be taken into account.

Construction loans are secured by the building created. Therefore, they are usually very low interest and designed for long-term repayment. Subordinated loans, however, generally require a much tighter repayment schedule. From the agreed repayment date, the monthly burden increases with the taking of a subordinated loan. This burden is in any case already strained by the existing senior loans.

If the planned investment is worth this risk, there is nothing against a subordinated loan: unexpected burdens in seasonal business models can for example be better managed this way. Fashion-dependent companies can quickly react to changing customer tastes with their help. Repayment periods from insurance payouts in reported claims can be bridged with the help of subordinated loans.

These are examples of sensible uses of a subordinated loan. However, if the overall business model is in decline, a subordinated loan can under some circumstances worsen an already tense situation. Subordinated loans thus also have a strong disciplining effect on the corporate-psychological side.

Balance sheet classification of subordinated loans

Subordinated loans are capital contributions without co-determination rights. That makes them, in the course of a balance sheet analysis or a rating, economically a component of equity. Under commercial law, however, they are classified as liabilities according to § 266 Absatz 3 C.2 HGB and thus increase the debt ratio. This mixed view assigns subordinated loans to the "hybrid financing instruments" and thus to "mezzanine capital."

This shows that taking out subordinated loans increases the complexity of the company structure. This invariably requires an increased professionalization of company management. Whether this can be managed permanently by the founder of the company remains to be assessed on a case-by-case basis.

From this circumstance, a broad range of professional service providers has already emerged who can assist in managing the increased administrative and communication effort.