Subordinated loan for the financing of intangible and capital assets

Intangible and capital assets are usually financed using loans with different repayment priorities and therefore higher risks and costs.

The following types of financing are available, in ascending order of risk:

  • traditional bank loans (senior debt);
  • subordinated loans (junior debt);
  • owned capital.

After a traditional bank loan, a subordinated loan is therefore the second level of debt, which, in terms of risk, is situated between the company’s shareholders' equity and traditional bank loans. Subordinated loans can come in different forms, namely a mezzanine loan, a subordinated debenture loan and/or a debenture loan convertible into shares. 

A subordinated loan can fill financing gaps – particularly in the case of the takeover of a company – that cannot be covered by shareholders' equity, venture capital or traditional bank loans.

In return for this high risk, the bank generally requires a higher interest rate margin compared to other traditional forms of credit.

Who is concerned

This type of financing is intended for medium and large-sized businesses which have long past the start-up stage and have strong growth potential but which are not yet ready to turn to the financial market to seek finance to fund the purchase:

  • of businesses;
  • of business assets;
  • of patents;
  • of licences, etc.

Prerequisites

Documentation or description of the business

  • copy of the company’s articles of association;
  • group structure if the company is part of a more complex group;
  • last 3 audited balance sheets of the borrower and, if applicable, the latest available trial balance;
  • order book (where applicable);
  • list of customers and their relative contribution to turnover;
  • list of suppliers.
  • forecast balance sheet and business plan for future years.

Presentation of the project

  • detailed description (including figures) of the planned investment and, where applicable, a market study;
  • financing plan;
  • calculation of feasibility and return and calculation of the breakeven point;
  • appendices:
    • preliminary sale agreement, due diligence, audited accounts, etc.;
    • forecast balance sheet and business plan.

Guarantees

The guarantees required by all banks before granting the loan are the solvency of the borrower and the profitability of the project to be financed. In addition, subordinated loans typically have a high rate of return. In exchange for the loan, banks generally do not require any guarantees, with the exception of moral commitments such as:

  • commitment not to withdraw (subordination of claim);
  • commitment not to distribute dividends until the loan is repaid;
  • maintaining the shareholder structure (Ownership Clause);
  • letter of intent;
  • allocation of the financing to expansion, strategic reorientation, succession or an MBO (management buy-out);
  • quarterly monitoring, notification of the business' figures, monitoring of financial requirements;
  • compliance with the business plan;
  • compliance with the various ratios (solvency, liquidity, profitability, etc.).

How to proceed

Duration and amount

Duration

  • medium to long-term;
  • generally between 5 and 10 years.

Amount

The amount of the subordinated loan depends on:

  • the quality of the application;
  • cash flow forecasts;
  • the proportion of injected capital;
  • whether or not there are any mezzanine loans.

Interest rate

  • interest rate depending on the quality of the client, the project and the guarantees offered;
  • fixed or variable rate;
  • higher interest rate than for traditional credit but not as costly as owned capital.

Repayment

Repayment depends on different criteria, including, for example, the amount, the rate, the amortisation period of the asset to be financed, etc.

In the majority of cases, given the size of the amounts involved, a junior loan is repayable in various forms:

  • constant annuity (repayment of the same amount each time, where the proportion of principal and interest varies);
  • constant amortisation (repayment of the same portion of the principal each time and varying amounts of interest);
  • balloon payment (sometimes referred to as bullet payment).

Set-up times

Given the amounts at stake, the risk taken on by the bank and the specificity of acquisition financing applications, the processing and reviewing times are generally longer than for traditional loan applications.

Advantages, disadvantages and risks

Advantages

  • greater freedom for the entrepreneur than is the case with self-financing (seeking finance on the financial market) thanks to creditors' restricted right of intervention;
  • increased stability of the financing thanks to the long-term availability of the funds borrowed;
  • tangible guarantees not generally required by the bank;
  • strengthening of the Basel 2 rating because these loans can be considered as owned capital and thus improve the business' solvency.

Disadvantages

  • higher margin than for a traditional loan;
  • high processing fees;
  • sizeable penalties for early repayment.

Risks

Risk of the company becoming over-indebted if the profitability analysis was not carried out meticulously.

Example

Financing the takeover of a business by combining different types of financing
  Amount Duration Repayment Priority

Takeover price of the business

100,000,000

/

/

/

Shareholders' equity

20,000,000

/

/

4

Subordinated loan (mezzanine loan)

15,000,000

8 years

Balloon payment

3

Subordinated loan

15,000,000

7 years

Balloon payment or annual

2

Traditional bank loan

50,000,000

6 years

Quarterly

1

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