As credit investors go searching for yield in today’s marketplace, junior capital could be just the ticket, providing lenders and investors with superior returns and borrowers with greater flexibility and capital access.

After a challenging 12 months, savvy credit investors are back on the lookout for yield in a landscape where the consensus view and forward SOFR curve point to lower interest rates. Junior capital — which encompasses a range of instruments, including subordinated debt, mezzanine debt, convertible debt and preferred equity — presents a compelling option for those hunting for yield in a market where spreads on senior and first lien debt are at historically tight levels.

Rather than investing in lower-quality businesses (and taking on the risk of the higher default rates that coincide with such a step-down in borrower quality), credit investors can enhance portfolio yields by simply moving down the capital structure to provide junior capital to high-quality companies. Moreover, junior capital tends to be more influenced by company-specific performance as opposed to macro conditions and the Federal Funds Rate, allowing investors with strong security selection to outperform across nearly all market conditions.

From a borrower’s perspective, junior capital provides a blend of debt- and equity-like features that can deliver enhanced flexibility, risk mitigation and growth-oriented capital.

JUNIOR CAPITAL: AN INTRODUCTION

As mentioned earlier, junior capital encompasses a variety of instruments, and it occupies a mid-tier position in the capital structure, sitting above common equity but below senior debt in terms of seniority.

Seniority can take multiple forms, including temporal, structural, payment and effective. This article will focus on payment seniority, which often comes to light in the event of a (simplified) bankruptcy, as senior debt must
be made whole (100% recovery) prior to junior debt receiving any type of recovery. Likewise, junior debt must be made whole prior to common equity receiving any form of recovery.

BENEFITS FOR BORROWERS

At a high level, junior capital can allow a company to attain more leverage and capital than would be possible using solely senior debt and common equity. In addition, it also tends to be more flexible and customizable in terms of payment structure, allowing a company to align cash generation more accurately with cash interest payments, an especially attractive feature at a time when interest rates have increased. Let’s dive a bit more deeply and look at the three main attractions of junior capital for borrowers:

1. Preservation of Control

Companies often gravitate toward junior capital as a strategic financing option primarily because it enables them to raise necessary funds without diluting the ownership stake of existing shareholders. Junior capital, by its nature, offers a middle ground between senior debt, which might come with stringent covenants, and equity, which can dilute the ownership and control of existing shareholders.

Opting for junior capital can enable companies to secure additional funding that is less impactful on corporate governance and operational control than equity financing. While equity investors may seek voting rights or board representation as a condition of their investment, junior capital providers typically do not. This means that companies can access the capital they need for growth or operational needs without the pressure of diluting their existing equity holders or altering the company’s strategic direction to appease new equity holders.

2. Customization

Junior capital distinguishes itself by offering structurally flexible financing options that align more closely with a company’s cash flow and growth trajectory than traditional senior loans. While senior loans typically have 1% mandatory amortization per annum, junior debt may forgo this requirement while also offering more tailored terms such as extended maturities, payment-in-kind (PIK) interest and/or warrants. This optionality can enable businesses to minimize near-term cash outflows for debt financing to help support large capex plans or temporary operational challenges.

The customization of junior capital also can allow a company to tailor facilities to minimize near term cash interest and execute growth plans in exchange for equity conversion, warrant accrual or some form of cash interest
holiday. While the interest rate will be higher than senior debt, it likely will remain well below the cost of equity.

Moreover, junior capital availability can be a resilient source of financing during economic downturns relative to broader capital markets, likely due to the stability of capital bases as well as the comfort and experience junior capital providers have when it comes to analyzing higher risk levels.

In exchange for providing capital during periods of operational weakness or economic turmoil, junior lenders expect to receive significantly higher rates, often with features such as equity kickers and exit fees to improve their economics. By adopting features like PIK interest or warrant accrual, borrowers can retain the ability to preserve cash in the short term while offering lenders greater upside as results recover. This strategic flexibility makes junior capital an essential tool for businesses navigating through varying economic landscapes, expansion plans or operational disruptions, ensuring they can continue to access necessary funds even when the broader capital markets tighten.

3. Strategic Credit Enhancement

In the world of corporate finance, borrowers often turn to junior capital as a strategic tool to maximize leverage without adversely affecting their credit profile. This approach can be particularly valuable when a company’s
senior secured leverage ratio approaches critical levels (whether related to covenants or loan-to-value (LTV) thresholds), limiting their capacity to raise additional senior debt. Using junior capital allows companies to continue funding their growth initiatives or bolstering liquidity without breaching covenants or impacting their credit standing.

Consider the simplified scenario in which a company has a senior net leverage ratio of 6x, measured as a net senior debt/EBITDA ratio against an enterprise value/ EBITDA ratio of 10x. This leaves a 4x “equity cushion” — a gap
that would absorb the first losses and provide senior lenders with a sense of security, possibly resulting in the senior debt at a spread of SOFR plus 500 basis points (bps).

Should the company opt to increase its first-lien leverage by an additional 1x, diminishing the equity cushion to 3x, senior lenders might grow wary of recovery rates in the event of bankruptcy. This apprehension could prompt
them to demand a higher yield, say S+600, to compensate for the perceived increased risk.

In contrast, by integrating junior debt, companies can maintain the 4x cushion for senior lenders and avoid triggering demand for higher spreads from those holding senior positions while still allowing the company to secure
necessary capital.

Junior capital serves as a strategic tool, providing additional funding while also preserving a company’s credit attractiveness, preventing any tightening of credit terms and increases in the cost of capital from senior lenders.

INVESTOR APPEAL

From an investor’s perspective, meanwhile, the increase in risk that comes with moving down the capital stack should be fully compensated for by higher expected returns, resulting from higher quoted interest rates and/or equity upside. Junior capital, on average, can deliver approximately 150-250 bps of incremental return for publicly traded bonds and closer to 250-450 bps for private credit junior capital. Moreover, should an investor be willing to extend the effective duration of its exposure via PIK and/or equity warrants, there may be additional upside to the pick-up in spread or expected return. Let’s unpack the drivers of enhanced junior capital returns for investors.

For credit investors, the allure of junior capital investments lies in their unique position within the capital structure, as they offer a compelling blend of risk and reward for investors with a slightly higher risk tolerance than senior debt lenders.

Despite its subordinate rank, which inherently carries higher risk due to its placement below senior debt, junior capital can provide investors with the potential for superior returns via higher interest rates and the potential of an “equity kicker,” such as options for conversion to common equity or the issuance of warrants, which is a common ancillary feature in junior debt.

Convertible debt, preferred equity or other equity-linked debt instruments allow investors to maintain a slightly elevated position in the capital structure in the event of financial distress, providing a safer vantage point than direct equity holders. However, in scenarios in which the company thrives, these investors stand to gain significant upside, transforming risk into a lucrative opportunity. Such dynamics are particularly appealing to those with an appetite for higher risk, as it can lead to portfolio diversification with investments that offer greater yield and the chance to partake in the company’s growth without immediate equity ownership.

Junior capital investors may also be willing to extend more flexible financial terms to borrowers, such as accepting PIK or agreeing to equity conversions in exchange for lower cash interest payments. This flexibility can
dramatically enhance the investor’s internal rate of return (IRR) or return on invested capital (ROIC), creating a longer-term commitment to the borrower’s success.

In essence, junior capital investments embody a strategic avenue for investors aiming to balance their portfolio’s risk-reward profile, offering a path to potentially higher returns through calculated exposure to the capital
structure.

In a comprehensive study by the University of Chicago1, for example, researchers found that the average spread differential between secured and unsecured bonds at the time of issuance hovered between 150 and 250 bps for publicly traded bonds. In the private credit market, the differential is usually closer to 250 to 450 bps (inclusive of original issue discount (OID) and spread), providing incremental return in exchange for the lack of liquidity. This observation aligns with a Federal Reserve study² indicating that investors in junior capital, such as unsecured bonds, display heightened sensitivity to macroeconomic shifts.

Given that junior capital ranks lower in the repayment hierarchy during bankruptcy, resulting in lower recovery rates, it’s naturally more vulnerable to broader economic trends, but investors are compensated by the higher
potential returns.

A WINDOW OF OPPORTUNITY

The flexibility that junior capital can offer borrowers, and the opportunity it presents for lenders and investors to secure higher yields, positions junior capital strongly in the current market environment.

The higher overall cost of funds from rising rates has had a short-term hit on borrower cash flows. Companies, however, still want to grow, and the flexibility junior debt offers will provide a runway to readjust business models. For lenders prepared to offer that flexibility in order to secure higher yields, this could be the perfect time to ramp up junior capital provisions. •

¹ Benmelech, E., et al., Secured Credit Spreads. Becker Friedman Institute for Economics at UChicago. February 2020.
² Arias, M. and Wen, Y., Secured and Unsecured Debt Over the Business Cycle. St. Louis Federal Reserve. February 2017.

René Canezin is managing partner and Ryan Dregney is an associate of Evolution Credit Partners, an alternative credit investment company.