Sponsors and lenders are constantly looking for new avenues to broaden the capabilities of subscription credit facilities. Particularly with larger credit facilities, sponsors are more willing to front-load additional costs of implementing more complex mechanics to help maximize flexibility and future efficiency, with the view such front-loading will ultimately reduce costs over the life of the facility. For example, parties are increasingly structuring subscription credit facilities to permit multiple tranches, each structured to address a sponsor’s specific needs.
Historically, subscription credit facilities have been structured as single-tranche revolving credit facilities (and most tranches, if any, have been primarily geared towards temporary increases, uncommitted leverage and even term loans). Over time, subscription facility tranche structures have evolved into more complex multi-tranche facilities, such as utilizing one or more subordinated tranches (each, a “Subordinated Tranche”) in addition to the senior revolving tranche(s) (each, a “Senior Tranche”) to allow a sponsor access to greater liquidity.
We have seen a notable uptick in credit facilities (though, primarily larger facilities) utilizing Subordinated Tranches since we last explored the topic in 2024 and we anticipate this trend to continue. Nevertheless, it is important to understand this is an ever-evolving area in subscription finance with no clear “market standard” and everything is heavily negotiated for each specific transaction.
This article focuses on a high-level overview of Subordinated Tranches and discusses key considerations for some of the more commonly negotiated provisions to be aware of when implementing Subordinated Tranche mechanics.
Subordinated Tranches
At its most basic level, a Subordinated Tranche, which can be structured as either a term loan or revolving line of credit, is an additional financing layer available to the borrowers which sits below the Senior Tranche in the priority and payment waterfall. In a typical multi-tranche facility with a Subordinated Tranche, the Senior Tranche has first priority over the borrowing base and related collateral, while the Subordinated Tranche has a secondary claim to the same collateral.
Although lenders under a Subordinated Tranche are typically willing to accept the incremental credit risk that comes with this subordinated position in exchange for enhanced pricing and fees, it is important to understand the key risk for subordinated lenders: that is, the potential of no recovery in a scenario involving significant investor defaults or fund-level distress, as subordinated lenders have no right to any recovery until all obligations under the Senior Tranche have been repaid in full.
Given this risk is inherent in the Subordinated Tranche structure, the credit agreement must be drafted to ensure all potential issues have been taken into consideration in the event such a default scenario occurs to sufficiently limit the risk of excessive losses under the Subordinate Tranche beyond the credit risk appetites of the subordinate lenders.
Sponsors will generally seek maximum borrowing capacity and flexibility to upsize the facility with minimal conditions, while lenders—particularly the lenders under the Senior Tranche—will seek to ensure the introduction of a Subordinated Tranche does not dilute their collateral coverage or otherwise impair their chances of repayment.
Unsurprisingly, the specifics surrounding order of priority in a default scenario, inter-creditor agreements between tranches, voting and other key items are heavily negotiated.
Key Mechanics
One of the primary questions is how the Subordinated Tranche will interact with the Senior Tranche and, more importantly, the borrowing base as the source of the collateral. As noted above, in addition to being subordinate to the Senior Tranche, a Subordinated Tranche will often have different pricing, maturity dates, advance rates and other tranche-specific terms. Subordinated Tranches may also have different—or entirely separate—representations and warranties, covenants and/or events of defaults.
Security Structure and Payment Waterfall
As previously noted in this newsletter, the security structure in multi-tranche facilities with one or more Subordinated Tranches can be accomplished through either (i) lien subordination or (ii) payment subordination (which tends to be the preferred approach). For lien subordination, the lenders of the Senior Tranche and Subordinated Tranche are granted separate security interests in the same collateral, but the Senior Tranche takes a first-priority position while the Subordinated Tranche takes a secondary position behind the Senior Tranche. Alternatively, a payment subordination structure enables the lenders of both the Senior Tranche and Subordinated Tranche(s) to each take a single first-priority security interest in the same collateral, while the specific order of priority in an event of default is set out in the credit agreement itself.
The payment waterfall mechanics are extremely important, heavily negotiated and must be carefully structured. While the payment waterfall can be structured in a myriad of ways, the one constant is that the Senior Tranche is given first priority in repayment (at least in a default scenario), while a Subordinated Tranche is only repaid after the Senior Tranche has been repaid in full, and only to the extent of the remaining collateral.
However, there are usually exceptions to this general rule with respect to repayments if no event of default or potential default exist and are continuing—for example, to allow the borrowers to repay amounts drawn under the Subordinated Tranche first (given the higher borrowing costs) in the absence of a default, including in full, where the fund no longer needs such added liquidity but still wishes to leave existing draws on the Senior Tranche outstanding. In any event, this is something that needs to be negotiated and built into the credit agreement from the outset.
Hard-Wired Mechanics and Open-Ended Terms for Future Subordinated Tranches
In many instances, a sponsor looking to implement Subordinated Tranche mechanics will not have an immediate need to draw on a Subordinated Tranche (e.g., in a new facility) if the cheaper Senior Tranche has not been fully drawn. Due to the increased pricing that comes with a Subordinated Tranche, a sponsor typically would not want to utilize a Subordinated Tranche until they have nearly maximized utilization under the Senior Tranche.
As such, parties typically elect to build out hard-wired mechanics for future tranches to be established down the road without the need to overhaul the existing credit agreement and other loan documents in an amendment at such time the need for a Subordinated Tranche first arises. Thus, the negotiations generally focus solely on the underlying structure and mechanics, such as conditions precedent, a form of request for a Subordinated Tranche, covenants, events of default, mandatory prepayments and voting, rather than specifics like maturity dates, pricing (including unused fees) or other tranche-specific terms, which might be left open-ended for the parties to agree at the time a Subordinated Tranche is requested.
The implementation of Subordinated Tranche mechanics in a credit agreement allows a fund to upsize the facility at a later time when a Subordinated Tranche is introduced, subject to an aggregate cap on the total maximum commitment across all tranches. In addition, the Senior Tranche and each new Subordinated Tranche will also be assigned its own maximum commitment.
The credit agreement mechanics may further allow flexibility for the sponsor to choose between a term or revolving Subordinated Tranche at the time of the request. In the case of a term loan Subordinated Tranche, the lenders may require the term loan to be fully drawn on day-one, while allowing subsequent Subordinated Tranches to be requested and drawn at later dates. However, sponsors may push for a delayed-draw feature for a term loan Subordinated Tranche to further maximize their flexibility.
In addition to typically having additional or entirely separate representations and warranties, covenants and/or events of default, Subordinated Tranches will necessarily have different conditions precedent to the establishment of a new tranche, though the general form for such a request typically follows that of a borrowing request (albeit far more built out, including the previously open-ended terms such as pricing, tenor, etc.). Drafting a credit agreement to enable some terms to apply across all tranches while limiting others to apply only to certain tranches requires more technical drafting for otherwise standard provisions to ensure there are no conflicts and the mechanics for both the senior and subordinated tranches work together as a whole.
Voting
The allocation of voting rights between the Senior Tranche and Subordinated Tranches can be contentious but is something that should not be overlooked at the time the Subordinated Tranche mechanics are built into a credit agreement. One issue that may arise is whether an event of default under a Subordinated Tranche be cured or waived without the consent of the lenders under the Senior Tranche.
Senior lenders will typically require protections to prevent adverse votes or amendments to the borrowing base, collateral or other material terms in the event the lenders under one or more Subordinated Tranches hold a majority, whereas the subordinate lenders will typically require similar protections to ensure their rights under the credit agreement and to the collateral are not unfairly diminished. Considerations should be given to avoid potential voting issues, such as wehher to bifurcate the “Required Lenders” definition to allow lenders of only one tranche to have a consent right on matters only affecting such tranche.
Other considerations arise when the sole or primary subordinate lender is also the administrative agent—the sponsor may push to give the administrative agent the greatest voting rights of all lenders, since the administrative agent has the closest relationship with the sponsor in the facility and is better positioned to provide approvals more quickly than the rest of the syndicate lenders. While the administrative agent, in its capacity as a subordinate lender, will still want to maintain the same voting and repayment safeguards, it may equally want to ensure all syndicate lenders are sufficiently represented. In its capacity as a subordinate lender, the administrative agent will likely seek to avoid the risk of potential conflicts of interests from the perspective of non-subordinate lenders if the subordinate terms (or administrative agent voting rights) appear overly broad or favorable to the administrative agent.
Expanded Lender Pool and Non-Bank Lenders
Another unique feature Subordinated Tranches can introduce to a subscription facility is the ability for such tranche to be offered not only by existing lenders under the Senior Tranche, but also new lenders who may only be brought in as subordinated lenders. While the Senior Tranche will generally be held by large commercial banks with more experience in the market, the Subordinated Tranche may attract new entrants, including non-bank lenders, smaller regional banks, other sponsors or even institutional investors seeking exposure to the subscription credit market that find the risk-adjusted returns from the subordinated position attractive. Opening the pool of potential lenders to these non-traditional subscription line lenders offers the sponsor greater flexibility in finding the right fit for the specific financing need and at the best price.
Given the lenders for a future Subordinated Tranche may not be known at the time the mechanics are built into the credit agreement, the parties will want to structure other provisions to account for the additional unknowns. For instance, the existing lenders will likely want to ensure letters of credit are only offered under the Senior Tranche to avoid fronting for unknown lenders that may join in the future under a Subordinated Tranche. Relatedly, sponsors may push for expansions on the confidentiality and competitor provisions.
Concluding Thoughts
As the subscription market has matured, fund sizes have grown and uses of credit facilities have expanded beyond simple bridge financing, the market has responded with increasingly sophisticated structural features tailored to best suit a particular sponsor, fund and the anticipated needs over the course of a fund’s life.
Subordinated Tranches are an exciting trend that is gaining momentum among some larger facilities to allow sponsors to maximize flexibility and enhance access to liquidity through a higher effective advance rate in exchange for paying a higher spread for a Subordinated Tranche. Similarly, Subordinated Tranches offer lenders greater returns in exchange for taking a subordinated position. They also open the door for new entrants in the subscription finance lending space and, whether a subscription finance veteran or a new entrant, lenders who are active in Subordinated Tranches can use this as a way to stand out in the market, expand existing or even build new sponsor relationships. The implementation of Subordinated Tranches is not for every facility, and generally only makes economic sense in larger syndicated facilities where a sponsor has or realistically expects the need.
While the use of Subordinated Tranches in the subscription finance market is still evolving and implementing their mechanics will not make sense for every facility, they are nevertheless a compelling and increasingly mainstream tool in the subscription finance toolkit, and reflect the continued sophistication and maturation of the fund finance market. As these structures continue to become more prevalent in the market, sponsors, lenders and investors alike should take note of this trend and can benefit from understanding not only the risks, benefits and strategic applications, but also the many technicalities and key items that must be addressed when considering whether Subordinated Tranche mechanics would be right for a particular facility.