The mysterious structural subordination…

The mysterious structural subordination…

The “structural subordination” is a concept many treasurers do not know or simply heard of. What does it means and what could be the consequences? Why is it so important for Credit Rating Agencies? We will try to give you a better idea and answer these frequent questions. It is a good reason for centralizing and upstreaming all debts to the parent company of the group or the “holdco”.

Mysterious concept for many of us

In corporate finance, structural subordination is the concept that a lender to a company will not have access to the assets of the company's subsidiary until after all the subsidiary's creditors have been paid and the remaining assets have been distributed up to the company as an equity holder. For example, if a lender lends money to a parent company, then that lender is structurally subordinated to a lender who lent money to a subsidiary of the parent. The lender to the subsidiary is structurally senior, and the lender to the parent can only be repaid from the assets of the subsidiary after the lender to the subsidiary has been repaid.

What does it means in practice?

Certainly, one of the trickiest kind of restructuring questions surround structural subordination and the dynamics of “HoldCo” versus “OpCo” structures. These were a bit more popular to ask in restructuring discussions couple of years ago but seem to be much less popular now. We must mention that issues of structural subordination, upstream guarantees, and HoldCo / OpCo dynamics can be quite complicated in practice. Like anything else in restructuring, terms can mean whatever you define them to mean so you will often come across rather thorny or ambiguous scenarios. This is compounded by the fact that as organizational structures grow over time, they aren't always overly well thought out. This can lead to having wildly sprawling organizational structures with upstream, downstream, and cross guarantees many of which may be slightly differently defined. By making acquisitions, a group may have to consolidate indebtedness from (new) affiliates. The best way to try to build up the understanding of structural subordination is through a series of questions and answers. We can advise to start with some basic definitions, then get into a few example scenarios where structural subordination is playing a role.

What is the legal umbrella?

These HoldCo / OpCo structures are simply the ones where we have a series of operating companies – often either diverse in the countries they operate in or with eachaffiliate being dedicated to one major corporate project – and a parent company that owns the equity of these operating companies. The HoldCo – as the name implies – is like a legal umbrella under which all the operating companies coexist so the parent has ultimate ownership. Normally the affiliates are where the assets themselves reside and parent holds nothing other than the equity of the OpCos. At least secured debt is housed where the assets are located. As a lender you always want to be closest to where the assets effectively reside. There are several reasons (mainly historical, fiscal or simple business M&A operations) which can explain these unbalanced structures and risks it imply in terms of credit rating potential downgrading. It is therefore always better to centralize at the Holdco level (i.e., parent company) the maximum of debt if not all of them. Structural subordination is subordination by virtue of the company group structure, where indebtedness incurred at the parent or holding levels in a corporate group is subordinated to debt incurred at the subsidiary level.?The subsidiary-level creditors have first claim to the subsidiary assets while parent-level creditors are limited to a claim on the assets of the parent company, which typically consists only of equity in the subsidiary. If the parent company in a special-purpose vehicle (SPV) is set up exclusively for the financing, its revenues consist substantially or wholly of dividends on equity or payments on downstream loans since it has no operating revenues of its own.?If the operating subsidiary makes no distribution to the holding company, no funds may be available to the parent company to pay the lender.

Structural subordination, leverage mean at the expense of the credit rating

Structural subordination is typical of leveraged and real estate investment finance.?In real estate finance, the mezzanine loan is advanced, pursuant to a separate mezzanine facility agreement, to the holding company of the PropCos while the senior loan is advanced to the borrowers and the companies that own each individual property.?Since the HoldCo is higher up the corporate structure and structurally removed from the assets held by the PropCos, it is structurally subordinated.?This structurally subordinated entity (HoldCo) only has recourse to the shares in its subsidiaries (PropCos) and receives payment only after the senior loans to the PropCos has been serviced. Generally, debt obligations at a holding company level are structurally subordinated to the debt claims at the subsidiary level, irrespective of if the debt at the holding company level senior debt is. However, there can be legal provisions in place within the contractual loan agreement that can impact the precise methodology by which creditors are paid, e.g., the HoldCo senior debt could be treated as “pari passu” with the subordinated debt to the subsidiary. Specifically, an upstream senior guarantee by a subsidiary of the holding company can provide structural subordination of the senior debt at the holding company level, allowing the claims to be treated with the same priority. The seniority of an upstream guarantee is the determinant of the structural subordination of senior debt at the holding company level.

Acceptable limits of structural subordination

Therefore, as we can see this structural subordination is checked by credit rating agencies. If you have decentralized debt for more than 20% of your total indebtedness, it is recommended to upstream them to the parent. This 80-20 percent range is usually the maximum tolerance of rating agencies. In your treasury reporting, you must always control this level of structural subordination and alert the C-level of any major change to prevent a possible downgrading.

Fran?ois Masquelier, CEO of Simply Treasury – Luxembourg January 2023

Disclaimer: This article was prepared by Fran?ois Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).