Senior Debt: First in Line and Cheapest for the Borrower

Senior debt is the claim paid first out of whatever a borrower's assets realise, and it is usually secured by a charge over identified property. Being first is why the senior layer carries the lowest contracted rate inside one capital structure. In Nilgiri Direct Lending Fund I, invented, position 1 is a senior secured term loan of Rs 50,00,00,000 at 13.5 per cent. The rate prices rank, not the borrower.

Consider an ordinary queue, of the kind anybody has stood in. A bank branch has one counter open and forty people waiting. Being at the front of that queue does not mean the counter has money. The front of the queue means that if there is money, the person at the front is paid before the person behind, and if there is not enough for everybody, the shortfall starts at the back and works forward. Nobody in that queue has been promised anything. The people in it have been placed. Rank decides the order in which a shortfall is felt, and it decides nothing else.

The worked case throughout is Nilgiri Direct Lending Fund I, invented, a private credit fund managed by Nilgiri Alternatives Advisors Private Limited, invented, with Nilgiri Trusteeship Services Private Limited, invented, as its trustee. The fund has Rs 3,00,00,00,000 of commitments and has lent Rs 2,40,00,00,000 of cost across eight positions. Every rate quoted is that fund's own contracted rateThe rate written in the document, as distinct from anything actually received., written into its own documents.

Senior to what, exactly, and who agreed to wait?

Senior debtThe claim paid first out of whatever a borrower's assets realise. is a comparative. Nothing is senior in the abstract; a claim is senior to some other claim, and the interesting question is always which one and by what mechanism. There are exactly two mechanisms, they are independent of each other, and readers merge them constantly.

The first is contract. Another lender signs a document agreeing that it will be paid after this one. The signed agreement to wait is contractual subordinationAnother lender agreeing in writing to be paid after this one., and it is pure paper. No property is identified, nothing is pledged, and the whole of the arrangement is a promise between creditors about the order they will take money in. Think of two brothers who both lent money to a cousin's workshop, one of whom has written to the other saying he will not take a rupee back until the other is whole. The workshop does not change. The order does.

The second is security. A lender with security holds a charge over identified property, and that property answers the secured claim before it answers anybody without a charge over it. Here something specific is named: these machines, that building, those receivables. The reach of a charge and the way it is created are covered under the security package. A charge is a second and separate way of getting in front of somebody, and it points at things rather than at people.

A position can hold one source of seniority, the other, or both, and the three cases are genuinely different. A lender can be contractually senior with no charge at all, in which case it is first in the queue but the queue is for whatever happens to be left over generally. A lender can hold a charge while having agreed to rank behind somebody by contract. Position 1 of this invented book has both: it is a senior secured term loan of Rs 50,00,00,000 at a cash coupon of 13.5 per cent, with a first charge over fixed assets and a first charge over receivables. Separating the two sources is how anybody works out afterwards what the rate pays for.

There is a third thing readers sometimes reach for and it is worth naming so it can be set aside. Structural seniorityBeing owed by the company that actually holds the assets rather than by a parent above it. is being owed money by the company that holds the assets rather than by a parent company sitting above it. Structural seniority is neither contract nor security, only a fact about which entity signed.

What does being paid first actually mean when the money arrives?

Being paid first means an order, and only an order. When a borrower's assets are sold and the proceeds land, those proceeds are applied to claims in a sequence. The first claim takes what it is owed, or takes everything if there is not that much. Then the next claim takes what is left, or takes all of what is left. Then the next. When the money stops, everybody below that point receives nil, and their place in the sequence is the whole of the reason.

Something is missing from that description. Nobody has said how much money there will be. Being first means being ahead of the shortfall rather than inside it, provided there is enough to reach that far at all. An order of payment is a rule about sequence and it makes no statement whatsoever about the size of the pot. A rate ladder tends to erode that distinction.

One more mechanic belongs here because the worked case turns on it. Claims of the same rank do not queue among themselves. Equal claims share, and they share in proportion to their size. Sharing in proportion is pro rata sharingClaims of the same rank taking the same number of paise in the rupee.: if two claims stand equal and there is not enough for both, each takes the same number of paise in the rupee, and the bigger claim takes more rupees for exactly that reason. A landlord owed two months of rent by three tenants who each pay a third of what they owe is the same arithmetic. Every one of them is a third paid. Nobody in that group is ahead of anybody. Every claim holding a first charge over the same property forms one such group, a first-charge classEvery claim holding a first charge over the same property, sharing what that property realises., and inside it there is no queue at all.

Why is the layer that is paid first also the cheapest layer for the borrower?

Because the two facts are the same fact, seen from opposite sides of the table. A lender agreeing to stand behind somebody else is agreeing to be inside the shortfall rather than ahead of it, and the price of that agreement is written into the document as a rate. A lender standing first has not made that concession, and its contracted rate reflects that it has not.

Consider two people lending Rs 1,000 each to two cousins running the same tea stall. One lender will be repaid out of the first takings; the other has agreed in writing to be repaid only after the first is whole. The second person is not lending to a worse stall. The stall is the same, the day is the same, the takings are the same. The second person is standing in a different place, and if that person is going to sign, the rate goes up. The concession and its price are the entire economics of a rate ladder inside a capital structureEverything a business owes and everything it has issued, set out in the order it is paid., and it is why the ladder exists at all.

The rate gap between two layers of the same borrower is a price for rank and security, and it says nothing about whether either lender will be paid. Read that sentence twice. Readers accept it and then quietly stop believing it as soon as the ladder is drawn.

What do the contracted rates on one invented book actually look like?

Here are five positions of Nilgiri Direct Lending Fund I, invented, set out by their place in their own borrower's order rather than by size. Every rate below is this invented fund's own contracted rate. Position 1 is the senior secured term loan of Rs 50,00,00,000 at 13.5 per cent. Position 4 is a senior secured loan of Rs 35,00,00,000 at 13.0 per cent with a first charge. Position 2 is a unitranche facility of Rs 45,00,00,000 at a blended 15.0 per cent with a first charge over all assets. Position 3 is mezzanine debt of Rs 30,00,00,000 as originally contracted at 11.0 per cent paid in cash plus 5.0 per cent paid in more debt, being 16.0 per cent in total, secured by a second charge. Position 5 is subordinated debt of Rs 20,00,00,000 at 16.0 per cent, unsecured, ranking behind a bank.

Two things about that list correct the reading a reader is most likely to arrive with. Position 1 does not carry the lowest contracted rate on this book: position 4 does, at 13.0 per cent against position 1's 13.5. Two senior secured positions, both with a first charge, half a point apart. Position 3 ties position 5 at 11.0 cash plus 5.0 in kind, so 16.0 per cent is not uniquely the highest either. The ladder is a ladder of layers, not a league table of positions, and two positions on different rungs of different borrowers can sit at exactly the same rate without any of it being strange.

A rate on its own is an abstraction and a coupon is not, so the ladder is worth putting into rupees. Position 1 at 13.5 per cent on Rs 50,00,00,000 is a contracted Rs 6,75,00,000 a year. Position 4 at 13.0 per cent on Rs 35,00,00,000 is Rs 4,55,00,000. Position 5 at 16.0 per cent on Rs 20,00,00,000 is Rs 3,20,00,000. And one arithmetic coincidence on this book is worth pausing on because it dismantles a lazy reading: position 2 at 15.0 per cent on Rs 45,00,00,000 produces a contracted Rs 6,75,00,000 a year, exactly the same rupees as position 1 at 13.5 per cent on Rs 50,00,00,000. A higher rate on a smaller principal, and the annual coupon is identical to the paisa. Whatever the rate ladder shows, it does not show which position produces more money.

Position 3 did not stay where the table puts it. Its terms were reset in a workout after a covenant test, and that reset is covered separately. The table states position 3 as originally contracted, and a rate ladder is read in that state.

How much was the rank worth on the one default this book had?

Rs 9,00,00,000, and the arithmetic that produces it follows. Every number in it belongs to one invented realisation of one invented enterprise.

Take the sequence in order. Position 5 of this book, subordinated debt of Rs 20,00,00,000 at 16.0 per cent, unsecured, ranking behind a bank, was the one position that defaulted. Its borrower missed a coupon in Year 3 Q1 and did not cure it. The enterprise behind it was sold in a distressed sale for Rs 68,00,00,000. The claims were paid in this order. A bank's senior secured term loan of Rs 60,00,00,000, with a first charge over fixed assets and receivables, was met in full at 100 paise in the rupee. Then the fund's unsecured Rs 20,00,00,000 took the residual Rs 8,00,00,000, being 40 paise in the rupee. Then the borrower's own ordinary shares received nil. Check the sum: Rs 60,00,00,000 plus Rs 8,00,00,000 is Rs 68,00,00,000, and nothing at all reached the shares.

Now the counterfactualA worked variation on a real case, stated as a variation and never as what happened.. A counterfactual is a worked variation on the case and never what happened. Suppose the fund's same Rs 20,00,00,000 had sat in the first-charge class alongside the bank's Rs 60,00,00,000. Same enterprise, same distressed sale, same Rs 68,00,00,000, same day. The class would then claim Rs 80,00,00,000 against Rs 68,00,00,000 realised, and equal claims share pro rata. The bank takes 60 over 80 of Rs 68,00,00,000, being Rs 51,00,00,000. The fund takes 20 over 80 of Rs 68,00,00,000, being Rs 17,00,00,000 and 85 paise in the rupee. Check the sum again: Rs 51,00,00,000 plus Rs 17,00,00,000 is Rs 68,00,00,000.

Rs 17,00,00,000 against Rs 8,00,00,000 is a difference of Rs 9,00,00,000 on the same enterprise on the same day, and not one fact about the borrower moved between those two figures. The borrower was not better run in the counterfactual. The enterprise did not sell for more. Nobody found a buyer at a higher price. The only thing that changed is where the claim sat and what it could reach, and that alone is worth Rs 9,00,00,000 on a Rs 20,00,00,000 exposure.

The counterfactual is not free money, and a symmetry in the figure shows why. The Rs 9,00,00,000 the fund gains in the counterfactual is exactly the Rs 9,00,00,000 the bank gives up: the bank falls from Rs 60,00,00,000 to Rs 51,00,00,000, from 100 paise to 85. The realisation did not grow. The document redistributed it.

What does the senior lender give up in exchange?

Everything that goes right. An account that describes only what the senior position gets has described half of a two-sided arrangement, so the giving up is worth stating at the same length as the 85 paise.

Position 1 is a term loan of Rs 50,00,00,000 at 13.5 per cent. If the borrower behind it doubles its earnings, opens in four new districts, is sold to a strategic buyer at a price nobody imagined at drawdown, and the shareholders walk away with a fortune, position 1 receives Rs 6,75,00,000 a year and its Rs 50,00,00,000 back. If the borrower merely survives, coughing along at exactly the size it was, position 1 receives Rs 6,75,00,000 a year and its Rs 50,00,00,000 back. The ceiling on a lender's return is unconditional and it is written into the same document that put the lender first.

The trade fits in one line: standing first buys a place in an order and pays for it by giving up every rupee above a fixed number. A shareholder has the opposite arrangement, standing last in the order and keeping whatever is left after everybody in front is paid. On the realisation worked above that was nil. Neither arrangement is the better one. Lender and shareholder are different instruments doing different jobs in the same structure, and a reader who cannot say what each one gives up cannot read either of them.

Why would a borrower want a senior layer at all?

Because it is the cheapest money available to it, and because the alternative is paying a subordinated rate on the whole amount. Look at it from the other side of the table for a moment. A borrower needing Rs 80,00,00,000 that raises all of it from lenders willing to stand behind everybody will pay a subordinated rate on all Rs 80,00,00,000. A borrower that carves the first Rs 60,00,00,000 into a secured senior layer pays the senior rate on three quarters of the money and the subordinated rate only on the remainder. The layering is what makes the total bill smaller.

A reader who only sees the ladder never sees who paid for it, so here is the cost of the ladder in rupees. On position 1 the borrower pays 13.5 per cent on Rs 50,00,00,000, being Rs 6,75,00,000 a year. As a variation, the same Rs 50,00,00,000 at position 5's contracted 16.0 per cent would cost Rs 8,00,00,000 a year, being Rs 1,25,00,000 more every year that the loan is outstanding. The borrower saved that Rs 1,25,00,000 by having somewhere to put a first charge and something worth putting it over.

But there is a consequence the layering creates and it lands entirely on the lenders below. Putting Rs 60,00,00,000 of first-charge debt into a structure means every claim beneath it is a claim on what is left after Rs 60,00,00,000, whatever those lower claims say about themselves. The subordinated lender in the realisation above did not have a claim on an enterprise. The subordinated lender had a claim on the part of an enterprise above Rs 60,00,00,000, and the enterprise happened to realise Rs 68,00,00,000, so that part was Rs 8,00,00,000. The size of that slice is the whole of why the recovery was 40 paise, and the senior layer's existence is a fact about the structure rather than a fact about the senior layer.

How does somebody reading a real document actually use this?

Three ways, and each of them is a habit rather than a technique. The three habits are what survive after the arithmetic has faded.

First, when a claim appears in a document, the question is what puts it where it is. Is it a contract in which somebody agreed to wait, is it a charge over identified property, is it both, or is it neither and the claim simply has nothing in front of it yet? An analyst who cannot separate those has no way to tell a rate that prices a genuine first charge from a rate that prices a promise somebody made on paper. A lender's credit committee asks it the other way round: what did the lender get for the points it gave away.

Second, always name the denominator. Position 1 is 20.8 per cent of the Rs 2,40,00,00,000 this invented fund has actually lent, and it is 16.7 per cent of the Rs 3,00,00,00,000 it has commitments for. Both sentences describe the same Rs 50,00,00,000 loan and they differ by more than four percentage points. A concentration figure quoted without its denominator has said almost nothing, and the reader who does not ask which one is in use will compare two numbers that were never comparable. The same discipline applies to a recovery: 40 paise in the rupee is 40 paise of a Rs 20,00,00,000 claim and would be a different quantity of money on any other claim.

Third, the two halves of the trade belong together. When somebody presents the recovery a senior position achieved, the question is what its ceiling was, and when somebody presents a high contracted rate, the question is what that lender agreed to stand behind. A household deciding whether to lend a relative money against the shop or without any security at all is running the same two-sided question at a scale it can feel: the security changes what the lender can reach, and the rate is the price of not having it. On this invented book the whole arithmetic of that trade fits into one line. One default out of eight positions wrote off Rs 12,00,00,000, being Rs 20,00,00,000 of cost less the Rs 8,00,00,000 recovered. The write-off is 5.0 per cent of the Rs 2,40,00,00,000 lent.