When a business is performing well, going about its day-to-day business and paying its lenders on time and in full, investors usually do not pay much attention to the legal entity that issued the bond they have invested in.
However, in a liquidation, the legal entity that issued the bond plays a significant role in determining recoveries due to “structural subordination”. In the case of a company that may re-emerge as a healthy company following a change in how it finances itself, “structural subordination” also affects the bargaining power of all parties involved in such out-of-court restructuring. Typically, existing capital providers across the capital structure take losses in an out-of-court restructuring, although such losses are not evenly allocated. Creditors who would otherwise achieve a better outcome in a liquidation have more bargaining power over those who do not and may demand better recoveries for themselves even in out-of-court restructurings where outcomes are negotiated.
What is structural subordination?
Structural subordination is the concept that a lender to a company will only have access to the assets of the company’s subsidiary after all of the subsidiary’s creditors have been paid and any remaining assets have been distributed to the company as an equity holder. Let us assume Arthur lends money to a parent company and Beatrice lends money to a subsidiary of this parent company. In a liquidation of the group, it is only after Beatrice and any other creditors of the subsidiary have been paid that any remaining assets will be available to satisfy the claims of creditors at the parent company (including Arthur’s), ceteris paribus. In other words, Arthur’s claims are structurally subordinate to Beatrice’s. In the case of a parent company raising money through corporate bonds, Arthur is the bond investor who has invested in the bonds issued by the parent company. While the terminology differs, the same concept applies.
The concept of structural subordination is typically not codified as law. It mainly arises from a company’s corporate structure and where claims sit, governed by legal frameworks. That said, insolvency laws in key financing jurisdictions establish a hierarchy of claims, particularly in liquidations. The parent company is an equity holder of the subsidiary and equity holders are ranked at the bottom of the hierarchy of claims, while debt holders are ranked at the top. Specific types of debt and different types of equity are stacked differently at these two ends. While the hierarchy of claims sets out the rules of engagement as to who gets paid first in a liquidation, creditors may still challenge the treatment of their claims in court, which may alter outcomes.
Why does structural subordination happen?
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A holding company is a legal entity set up to hold equity stakes in other companies rather than operating its own businesses. Parent companies may also be holding companies, although not necessarily. Assume a simple corporate structure where a parent company that is a holding company (“HoldCo”) has only equity stakes in two separate operating subsidiaries. Each operates a different business, Opco One and Opco Two, and there are no legal guarantees across these three entities. In this case, aside from reputational repercussions, the holding company is legally insulated from either Opco One or Opco Two’s failure. In the case of a liquidation, creditors of Opco One and Opco Two have no right to go after the assets of HoldCo. However, as business operations are carried out by Opco One and Opco Two, these operating subsidiaries tend to own valuable assets and know-how to run the day-to-day business. The operating subsidiaries are also likely to employ staff and a management team and hold customer contracts.
Structural subordination happens as Opco One, Opco Two and HoldCo may be three separate borrowers. With assets and businesses, operating subsidiaries can typically borrow on their own credit standing. Despite holding companies not operating their own businesses, they typically own the equity stakes in operating subsidiaries and thus receive equity dividends from the profits that operating subsidiaries earn. In this case, we can assume both Opco One and Opco Two pay dividends to HoldCo.
Notwithstanding the issue of structural subordination, the value of HoldCo’s shares in Opco One and Opco Two and the equity dividends may mean that the holding company is attractive to creditors. This is particularly so if the returns from investing in HoldCo’s bonds are higher than investing in the standalone operating subsidiaries. Conversely, the credit risk from two different income sources (albeit in the form of dividends) may also be lower vis-à-vis lending to standalone operating subsidiaries with a single income stream.
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From the perspective of the parent company’s shareholders (in this case, the equity holders of HoldCo), the ability to maximise the capacity of the overall group to take on higher levels of debt may mean higher returns to shareholders. Instead of financing the business using more equity, using debt means fewer owners with whom to share the upside. As such, there is also a ready supply of holding companies demanding debt capital. In the corporate credit market, corporate bonds are typically issued at the holding company level on an unsecured basis.
Complications
While subordination can be embedded in corporate structures without factoring in the existence of security, structural subordination goes hand in hand with the lack of security as valuable assets and know-how sit at the operating subsidiaries instead of holding companies. As assets are typically pledged to obtain debt at the operating subsidiaries, creditors of the operating companies have the right to seize the secured assets in the event of a default. Returning to our illustration, if the group defaults, the claims at Opco One and Opco Two will be paid first. There may not be any assets left after to pay off HoldCo creditors.
Structural subordination issues may be compounded by a company history that includes expansions into many businesses, organically or through mergers and acquisitions. Cross-border activities with legal entities set up in multiple jurisdictions can complicate the corporate structure, as can the use of various financing instruments and guarantees. Together, these factors can result in difficulties in assessing the risk to different groups of creditors.
While the SGD credit market has not seen a wave of default in recent years, two notable issuers in the Asiadollar market have been trading at prices suggesting financial stress, namely China Vanke Co and New World Development Co. As developments at these two issuers unfold, lessons learned from previous defaults have taught us that in challenging circumstances, being far from the assets can result in diminished bargaining power compared to other creditors who have a direct claim on those assets.
Ezien Hoo, Andrew Wong, Wong Hong Wei and Chin Meng Tee are credit research analysts with OCBC’s Global Markets Research & Strategy team
