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6. Unsecured Debt
Unsecured debt offers investors higher interest rates but without any need to put up collateral. Other characteristics of unsecured debt are also explained in this lesson.
Lesson Goal (00:04)
The goal of this lesson is to learn about the properties and types of unsecured debt.
Properties of Unsecured Debt (00:19)
Unsecured debt is debt which has no collateral. As a result, interest rates on unsecured debt tend to be higher than for secured debt. Interest rates tend to be fixed, not floating. There is no amortization - the principle is only paid back at the end of the loan. As a result, the cashflow profile of unsecured debt is better than for secured debt. Unsecured debt may include covenants, but these tend to be less restrictive than for secured debt. Prepayment is not normally allowed.
Unsecured debt is usually offered by investors with a high risk appetite, such as merchant banks or investment funds. Borrowers may also be offered payment-in-kind terms. This means that no payments of interest or principal are required until the end of the loan.
With payment-in-kind terms, the interest payments are calculated each year, and added to the principal value of the loan. At the end of the loan period, the principal and interest are paid in a single payment, called a bullet payment. These payment terms create a high total amount of interest, but this is offset by the fact that this interest does not have to be paid until the very end of the loan.
Types of Unsecured Debt (02:45)
There are several different types of unsecured debt. All have high interest rates, longer durations than secured debt, and a bullet payment at the end.
- Senior Notes: These tend to have shorter durations and lower interest rates than other unsecured debt types. They may sometimes require security.
- Subordinated Notes: These have a higher interest rate and a longer duration than senior notes, and are always unsecured.
- Mezzanine: This is a particularly high-risk option, with a very high interest rate and a long duration. Mezzanine lenders may also have equity options attached to the loan.
Companies seeking to take on debt want to balance the lowest possible costs with the fewest restrictions and the best cashflow profile. This often involves mixing secured and unsecured debt, and mixing different debt instruments.
In the previous lesson, we explored secured debt and the different forms it can take in a leveraged buyout. In this lesson, we'll move on to unsecured debt and explore the characteristics of this debt instrument. As you may have guessed, unsecured debt has no collateral, so if a company defaults on its debt, lenders cannot automatically rely on collateral for repayment.
Consequently, interest rates on this type of debt tend to be higher. Interest rates also tend to be fixed, not floating, but the cash flow profile tends to be better, because the principal is normally paid back at the end of the loan rather than during the loan. This reduces the strain on the cash flows of the company.
With unsecured debt, there also tends to be covenants similar to secured debt, but these covenants are not as onerous.
Prepayment on the other hand, is not normally allowed and the typical providers of unsecured debt are merchant banks, hedge funds or specific high-yield debt funds, and generally investors with a greater risk appetite than those that provide the secured debt. In certain circumstances, investors will offer borrowers payment-in-kind terms, and this means that the borrower does not pay any interest or any principal until the end of the loan. Here's how it works. The interest is not paid at all during the life of the loan but added to the balance of the principal. The interest payment and principal are all paid at the end of the loan period in what's called a bullet payment.
To understand how the mechanics of this works, let's take an example of a one million dollar loan at 10% interest due in three years.
Below, I've included the workings to calculate the bullet payment at the end of year three. The interest incurred in the first year of 100,000 is added to the ending principal for that year. This then becomes the beginning principal for year two and as a result, the interest incurred in year two is greater than for year one.
This compounding effect results in a greater total interest being paid at the end of the loan. However, the cash flow profile of the loan is very borrower friendly, with no payments made in year one or year two.
On the next slide, I've included three examples of unsecured debt, from senior notes right through to subordinated notes and on to mezzanine.
Mezzanine in particular is high-risk lending and in certain circumstances, mezzanine lenders can also get equity options attached to the loan, which means the lender may end up owning some shares in the business as well. It's important to note that these descriptions are general rules and companies can be as creative as they wish when putting a debt structure in place. Ultimately, private equity firms, such as Priveq, want to balance the lowest cost of debt with the best cash flow profile and unrestrictive covenants. A mix of these components will result in a debt package that often contains both secured and unsecured debt, as you'll see with MarkerCo in the next lesson.