Seniority
Why Seniority Matters
Seniority answers one question: who gets paid first? When a company is healthy and generating cash, everyone gets their due — interest payments go to lenders, dividends go to shareholders, and the order barely matters. But the moment a company can’t cover all its obligations, seniority becomes everything.
This priority structure directly drives the cost of each layer. Senior secured lenders accept lower interest rates because they’re first in line with collateral backing them. Subordinated debt holders demand more. Common equity holders — last in line with no guaranteed claim — require the highest return of all. This is why the cost of equity always exceeds the cost of debt in the WACC calculation.
The Capital Stack: Full Priority Order
The “capital stack” is the complete hierarchy of claims on a company’s assets, ranked from highest to lowest priority:
| Priority | Layer | Security / Collateral | Typical Recovery in Bankruptcy |
|---|---|---|---|
| 1 | Senior secured debt | Backed by specific assets (real estate, equipment, receivables) | 60%–80%+ |
| 2 | Senior unsecured debt | No collateral, but senior claim on all remaining assets | 40%–60% |
| 3 | Subordinated debt | Ranks below senior claims; only paid after senior is made whole | 20%–40% |
| 4 | Mezzanine debt | Junior unsecured, often with equity warrants or conversion features | 10%–30% |
| 5 | Preferred equity | Priority over common equity but behind all debt | 5%–20% |
| 6 | Common equity | Residual claim — gets whatever is left after everyone else | 0%–10% |
Secured vs. Unsecured Debt
The first major dividing line in seniority is whether the debt is secured by specific collateral.
Secured debt is backed by a lien on identified assets — inventory, accounts receivable, real estate, equipment, or intellectual property. If the borrower defaults, the secured lender can seize and liquidate those assets to recover its claim. This makes secured debt the safest position in the capital stack, which is why revolving credit facilities and term loans from banks are almost always secured.
Unsecured debt has a general claim on the company’s assets but no lien on specific collateral. If the company liquidates, unsecured creditors only get paid from whatever value remains after secured creditors are satisfied. Corporate bonds — particularly investment-grade issues — are often unsecured, relying on the company’s overall creditworthiness rather than specific collateral.
Senior vs. Subordinated Debt
Within the unsecured category, debt can be either senior or subordinated:
| Feature | Senior Unsecured | Subordinated |
|---|---|---|
| Priority | Paid before subordinated and equity | Paid only after all senior debt is satisfied |
| Interest rate | Lower — less risk, higher recovery | Higher — compensates for lower priority |
| Typical issuers | Investment-grade companies | LBO targets, high-yield issuers |
| Credit rating | Rated at or near issuer level | Typically 1–3 notches below senior |
| Covenants | Moderate protection | Often looser — less leverage in negotiations |
A subordination agreement is the legal document that formally establishes one creditor’s claim as junior to another’s. Without it, all unsecured creditors would rank equally (pari passu).
First Lien vs. Second Lien
Even within secured debt, there can be tiers. First-lien debt has the primary claim on collateral. Second-lien debt has a claim on the same collateral, but only after the first-lien lender is fully repaid. Second-lien loans carry higher interest rates — typically 200–400 basis points above first-lien — to compensate for the weaker position.
Second-lien structures are common in leveraged buyouts where the borrower needs more debt than the first-lien lender is willing to provide. The second-lien lender fills the gap, accepting a lower recovery expectation in exchange for a higher yield.
Where Equity Fits
Equity sits at the very bottom of the capital stack. Preferred stockholders have priority over common stockholders but rank behind all debt holders. Common equity holders are the absolute last in line.
This residual position is precisely why equity investors demand the highest return. In a bankruptcy, common shareholders are frequently wiped out entirely — recovering 0 cents on the dollar. But in exchange for this risk, equity holders capture all the upside when the company performs well. Debt holders get their fixed interest payments regardless of how much the company earns; equity holders get everything above that.
This risk-return dynamic is the foundation of the capital structure decision: each layer of the stack carries a different risk profile and cost, from the cheapest (senior secured) to the most expensive (common equity).
Seniority and Credit Ratings
Rating agencies assign separate ratings to individual debt issues, not just to the overall company. A company might have a corporate credit rating of BBB, but its senior secured debt could be rated BBB+ (one notch higher, reflecting the collateral) while its subordinated notes are rated BBB− or BB+ (one to two notches lower, reflecting the junior position).
This “notching” directly affects the credit spread and interest rate on each tranche. Investors use these issue-level ratings to compare risk across instruments and issuers.
Seniority in Practice: A Typical LBO Capital Stack
A leveraged buyout illustrates how seniority layers work together:
| Layer | Typical % of Capital | Typical Cost | Provider |
|---|---|---|---|
| Senior secured (first lien) | 40%–50% | SOFR + 200–400 bps | Banks, CLOs, institutional lenders |
| Senior secured (second lien) | 5%–15% | SOFR + 500–800 bps | Credit funds, institutional investors |
| Mezzanine / subordinated | 5%–15% | 12%–18% (cash + PIK) | Mezzanine funds, BDCs |
| Equity (sponsor + management) | 30%–50% | 20%–30% target IRR | Private equity firms |
Notice the pattern: as you move down the stack, the cost of capital rises because the recovery expectation falls. This is the seniority premium in action.
Key Takeaways
- Seniority determines the order in which creditors and investors get paid — from senior secured debt (first) down to common equity (last).
- Secured debt has a claim on specific collateral. Unsecured debt has a general claim. Subordinated debt only gets paid after all senior claims are satisfied.
- Higher seniority = lower risk = lower required return. Lower seniority = higher risk = higher required return. This drives the cost of each layer in the WACC calculation.
- Rating agencies notch individual debt issues above or below the corporate rating based on their position in the capital stack.
- In bankruptcy, the absolute priority rule governs distribution — senior classes must be paid before junior classes receive anything.
Frequently Asked Questions
What does “pari passu” mean in debt seniority?
Pari passu is Latin for “on equal footing.” When two debt instruments are pari passu, they rank equally in the repayment hierarchy. In bankruptcy, pari passu creditors share recoveries proportionally rather than one being paid before the other.
Can equity holders ever recover before debt holders?
In a Chapter 7 liquidation, generally no — the absolute priority rule prevents it. In a Chapter 11 reorganization, it’s technically possible if all impaired creditor classes vote to approve a plan that gives equity holders some recovery. This is rare but has happened in high-profile restructurings.
Why does senior debt have a lower interest rate?
Because senior lenders face less risk of loss. They’re first in line during repayment and often hold collateral. With higher expected recovery rates, they don’t need as much return to compensate for default risk. The result: a lower credit spread relative to subordinated or mezzanine debt.
How does seniority affect WACC?
Each layer in the capital stack has a different cost. Senior secured debt is cheapest, subordinated debt is more expensive, and equity is the most expensive. WACC blends all these costs together, weighted by their proportion in the capital structure. Adding cheaper senior debt (up to a point) lowers WACC; replacing it with expensive equity raises it.
What’s the difference between seniority and security?
Security refers to whether debt is backed by specific collateral (a lien on assets). Seniority refers to the priority of the claim relative to other creditors. Debt can be senior but unsecured (high priority, no collateral) or secured but subordinated (has collateral but ranks behind other secured claims). The two concepts are related but distinct.