What Is Junior Credit?

Junior credit is a specialized form of private financing. It refers to debt that sits below senior secured debt but above equity in a company’s capital structure. Given the intermediate risk profile of this type of investment strategy, investors in a company’s junior credit are typically rewarded with higher yields than those offered to holders of senior debt and better downside protection than holders of equity.

Capital structure

This image shows the capital strucutre of a company: senior debt, junior credt, equity

For illustrative purposes only

Junior credit typically takes the place of high-yield bonds issued by larger companies. Whereas the high-yield bond market typically doesn’t entertain issuances of under $200 million, many businesses don’t have the need or ability to access that much capital. Middle market companies, those with annual revenues between $10 million and $1 billion, can seek junior credit from private investors, which may offer greater certainty of execution and more flexibility in downturns than traditional lenders, such as banks.

What are the different types of junior credit investment strategies?

Junior credit comes in a variety of options.

The debt hierarchy

For illustrative purposes only

Strategy

Description

Second-lien debt

Second-lien debt is a type of borrowing that’s secured by collateral that has already been pledged for another debt instrument or loan. Second-lien debtholders are second in line to be repaid in the case of the borrower’s insolvency. Given the greater risk, second-lien debtholders are often paid higher interest rates than first-lien debtholders.

Senior unsecured debt

Senior unsecured debt is a type of borrowing that’s not backed by any specific assets of the company. It gives holders preferential treatment over holders of subordinate debt but is only backed by the general solvency of the company.

Subordinated debt without equity enhancements

This type of borrowing ranks behind senior unsecured debt. Holders of this debt won’t get paid until more senior loans are paid in full.

Subordinated debt with equity enhancements or mezzanine capital

This type of borrowing has features of both debt and equity financing. As with debt investments, the investor receives coupon payments, and as with equity investments, investors gain upside exposure to the business through attached stock warrants, bonus payments based on the valuation of the company, or conversion features. The deal structures can be simple or complicated depending on the negotiated terms.

What are the benefits of investing in junior credit?

Junior credit investors look for healthy companies that offer strong free cash flow generation, room for operational improvements, and multiple ways to create value. The benefits of investing in this asset class may include:

High yields—Junior credit investments typically offer higher yield premiums than senior debt to compensate for higher risk profiles
Equity upside—Certain junior credit strategies may offer upside exposure through equity participation alongside debt investments
Portfolio diversification—Can be achieved by building balanced portfolio exposure by sector, vintage year (date of capital deployment), security type, and private equity sponsor
Downside risk management—Junior credit investors enter long-term relationships with borrowers, which give them greater access to company information—and therefore the ability to better understand the borrower, negotiate terms, and structure loans most appropriate for the investor and the underlying business

What sources of return do junior credit investors earn?

Junior credit investments offer several sources of return depending on the strategy.

Junior credit investing strategy	Return driver
Second-lien debt	Coupon payments Up-front closing fee paid by borrower to lender
Senior unsecured debt	Coupon payments Up-front closing fee paid by borrower to lender
Subordinated debt without equity enhancements	Coupon payments Up-front closing fee paid by borrower to lender
Subordinated debt with equity enhancements or mezzanine capital	Coupon payments Up-front closing fee paid by borrower to lender Capital appreciation exposure through things such as attached stock warrants, bonus payments to the lender based on the valuation of the company, and debt that can be converted to equity if the borrower defaults on the loan

What are the risks of investing in junior credit, and how are those risks managed?

Given the position of junior credit on a company’s capital structure, in the event of default, junior credit investors have a lower priority for repayment than other senior debtholders. These types of investments are also relatively illiquid and therefore difficult to sell. Junior credit investors can manage this risk by conducting careful due diligence prior to investment to minimize the probability of default during the term of the loan.

Relative to larger-cap companies, middle market companies may also have fewer professional management teams in place. This risk can be managed by lending only to companies backed by capable private equity sponsors with the experience, resources, and skills required to support the company management teams.

How can investors access junior credit?

There are two main ways to invest in junior credit:

Through directly negotiated transactions with a company or its owners
By investing in private funds that target junior credit investments

The complexity of investing in junior credit lies in developing a deep understanding of companies issuing capital. Most investors choose to invest in private funds that specifically target this part of the market and have the experience to distinguish the most promising capital raises from those with weaker risk/return profiles. We believe partnering with the right asset manager is critical as the strength of deal origination networks and depth and skill of an investment team can make a significant difference in achieving successful investment outcomes.

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

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What is junior credit?