When senior debt stops being the right instrument

Senior debt is the first claim on a business. It ranks ahead of other creditors for repayment, it is usually secured on assets or receivables, it carries the tightest covenants, and it is the cheapest money most companies will ever raise. Bank term loans and working capital lines are its ordinary form in India, and for most businesses most of the time it is the correct answer.

It is cheap for a reason, and the reason is the constraints. The lender is first in line, holds security it expects to be able to realise, and can call the facility if defined ratios are breached. The price reflects the position. A borrower comparing a bank rate with anything else is not comparing two prices; they are comparing an instrument carrying those constraints with one that does not.

The bargain has three conditions

Senior debt works when three things hold at the same time.

• The cash arrives on the lender's schedule. Not eventually, but quarterly and in the amounts the amortisation assumes.
• The security fits a standard charge. Assets the lender can value conventionally, perfect without unusual consents, and realise without a contested process.
• The business fits the credit box. Rating, sector, promoter profile and balance sheet shape all fall inside what the committee is set up to approve.

Most businesses satisfy all three for most of their life, which is why senior debt is the default and should remain so. The useful question is what to do during the periods when one of them stops holding.

What usually breaks first

Timing, most often. A business that generates in nine months what its facility demands in twelve is not a weaker credit. It is a credit whose cash and whose repayment schedule have come apart, and no amount of additional security fixes a mismatch of dates.

Then security. Value sitting inside a subsidiary, in contracted receivables, in a single project, or in an asset that needs third-party consent to transfer is real value that a standard charge does not capture. The lender is not wrong to discount it; the instrument simply cannot reach it.

Then the box itself. A downgrade, a sector the bank is quietly retreating from, or a promoter-level event entirely unrelated to the operating business. Nothing about the company changed. What changed was the set of exposures the lender is rewarded for writing.

The expensive mistake

When one of these breaks, the instinct is to keep the instrument and pay for the problem: accept a higher rate, pledge more, add a guarantee, give up covenant headroom. Sometimes that is right. Frequently it produces a facility that is both more expensive and still mismatched, because the schedule is unchanged, the security package has widened to cover a timing problem it cannot solve, and the borrower has surrendered flexibility that will be needed at the next turn of the cycle.

The alternative is to change the instrument rather than the price. Where the cash exists but is mistimed, the answer is a schedule dated to the cycle that produces it. Where the value exists but is not chargeable in standard form, the answer is to isolate that value and secure it directly. Where the business sits outside the box, the answer is a lender underwriting the cash flows rather than the box.

Senior debt has stopped being the right instrument when the concessions required to keep it are worth more than the pricing advantage it carries.

That is a calculation rather than a feeling, and it is worth doing explicitly. Add up the wider security package, the additional guarantee, the covenant headroom surrendered and the operational restrictions accepted, and set the total against the spread being saved. Borrowers who put both sides on paper frequently discover they have been paying a substantial premium in flexibility to protect a modest discount in rate.

None of this is an argument against senior debt. It should be the first thing attempted and it should remain the largest part of the capital structure for most businesses. It should simply stop being the only thing considered once the conditions that made it cheap have stopped holding.