Seniority and the Capital Stack
When a company runs out of money, who gets paid first is decided by a strict order agreed years earlier — the capital stack — and where a claim sits in that stack matters more to its recovery than almost anything else.
Prerequisites: Credit Risk Fundamentals
Every company that borrows money issues claims that are not all equal. A bank loan, a senior bond, a subordinated bond and common equity can all sit on the same balance sheet, but they don't have equal rights to the company's assets if things go wrong. That ranking — who gets paid first, who gets paid last, and who might get nothing — is the capital stack, and it's fixed by contract long before any distress shows up.
The capital stack ranks every claim on a company by seniority. In a liquidation or restructuring, value flows from the top down — each layer must be paid in full before the layer below it gets anything — so where a bond or loan sits matters more to its ultimate recovery than the company's overall financial health does.
The typical order
From the top (paid first) to the bottom (paid last, if anything is left):
- Senior secured debt — bank loans and bonds backed by specific collateral (a mortgage on real estate, a lien on equipment). Gets repaid from the sale of that specific collateral before anyone else touches it.
- Senior unsecured debt — a general claim on the company's assets, ranking behind secured claims but ahead of anything subordinated.
- Subordinated (junior) debt — contractually agrees to be paid after senior unsecured debt, usually in exchange for a higher coupon.
- Preferred equity — ranks below all debt but above common stock; often gets a fixed dividend when paid at all.
- Common equity — last in line, and the layer that absorbs losses first as a company's asset value falls, and only gets anything once every layer above it is repaid in full.
Worked example
A company defaults with $300 million in remaining asset value, against a capital stack of $150 million senior secured debt, $120 million senior unsecured debt, $80 million subordinated debt, and $100 million equity (total claims of $450 million against $300 million of value). Senior secured is paid in full: $150 million, recovering 100%. That leaves $150 million for senior unsecured's $120 million claim — also paid in full, recovering 100%, leaving $30 million. Subordinated debt's $80 million claim gets only that remaining $30 million, a recovery of 37.5%. Equity gets nothing at all — the value ran out two layers above it.
What this means in practice
Understanding the stack is the starting point for distressed debt investing: the goal is often to identify the fulcrum security — the layer of the capital stack where the money actually runs out, which is the layer most likely to convert into the new equity of a reorganized company and therefore the one worth the closest analysis.
Seniority is a legal ranking, not a guarantee of full recovery — even the most senior claim can take losses if the company's asset value has fallen far enough, and being "first in line" only means first, not automatically whole.
Further reading
- Moyer, Distressed Debt Analysis: Strategies for Speculative Investors (ch. 2)