Senior debt vs preferred equity: two ways to get paid before someone else

Senior debt vs preferred equity: two ways to get paid before someone else

Senior debt and preferred equity both sit ahead of common shareholders. Both promise a set return. Both get described as "lower risk" in pitch decks. But they're legally different instruments, and the difference shows up exactly when it matters: when the company can't pay everyone.

Senior debt

Senior debt is a loan that ranks first for repayment. The borrower owes a fixed contractual payment obligation: principal plus interest, on set dates. Missing a payment is a default. A default gives the lender legal remedies: accelerating the loan, enforcing on collateral, and in the end forcing the borrower into bankruptcy.

In a liquidation, senior secured lenders are paid from their collateral first. Senior unsecured lenders rank ahead of subordinated debt and all equity. (See Seniority and payment priority for the full ladder.)

The upside is capped. A lender gets its interest and its money back. Nothing more, however well the business does.

Preferred equity

Preferred equity is ownership, not a loan. Preferred holders usually get a set dividend, paid before any dividend to common shareholders, and a liquidation preference: in a sale or wind-down, they get their money back before common holders get anything.

But the dividend isn't a debt. If the company doesn't pay it, that's usually not a default. With cumulative preferred, unpaid dividends pile up and must be paid before common holders get anything. With non-cumulative preferred, a skipped dividend is simply gone.

Preferred holders rank behind every creditor. In a bankruptcy, all debt, senior and junior, is paid before preferred equity sees a dollar.

Side by side

| Senior debt | Preferred equity

Legal nature | Loan | Ownership

Payment | Fixed contractual obligation | Dividend, can be skipped

Missed payment | Default, legal remedies | Usually not a default

Rank in liquidation | Ahead of all equity | Behind all debt

Upside | Capped at interest | Sometimes participates or converts

Typical security | Often secured by collateral | Unsecured

Why it matters

The two can look identical on a yield sheet. An 11% senior note and an 11% preferred dividend show the same number. They aren't the same risk.

The question to ask of any instrument is: if the issuer can't pay, what can I do about it? A senior lender can enforce. A preferred holder, in most cases, waits.

This is also why "fixed income" is a precise term. It means the payment is a contractual obligation the issuer must meet, not a distribution that's paid when there's money to spare. When you see an instrument described as fixed income, check the documents for whether the payment is owed or merely intended.