3.1 The capital structure

Every company is funded by a mix of debt and equity. That mix is called the capital structure. Where a loan sits in it decides two things: who gets paid first if the company runs into trouble, and how much interest the lender can charge.

When a private credit fund says it "invests in senior secured loans" or "provides mezzanine capital," it is telling you where in the capital structure it sits. Knowing the layers lets you read a fund's strategy, a deal memo or a portfolio report and quickly understand how much risk is being taken.

The capital stack

People often draw the capital structure as a stack, with the safest claims at the top and the riskiest at the bottom. The top layers are debt. The bottom layers are equity, which is ownership.

Two ideas run through the whole stack:

• Seniority (also called priority) is the order in which investors get repaid. Senior claims are paid before junior ones.
• Security means a lender holds a lien, a legal claim over specific assets called collateral. If the borrower doesn't pay, a secured lender can enforce its lien, for example by taking control of and selling those assets. An unsecured lender has no such claim and simply stands in line with other general creditors.

Here are the main layers, from top to bottom.

"Relative cost" is the return each investor expects, which is the price the company pays for that money. The pattern is simple: the lower you sit, the more risk you take, and the higher the return you require.

Senior secured debt: first lien and unitranche

First lien loans sit at the top. The lender has the first-priority lien on the company's assets, usually "substantially all assets," plus a pledge of the shares of the borrower and its subsidiaries. If the company fails, first lien lenders are paid from the collateral before anyone else.

A first lien package often has two parts:

• A term loan: a lump sum lent at closing and repaid over time or at maturity.
• A revolving credit facility (a revolver): a credit line the company can draw, repay and draw again, like a corporate credit card. Revolvers fund day-to-day needs such as working capital. They usually share the first lien with the term loan and sometimes get paid ahead of it.

A unitranche loan is a single first lien loan that replaces the older structure of a separate first lien loan plus a second lien loan. Instead of two lender groups with two documents, the borrower has one loan, one set of terms and one blended interest rate that sits between what the first lien and second lien would have cost. Borrowers like the simplicity and speed. Unitranche loans are a core product for private credit direct lenders.

Behind the scenes, unitranche lenders sometimes split the loan among themselves into a first-out piece (paid first, lower return) and a last-out piece (paid after, higher return). The borrower still sees one loan. You'll meet these arrangements again in later courses.

Junior debt: second lien and mezzanine

Second lien loans are secured by the same collateral as the first lien, but their lien ranks second. An intercreditor agreement, a contract between the two lender groups, sets out that the first lien gets paid in full from the collateral before the second lien receives anything. Second lien lenders are still secured, but they are paid from what is left over.

Mezzanine debt (often called "mezz") sits below all the secured debt. It is usually unsecured, or subordinated, meaning it has agreed by contract to be repaid only after the senior debt. To make up for that risk, mezzanine lenders ask for more, often in forms that ease the borrower's cash burden:

• PIK interest (payment in kind): some or all of the interest is added to the loan balance instead of being paid in cash. The lender is paid later, when the loan is repaid. Lesson 3.2 covers PIK in detail.
• Equity warrants: rights to buy a small amount of the company's shares at a set price. If the company does well, the warrants give the lender a slice of the upside.

Equity: preferred and common

Preferred equity is ownership, not debt, so it ranks below every lender. It ranks above common equity. Preferred holders typically receive a fixed dividend, which often builds up (accrues) rather than being paid in cash, and they get their money back before common shareholders. Some private credit funds invest in preferred equity as a higher-returning, higher-risk strategy.

Common equity is the bottom of the stack. In a private-equity-backed company, most of the common equity is owned by the sponsor, the private equity firm that bought the company. Common shareholders get whatever is left after everyone above them is paid. They have the most to gain if the company grows, and they are the first to be wiped out if it fails.

The equity below a loan acts as a cushion. The more equity there is, the more the company's value can fall before the lender loses money.

Priority in a default: a simple example

Imagine Northfield Components, a fictional maker of industrial parts owned by a private equity sponsor. When it was bought, it was worth $500 million, funded like this:

Business goes badly, Northfield defaults, and the company is sold for $260 million. The proceeds flow down the stack, top first. Each layer must be paid in full before the next receives anything. This ordering is often called the waterfall.

The first lien is repaid in full. The second lien gets the remaining $60 million, 80 cents on the dollar. Mezzanine and both equity layers get nothing.

Notice what the equity cushion did. The company's value fell by almost half, from $500 million to $260 million, yet the first lien lost nothing. That protection is why first lien lenders accept the lowest return.

Real restructurings are messier than this. There are legal and advisory costs, negotiations between creditor groups, and sometimes junior investors receive something to secure their agreement. But the basic order holds, and it is the starting point for every recovery analysis.

Key terms

• Capital structure: the mix of debt and equity a company uses to fund itself.
• Seniority: the order in which investors are repaid; senior claims come first.
• Lien: a legal claim over a borrower's assets that secures a loan.
• Collateral: the assets a lien covers, which the lender can enforce against on default.
• First lien: a secured loan with the top-priority claim on collateral.
• Revolver: a credit line the borrower can draw, repay and redraw.
• Unitranche: a single first lien loan with one blended rate that replaces a first lien and second lien split.
• Second lien: a loan secured by the same collateral as the first lien but ranked behind it.
• Intercreditor agreement: a contract between lender groups that sets their relative rights and priority.
• Mezzanine debt: junior debt, usually unsecured or subordinated, often with PIK interest and sometimes warrants.
• Subordinated: agreed by contract to be repaid only after more senior debt.
• Preferred equity: ownership that ranks below all debt but above common equity.
• Sponsor: the private equity firm that owns a company.
• Waterfall: the top-down order in which proceeds are paid out.

Key takeaways

• The capital structure runs from senior secured debt at the top to common equity at the bottom.
• In a default, each layer is repaid in full before the next one gets anything.
• "Secured" means the lender holds a lien on collateral; a secured loan can still rank behind another secured loan.
• A unitranche replaces a first lien and second lien split with one first lien loan at a blended rate.
• The lower an investor sits, the more risk it takes and the higher the return it requires.