Debt tranches and seniority
6 min read · updated July 2, 2026
Every dollar that funds a buyout has a rank. That ranking, top to bottom, is the whole story of an LBO's financing, and it decides two things that matter: what each layer costs, and who gets their money back when the company can't pay everyone.
Start with the intuition. A lender who is first in line to get repaid and has a claim on the company's assets will accept a low rate. A lender who sits behind them, with no collateral and a promise to be paid only after the senior guys are made whole, demands a lot more. And the owner, the equity, gets whatever is left after every lender is satisfied. That's the entire logic of the capital structure: more risk sits lower in the stack, and lower means more expensive.
The stack, top to bottom
Here is the order you need cold. The top is safest and cheapest. The bottom is riskiest and most expensive.
| Layer | Secured? | Rough cost | Repaid | |---|---|---|---| | Revolver | Yes (1st lien) | Lowest | First | | Senior secured term loans (TLA / TLB) | Yes (1st lien) | Low | First | | Senior unsecured / high yield | No | Medium | After secured | | Subordinated / mezzanine | No, contractually junior | High | Near-last | | Equity | n/a | Highest required return | Last |
The revolver is a credit line the company draws on and repays as it needs working capital, like a corporate credit card. It's usually undrawn at close and priced cheaply because it's first-lien secured.
Senior secured term loans are the workhorse of most LBOs. TLA typically amortizes (pays down principal on a schedule) and is often held by banks. TLB amortizes very little, runs longer, and gets sold to institutional investors. Both are secured by the company's assets, so they carry a low rate and sit at the top.
Below the secured debt sits high yield (senior unsecured bonds). No collateral, longer maturity, fewer restrictions on the borrower, and a higher coupon to compensate. Then mezzanine debt, the most expensive layer of debt, which is contractually subordinated and sometimes carries warrants or a PIK feature so the lender shares in the upside.
At the very bottom is the equity the sponsor (the PE firm) writes. Highest risk, highest required return, paid last. If you want the full picture of how these pieces come together at close, see the LBO and paper LBO.
Why cost rises as you go down
It's not arbitrary. Price tracks the probability of getting repaid and how much you recover if things break.
Secured senior debt has a lien on real assets. In a bad scenario it gets repaid from those assets before anyone else sees a dollar, so its expected loss is small and its rate is low. Unsecured and subordinated lenders have weaker claims and thinner recovery, so they price in that risk with a fatter coupon. A useful mental model: the higher the layer's credit rating, the tighter its spread.
Seniority and security are two different things, and both push cost down. "Senior" is about payment order. "Secured" is about having a claim on specific collateral. First-lien senior secured debt has both, which is why it's the cheapest money in the deal.
Who gets paid first in a default
When the company can't service its debt and lands in a restructuring or Chapter 11, the value of the business gets distributed strictly by rank. This is the waterfall: secured lenders recover first, up to the value of their collateral. Then senior unsecured. Then subordinated. Equity is last, and in most distressed cases equity gets wiped out, meaning it recovers nothing.
The layer where the money runs out is the fulcrum security: the tranche that is only partially repaid and typically converts to the new equity of the reorganized company. Everything above it gets paid in full. Everything below it gets little or nothing.
Getting the seniority order backwards. Some candidates rank tranches by size or by coupon and end up saying mezzanine or high yield gets repaid before the term loan. It's the opposite. Secured senior debt is repaid first and is the cheapest. Mezzanine and subordinated debt are riskier and more expensive. Equity is paid last. In a default, you walk down the stack, and the money frequently runs out before it reaches the bottom.
Covenants: the lender's guardrails
Lenders don't just set a rate and hope. They attach covenants, rules the borrower must follow. Two flavors:
- Maintenance covenants test a ratio every quarter, for example a maximum leverage ratio (Debt / EBITDA) or a minimum interest coverage. Breach one and you've defaulted, even if you never missed a payment.
- Incurrence covenants only bite when the company takes an action, like raising new debt or paying a dividend.
Term loans have historically carried maintenance covenants. High yield bonds lean on incurrence covenants and give the borrower more room. Covenants matter for returns because they cap how much debt the deal can carry and they govern the cash sweep, the mechanism that forces excess cash to pay down senior debt early.
How the layers change the return
The mix isn't just plumbing. Cheaper senior debt lowers the blended cost of capital and lets the sponsor put in a smaller equity check, which lifts returns if the deal works. Pile on too much expensive junior debt, though, and interest eats the cash that would otherwise pay down principal or fund growth. That's the tension every capital structure is solving: enough leverage to juice the equity return, not so much that a normal downturn breaks a covenant or the cash flow.
Be able to recite the stack from top to bottom in one breath: revolver, senior secured term loans, senior unsecured / high yield, subordinated / mezzanine, then equity, with cost rising and repayment priority falling as you descend. Then add the one line that shows depth: "the fulcrum security is the tranche that doesn't get fully repaid in a default, and it usually converts into the equity of the restructured company." Saying the order fluently, then landing that second-order point in a sentence, is the kind of answer that separates you in a Superday.
Glossary
New to the lingo? Every term used above, in plain English.
- LBO (Leveraged Buyout)
- Buying a company using mostly borrowed money, then using the company’s own cash flow to pay that debt down over time. The classic private equity playbook.
- Capital structure
- The mix of debt and equity a company uses to fund itself. More debt is cheaper but riskier, and finding the right balance affects both value and risk.
- Revolver (revolving credit facility)
- A flexible line of credit a company can draw on and repay as needed, like a corporate credit card. In a model it plugs any short-term cash shortfall.
- Senior debt
- The safest, cheapest layer of borrowing, first in line to be repaid and usually secured by assets. It sits at the top of the capital structure.
- High-yield bond
- A bond from a company with a lower credit rating (below investment grade). It pays more interest to compensate lenders for the higher risk of default.
- Mezzanine debt
- A riskier, more expensive layer of debt that sits below senior debt and above equity. It gets repaid later, so it demands a higher return.
- Covenant
- A rule in a loan agreement the borrower must follow, like keeping debt below a set multiple of EBITDA. Breaking one can let lenders demand repayment.
- Cash sweep
- Using a company extra cash to pay down debt automatically each year. It is the engine of deleveraging in a leveraged buyout.
- Leverage ratio
- How much debt a company carries relative to its earnings, usually measured as debt divided by EBITDA. Higher leverage means more risk and more required debt paydown.
- EBITDA
- Earnings Before Interest, Taxes, Depreciation, and Amortization. A rough proxy for a company’s operating cash profit, before financing and accounting choices.
- Sponsor
- A private equity firm. In an LBO the sponsor is the buyer that puts up the equity and controls the company.
- Equity Value
- The slice of a company that belongs to its shareholders. For a public company this is the market capitalization (share price times shares outstanding).
- Credit rating
- A grade from an agency (like S&P or Moody's) on how likely a borrower is to repay. Investment grade is safer; below that is high yield, and lower ratings mean higher borrowing costs.
- Fulcrum security
- The layer of debt in a bankruptcy that gets only partly repaid, so it converts into the equity of the restructured company. Owning it is how distressed investors take control.
- Chapter 11
- A US bankruptcy process where a company keeps operating while it restructures its debts, rather than shutting down and liquidating. Creditors get repaid based on seniority.
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