Introduction to Debt Financing

The Debt Capital Structure

Overview:

• Debt financing comes in multiple layers, each with different risk/return profiles
• Structure follows "seniority waterfall"—who gets paid first in distress matters
• Higher in capital structure = lower risk = lower return (and vice versa)
• Most transactions use multiple tranches to optimize cost of capital

The Debt Capital Structure

The Debt Capital Structure

The Debt Capital Structure

• Senior secured lenders have first claim on collateral (assets pledged as security)
• Unsecured creditors rank behind all secured debt but ahead of subordinated debt and equity
• Equity holders are last in line and only receive value after all debt is repaid
• This hierarchy determines pricing: lower risk = lower yield, higher risk = higher yield

Revolving Credit Facilities (Revolvers)

What is it?

• Committed line of credit that can be drawn, repaid, and re-drawn during the term
• Typically 3-5 year maturity with option to extend
• Borrower pays commitment fee on undrawn portion (0.25-0.50%)
• Acts as liquidity backstop and working capital financing

Revolving Credit Facilities (Revolvers)

Key characteristics:

• Senior secured with first lien on all assets
• Floating rate tied to SOFR (Secured Overnight Financing Rate)
• Usage-based pricing—only pay interest when drawn
• Covenants: Maintenance covenants tested quarterly (most restrictive)

Revolving Credit Facilities (Revolvers)

Typical uses:

• Working capital fluctuations (seasonal inventory, receivables)
• Short-term liquidity needs and operational flexibility
• Letter of credit issuance for trade finance
• Bridge financing until permanent capital is arranged

Term Loan A (TLA)

What is it?

• Amortizing senior secured term loan with scheduled principal repayments
• Typically 5-7 year maturity
• Held primarily by commercial banks
• Designed for strategic acquisitions and conservative capital structures

Term Loan A (TLA)

Key characteristics:

• Senior secured with pro-rata claim alongside revolver
• Amortizing: 5-15% annual principal payments (deleverages over time)
• Floating rate (SOFR + spread)
• Maintenance covenants: Tested quarterly, similar to revolver

Term Loan A (TLA)

Typical uses:

• Strategic acquisitions by investment-grade or near-investment-grade companies
• General corporate purposes and refinancing existing debt
• Companies that want to maintain strong credit profiles

Term Loan A (TLA)

Term Loan B (TLB) / Institutional Loans

What is it?

• Non-amortizing (or minimal amortization) term loan sold to institutional investors
• Typically 7-8 year maturity
• The workhorse of LBO financing—highest leverage layer
• Held by CLOs (Collateralized Loan Obligations), mutual funds, hedge funds

Term Loan B (TLB) / Institutional Loans

Key characteristics:

• Senior secured with first lien (pari passu with TLA/revolver if present)
• Minimal amortization: 1% per year or bullet repayment at maturity
• Floating rate (SOFR + spread)
• Incurrence covenants only: No quarterly maintenance tests—only triggered if specific actions taken

Term Loan B (TLB) / Institutional Loans

Typical uses:

• LBO financing (majority of debt stack in PE deals)
• Dividend recapitalizations (refinance to pay dividends to sponsors)
• High-leverage refinancings

Term Loan B (TLB) / Institutional Loans

Why institutional investors buy it:

• Higher yields than investment-grade bonds
• Floating rate protects against rising rates
• Senior secured = better recovery in default than unsecured bonds
• Liquid secondary market for trading positions

High-Yield Bonds / Senior Notes

What is it?

• Unsecured debt issued in public or private (144A) bond markets
• Typically 7-10 year maturity
• Fixed-rate coupon paid semi-annually
• No collateral claim on assets (subordinated to secured debt in bankruptcy)

High-Yield Bonds / Senior Notes

Key characteristics:

• Unsecured (behind all secured debt in recovery waterfall)
• Fixed rate (e.g., 6.5% coupon paid twice yearly)
• Callable: Issuer can refinance after 3-5 years (often at premium)
• Incurrence covenants: Similar to TLB—only tested when taking specific actions

High-Yield Bonds / Senior Notes

Typical uses:

• LBO financing alongside TLB (provides "cushion" below secured debt)
• Refinancing existing unsecured debt
• Funding acquisitions when secured lending capacity exhausted
• Companies with limited tangible assets to pledge (service businesses, tech)

High-Yield Bonds / Senior Notes

Second Lien Debt

What is it?

• Secured debt with junior claim on same collateral as first lien debt
• Typically 8 year maturity (longer than TLB)
• Sits between senior secured and unsecured debt in capital structure
• Less common post-2008 (unitranche and high-yield often preferred)

Second Lien Debt

Key characteristics:

• Secured but subordinated to first lien holders on same collateral
• Higher yield than first lien (compensates for subordination)
• Typically minimal amortization or bullet repayment
• Incurrence covenants (less restrictive than first lien)

Second Lien Debt

Typical uses:

• LBO financing when first lien capacity is exhausted
• Refinancing existing second lien or subordinated debt
• Companies needing additional secured capacity without diluting first lien

Second Lien Debt

Unitranche Debt

What is it?

• Single "tranche" combining first and second lien characteristics
• Provided by direct lenders (BDCs, credit funds) not traditional banks
• Typically 6-7 year maturity
• Increasingly popular for middle-market LBOs ($10-500M EBITDA companies)

Unitranche Debt

Key characteristics:

• First lien secured on all assets (simpler structure than separate first/second lien)
• Blended pricing: One rate averaging what first and second lien would cost separately
• Flexible structure: Can customize amortization, PIK options, equity kickers
• Incurrence covenants with one maintenance covenant (often just leverage test)

Unitranche Debt

Typical uses:

• Middle-market LBOs where speed and certainty matter
• Situations requiring flexible documentation and relationship lending
• Borrowers willing to pay premium for simplified one-lender structure

Unitranche Debt

Advantages over traditional senior/junior structure:

• Single negotiation (not coordinating banks + second lien investors)
• Faster execution (one credit committee, one set of documents)
• More flexible during operational issues (one lender to work with, not multiple constituencies)
• Higher leverage often available (6-7x vs 4-5x from banks)

Mezzanine Debt / Subordinated Notes

What is it?

• Unsecured subordinated debt with equity-like features
• Typically 8-10 year maturity
• Highest layer of debt before equity in capital structure
• Bridges gap between senior debt capacity and equity check size

Mezzanine Debt / Subordinated Notes

Key characteristics:

• Unsecured and subordinated to all other debt (lowest priority)
• PIK toggle option: Can pay interest in-kind (adding to principal) instead of cash during early years
• Equity kicker: Often includes warrants for 5-15% equity ownership
• Minimal covenants: Typically none—operates like quasi-equity

Mezzanine Debt / Subordinated Notes

Typical uses:

• Highly leveraged LBOs where debt capacity maximized
• Growth capital for companies not yet profitable (cash interest burden problematic)
• Recap transactions where sponsors extract value but preserve leverage headroom
• Distressed situations where senior lenders won't provide more capital

Mezzanine Debt / Subordinated Notes

Return profile:

• Current yield: 10-15% cash interest (or PIK)
• Equity upside: Warrants provide additional 3-8% IRR if exit successful
• Total return target: 15-20% IRR

Bridge Loans

What is it?

• Short-term financing (typically 6-12 months, extendable to 2 years)
• Intended to be temporary until permanent financing is arranged
• Used when closing needs to happen before long-term debt is syndicated
• "Bridges" timing gap between transaction close and capital markets access

Bridge Loans

Key characteristics:

• Senior secured typically (same priority as permanent TLB)
• High cost: SOFR + 600-800 bps plus ticking fees (0.50-1.00% per quarter if not refinanced)
• Takeout commitment: Often comes with committed longer-term financing to refinance bridge
• Short maturity: Forces urgency to refinance into permanent capital

Bridge Loans

Typical uses:

• LBO closings where high-yield bond syndication not complete at close
• Strategic M&A where timing critical and permanent structure being finalized
• Acquisition financing during market volatility (bond markets closed temporarily)

Bridge Loans

Why not just wait for permanent financing:

• Competitive deal processes require certainty and speed
• Seller won't wait for 6-8 week syndication process
• Market windows close—better to close on bridge and refinance later

Asset-Based Lending (ABL)

What is it?

• Revolving credit facility secured by specific current assets (not all enterprise assets)
• Borrowing base calculated from eligible receivables and inventory
• Availability fluctuates with working capital levels
• Administered by specialized lenders who monitor collateral closely

Asset-Based Lending (ABL)

Key characteristics:

• Secured by current assets only: Receivables (advance rates: 80-90%), inventory (40-60%)
• Borrowing base: Can only draw up to % of eligible collateral value
• Monthly/weekly reporting: Must provide detailed collateral reports (aging, dilution, inventory turns)
• Lower leverage: Typically 2-3x EBITDA but could be higher availability based on assets

Asset-Based Lending (ABL)

Typical uses:

• Companies with substantial working capital (retail, distribution, manufacturing)
• Cyclical businesses where EBITDA fluctuates but current assets more stable
• Distressed situations where cash flow unreliable but tangible assets exist
• Supplement to cash flow loans when additional liquidity needed

Asset-Based Lending (ABL)

Advantages:

• Available when cash flow loans won't work (losses, restructuring, turnarounds)
• Flexibility—availability grows as business grows inventory/receivables
• Often survives bankruptcy (lenders secured by liquid assets, keep lending through Chapter 11)

Payment-in-Kind (PIK) Features

What is it?

• Structural feature allowing borrower to pay interest by issuing more debt instead of cash
• "PIK toggle" gives borrower choice each period: pay cash or PIK
• Compounds over time—deferred interest accrues and itself bears interest
• Common in mezzanine, sometimes in high-yield bonds

Payment-in-Kind (PIK) Features

Key characteristics:

• Preserves cash: Borrower conserves cash during early years or weak periods
• Debt grows: Principal balance increases by amount of PIK'd interest
• Higher rate: PIK interest rate typically 100-200 bps higher than cash interest rate
• Maturity wall risk: Large balloon payment at maturity if heavily PIK'd

Payment-in-Kind (PIK) Features

Typical uses:

• Growth companies that are cash flow negative or breakeven
• LBOs of cyclical businesses (PIK during downturns, cash during upturns)
• Highly leveraged deals where initial cash interest burden too heavy
• Distressed exchanges (amend-and-extend transactions to avoid default)

Payment-in-Kind (PIK) Features

Example:

• $10M mezzanine note at 12% cash / 14% PIK
• Year 1: Elect PIK → Owe $1.4M interest → Add to principal → New balance $11.4M
• Year 2: Elect PIK on $11.4M → Owe $1.596M → New balance $12.996M
• After 5 years of PIK: ~$19.3M owed (nearly doubled)

How to Choose the Right Debt Structure

Company characteristics:

• Asset intensity: Tangible assets → ABL possible; intangibles → cash flow lending
• Cash flow stability: Predictable → term loans; volatile → revolvers + conservative leverage
• Size: Large companies → bond markets; middle market → direct lenders; small → banks

How to Choose the Right Debt Structure

Transaction type:

• LBO: Maximize leverage → TLB + high-yield + mezzanine, aggressive structure
• Strategic M&A: Preserve flexibility → TLA + modest bonds, conservative structure
• Growth capital: Future-focused → Unitranche with PIK, flexible covenants

How to Choose the Right Debt Structure

Market conditions:

• Strong markets: Covenant-lite, higher leverage, tight spreads
• Weak markets: Maintenance covenants, lower leverage, wide spreads
• Rate environment: Rising rates favor floating (SOFR + spread); falling rates favor fixed (bonds)

How to Choose the Right Debt Structure

Cost vs. flexibility trade-off:

• Cheaper debt = more restrictions: Bank TLA with maintenance covenants, amortization
• Expensive debt = more freedom: Mezzanine/PIK with no covenants, long maturity

Debt Instruments Summary Table (Part 1)

Debt Instruments Summary Table (Part 2)

Debt Instruments Summary - Key Takeaway

Summary: Debt Capital Structure