THE CAPITAL STACK
When it comes to deals, debt is cheaper than equity. Why? Let’s look at the capital stack.
The capital stack represents the underlying financial structure of a deal. It is referred to as a stack because as the name suggests, it is made up of layers of investment. These layers, comprised of debt and equity, are the funding sources that go into making an acquisition.
Fundamentally, debt and equity are functions of risk and reward within a capital stack. While both debt and equity represent structured layers of the stack, understanding its architecture defines not only who gets paid, but more importantly, how and when they get paid.
A debt position represents a lower layer in the stack. The lower the position, the lower the risk and return. The higher positions in the stack, equity, have higher risks and yield higher returns.
Let’s take a closer look at each of the layers.
DEBT LAYERS OF THE STACK
Debt financing can be a strategic way to retain equity in a deal and is often defined as senior debt or mezzanine/junior debt.
Senior debt is provided by a bank or lending institution and is at the bottom of the capital stack. Senior debt looks to finance a defined portion of the deal for a specific interest rate. The amount of senior debt is typically collateralized by the assets being transferred in the transaction. Examples of senior debt include: term debt, lines of credit or real estate debt (mortgage).
Senior debt is the lowest risk in the stack and typically requires the lowest return. Senior debt holders do not share in business profits, but are paid on a fixed schedule whether the business is profitable or not. They are also in first lien position, meaning if the loan they provide defaults, they have first claim to the assets.
Mezzanine debt, also known as subordinated debt or junior capital, is subordinate to senior debt. Because this loan is not collateralized by the business assets (unsecured) and is in second position behind senior debt in case of loan default, it commands a higher interest rate. This type of debt typically has a feature that allows it to be converted from debt to equity as well. Mezzanine debt holders reside just above senior debt in the capital stack.
EQUITY LAYERS OF THE STACK
Selling equity can be a strategic way to reduce leverage and increase liquidity. It is often defined as preferred or common equity.
Preferred equity has higher priority for distributions of a company’s cash flow or profits than common equity and functions very much like common equity, but typically has enhanced payment and default rights. Although preferred equity is subordinate to all debt, it bears less risk than common equity. In case of default, preferred equity holders get paid after debt holders but before common equity investors.
Common equity bears the greatest risk and yields the highest reward within the capital stack. There are no guarantees with this investment. These investors share in the peaks and the valleys of the cash flow and are the last to be paid in cases of default or exit.
Need help understanding the capital stack in your transaction? Reach out and let’s have a conversation.