Basic, lesson 1 of 4
The capital structure
Every dollar that funds a company has a place in line. The closer to the front, the safer the claim and the lower the return it pays.
8 min, 3 checks
1A line, not a pile
A company's capital structure is every claim on its value, ranked by who gets paid first if the company fails. Lenders at the front take the least risk and accept the lowest return. Equity at the back takes the most risk, gets paid only after every lender, and keeps all the upside.
Two things set a claim's place in line. Security: is the loan backed by a pledge of specific assets, like receivables, inventory, plants, or the stock of subsidiaries? Seniority: when two claims share the same assets, which one is paid first? A first lien loan has the first claim on the collateral. A second lien loan is secured by the same collateral but is paid only after the first lien is whole.
| Layer | Secured? | Typical pricing | What it is |
|---|---|---|---|
| Revolver | First lien | Base rate + 2.5% to 3.5% | A credit card for the company: draw, repay, draw again |
| First lien term loan | First lien | Base rate + 3% to 6% | The main loan, floating rate, little required repayment |
| Second lien term loan | Second lien | Base rate + 6% to 9% | Same collateral, paid after the first lien |
| Senior unsecured notes | No | Fixed 7% to 10% | High yield bonds, a claim on whatever is left |
| Mezzanine or subordinated debt | No | 11% to 14%, part paid in kind | Junior debt, often with warrants |
| Preferred and common equity | No | No contracted return | The sponsor's and management's money |
Check 1
A company is liquidated. Which claim is paid first from the value of its pledged collateral?
2Reading leverage through the stack
Lenders describe each layer by how many turns of EBITDA sit at or ahead of it. A turn is one times EBITDA. If EBITDA is $100m and the first lien loan is $400m, first lien leverage is 4.0x. Add a $100m second lien and total secured leverage is 5.0x.
Worked example
One company, valued at $1,000m, EBITDA $100m
- 1Revolver: $50m commitment, undrawn at close, so $0 outstanding.
- 2First lien term loan: $400m, so first lien leverage is $400m / $100m = 4.0x.
- 3Second lien term loan: $100m, so leverage through the second lien is $500m / $100m = 5.0x.
- 4Sponsor equity: $1,000m minus $500m of debt, $500m.
The first lien lender is owed 40% of the company's value ($400m of $1,000m). The value has to fall 60% before that loan is impaired. The second lien lender is impaired after a 50% fall.
Check 2
EBITDA is $80m. The first lien loan is $280m and the second lien loan is $80m. What is leverage through the second lien?
Check 3
A company is worth $600m and has a $240m first lien loan ahead of everything. What is the first lien loan to value, in percent?
Terms in this lesson: Sponsor, Revolving credit facility, EBITDA.
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