Capital structure and instruments

Waterfall recovery by tranche

Given an enterprise value at the point of restructuring, each tranche is paid in full in seniority order until the value is exhausted. Every recovery estimate in private credit is this one calculation, and the whole of the analytical work is in the enterprise value input, not the arithmetic.

Field	Value
Formula	Rec_i = min(Claim_i, max(0, EV - sum of Claim_j for all j senior to i)); Recovery percent = Rec_i / Claim_i
Worked	EV = 420. First lien 300, second lien 150, mezzanine 75. First lien: min(300, 420) = 300, 100 percent. Second lien: min(150, 420-300 = 120) = 120, 80.0 percent. Mezzanine: max(0, 420-450) = 0, 0 percent.
Total claims	525 against 420 of value; the fulcrum sits inside the second lien

• The fulcrum security is the tranche in which the value runs out, and it is the only tranche whose holders convert into the post-restructuring equity. Identifying it before filing is the entire game in distressed private credit.
• Recovery is a step function in enterprise value, not a smooth one. A tranche is at 100 percent or at a partial number or at zero, and the transitions are one turn of EBITDA apart. Point estimates of recovery are therefore far less useful than the enterprise value at which the tranche stops being money-good.
• Claims accrete. Default interest, PIK, and unpaid fees enlarge senior claims during the period when the junior tranche can do least about it, so a junior recovery computed off the pre-default claim stack is optimistic.

Unitranche

A single first-lien credit facility, under one credit agreement with one spread, that occupies the loss band a first lien and a second lien would otherwise split between them. The lender group may privately divide that band into a first-out and a last-out position under an agreement among lenders, which the borrower may never see.

Field	Value
Formula	S_blended = (Q_fo * S_fo + Q_lo * S_lo) / (Q_fo + Q_lo), where Q is quantum and S is spread in bps
Worked	FO 60 of 100 at 450 bps, LO 40 of 100 at 1050 bps: S_blended = (60*450 + 40*1050) / 100 = (27,000 + 42,000) / 100 = 690 bps
Reading direction	Given a quoted blended spread and an FO spread, the implied LO spread is S_lo = (S_blended*(Q_fo+Q_lo) - Q_fo*S_fo) / Q_lo
Illustrative	Spreads above are inputs chosen to make the algebra legible, not market levels

• The borrower's benefit is procedural, not financial: one document, one lender, one vote, and a closing timetable that does not wait on a second-lien syndication. That benefit is real and it is paid for in the blended spread.
• The blended spread is the arithmetic mean only when the FO and LO holders take their stated quantum. Where the LO holder also holds part of the FO strip, the effective spread to that holder is a weighted average across both and is not recoverable from the credit agreement.
• The AAL is a lender-to-lender contract. It does not bind the borrower and, in most formulations, the borrower cannot enforce it. A borrower negotiating protections against lender infighting must get them in the credit agreement, not the AAL.

Agreement among lenders (AAL)

The contract that divides a single unitranche facility into first-out and last-out positions, allocating payments, voting rights, and remedies between holders of the same lien. It sits alongside the credit agreement rather than inside it.

Field	Value
Payment waterfall	Interest is usually paid to both tranches currently while no event of default exists; principal and post-default proceeds go FO first
Voting	The FO holder typically controls enforcement and specified amendments; the LO holder reserves consent over changes to its own economics
Standstill	A defined period during which the LO holder may not exercise remedies, enforceable only against the FO holder as a matter of contract
Buyout option	The LO holder's right to purchase the FO position at par plus accrued on a trigger, which is how the LO holder takes control of a workout

• Because the AAL is not part of the credit agreement, a court asked to adjudicate an FO/LO dispute is construing a document to which the debtor is a stranger, and the debtor's plan may be confirmed while that dispute is unresolved. This is the principal untested risk in the instrument.
• The LO buyout option is the term that matters most and is negotiated least. Without it, the LO holder holds junior risk with no ability to control the outcome that determines its recovery.
• AALs are not standardised in the way LSTA intercreditor forms are. Two facilities described identically to a borrower can allocate control very differently.
• Where an AAL is silent on the treatment of a post-petition adequate-protection payment or a DIP priming, the silence resolves in favour of the party with control of enforcement, which is the FO holder.

Source: LSTA (Loan Syndications and Trading Association) publishes market-standard intercreditor forms; AALs are bespoke and not among them.

First-out / last-out (FLFO) split

The division of one first-lien facility into a first-out tranche, paid first from all proceeds, and a last-out tranche that carries the same lien but the junior payment position. Both tranches are secured; only the payment order differs.

Field	Value
Formula	LO impairment begins when EV < FO detachment quantum; LO recovery = min(Q_lo, max(0, EV - Q_fo)) / Q_lo
Worked	EBITDA 40. FO attaches 0.0x-3.0x = 120. LO attaches 3.0x-5.5x = 100. At EV = 7.0x = 280 both are money-good. At EV = 4.0x = 160: LO recovery = min(100, 160-120 = 40) / 100 = 40.0 percent while FO is at 100 percent.
LO cushion	EV can fall from 280 to 220 before the LO is impaired: (280-220)/280 = 21.4 percent

• The LO holder has second-lien economics with first-lien collateral rights. In a liquidation that is a meaningful improvement over a true second lien, because the LO holder is a secured creditor for voting and adequate-protection purposes. In a going-concern reorganisation it is worth much less, because the FO holder controls enforcement.
• A common misreading is that an FLFO structure gives the LO holder the first lien's recovery. It gives the LO holder the first lien's *lien* and the second lien's *place in the queue*. Those are different assets.
• Because the whole facility shares one lien, there is no separate second-lien class to be crammed down. The debtor faces one secured class, which simplifies its plan and removes a blocking position the second-lien holder would otherwise have had.

FILO (first-in, last-out) tranche

A term tranche secured on the ABL priority collateral, ranking behind the revolver in payment but ahead of the term loan in that collateral pool. It monetises the gap between the conservative advance rates of a borrowing base and the actual liquidation value of the working-capital assets.

Field	Value
Formula	FILO recovery from the working-capital pool = min(Q_filo, max(0, NOLV_pool - ABL_drawn)) / Q_filo
Worked	Net orderly liquidation value of the pool = 70. ABL drawn = 45. FILO of 30: min(30, 70-45 = 25) / 30 = 83.3 percent from the pool, with any deficiency claim ranking with the general unsecured or the term loan per the intercreditor.

• A FILO exists because the ABL lender will not advance against the top slice of liquidation value at any price. Someone willing to underwrite that slice is buying the difference between an advance rate and an appraisal.
• FILO risk is appraisal risk, not EBITDA risk. It is one of the few private credit positions where the correct diligence is a field exam and a liquidation appraisal rather than a credit model.
• The intercreditor question that decides the outcome is whether the FILO deficiency claim shares in the term-loan collateral or falls to unsecured. That single clause moves recovery by more than any pricing term in the tranche.

Second lien term loan

A term loan secured by a second-priority lien on the same collateral as the first lien, governed by a separate credit agreement and an intercreditor agreement that subordinates its lien and restricts its remedies. Payment of interest is generally not subordinated while no event of default exists.

Field	Value
Formula	Money-good iff EV > (first lien claim + second lien claim); cushion as a fraction of EV = (EV - total claims through the second lien) / EV
Worked	EBITDA 40, first lien 3.0x = 120, second lien 3.0x-5.5x = 100, EV at 7.0x = 280. Cushion = (280 - 220) / 280 = 21.4 percent of enterprise value.
Breakeven EV multiple	5.5x EBITDA. Below that the second lien takes a loss; below 3.0x it recovers nothing.

• Second-lien risk is best expressed as the percentage decline in enterprise value the tranche can absorb, not as a leverage multiple. Two loans at the same 5.5x total leverage have entirely different risk if one sits on a 7.0x business and the other on a 6.0x business.
• The intercreditor agreement is worth more than the second lien. A second lien with a 180-day standstill, a waiver of the right to object to a first-lien credit bid, and deemed consent to a DIP has a lien it cannot use.
• Because interest is usually not payment-subordinated, a second lien can be current on cash interest while its collateral coverage is already gone. Coupon receipt is not evidence of coverage.

Mezzanine debt

Unsecured debt of the operating company, contractually subordinated to all senior debt by a subordination agreement, typically carrying a cash coupon, a PIK component, and an equity participation through warrants or a co-investment.

Field	Value
Formula	Total mezzanine return = cash coupon + PIK accretion + equity participation value; IRR solves the combined cash flow stream
Worked	100 of mezzanine, 5 years, 10.00 percent cash and 2.00 percent PIK, plus warrants worth 15 at exit. PIK balance = 100 * 1.02^5 = 110.41. Terminal cash flow = 110.41 + 15 = 125.41 with 10.00 of cash interest each year on the accreting base.
Structural note	Contractually subordinated but at the opco, so it ranks ahead of any holdco claim and shares the opco's unsecured pool

• Mezzanine has been displaced in most sponsor-backed structures by unitranche, because a single first-lien lender will now underwrite to a leverage level that previously required a mezzanine layer. Where mezzanine survives it is usually because the sponsor wants a non-amortising, non-covenant-heavy layer that does not consume first-lien capacity.
• The equity participation is not decoration. Strip the warrants out and the coupon alone rarely compensates for a position that recovers nothing in a moderate downside. Mezzanine underwritten on coupon alone is mispriced by construction.
• Contractual subordination at the opco is weaker than structural subordination at a holdco in one respect and stronger in another: the mezzanine holder has a direct claim against the entity that owns the assets, but that claim is expressly turned over to the senior lenders in a waterfall.

PIK and the PIK toggle

Payment in kind means interest is added to principal rather than paid in cash. A PIK toggle gives the borrower, or in some documents the lender, a contractual election between cash pay and PIK for a given period, usually at a premium to the cash rate.

Field	Value
Formula	Balance after n periods of PIK = P * (1 + r_pik)^n; cash interest forgone in period t = P * (1 + r_pik)^(t-1) * r_pik
Worked	100 at 12.00 percent PIK for 3 years: 100 * 1.12^3 = 140.49. The claim has grown 40.49 while no cash has moved.
Toggle premium	If cash pay is r and PIK is r + p, electing PIK costs the borrower p on a compounding base, in exchange for retaining P*r of cash per period

• PIK converts a liquidity problem into a solvency problem, and it does so silently. A borrower toggling to PIK is reporting a covenant-compliant interest coverage ratio precisely because the interest is no longer cash.
• The lender's accrual is taxable income in most structures without corresponding cash, which is why PIK is expensive to hold in a taxable vehicle and why the accrual shows up in a BDC's net investment income and therefore in its distribution requirement. Distributions can end up funded from something other than the income that created them.
• A borrower-elective toggle is a valuable option granted to the party with the information advantage. The toggle premium is the price of that option and is usually set by convention rather than by option value.
• Interest coverage covenants defined on cash interest are not breached by a PIK election. Where the lender wants the covenant to bite, the definition must reference total interest, including accrued and unpaid.

Holdco PIK note

A PIK obligation issued by a holding company that owns the equity of the borrower group. It has no lien and no claim against operating assets; it is repaid only from value that reaches the holdco after every opco claim has been satisfied. This is structural subordination.

Field	Value
Formula	Value available to holdco = max(0, EV - total opco claims); holdco recovery = min(Balance_holdco, that value) / Balance_holdco
Worked	EV = 420, opco debt = 300. Value to holdco = 120. Holdco PIK of 100 accreted at 12.00 percent for 3 years = 140.49. Recovery = 120 / 140.49 = 85.4 percent.
Same value, no accretion	A 100 cash-pay holdco note against the same 120 would be money-good. The accretion, not the enterprise value, caused the loss.

• The worked example is the whole argument against holdco PIK as a yield instrument: the position was covered at inception and became uncovered because its own claim grew faster than the value beneath it. PIK positions are short volatility on the value cushion and long time.
• Holdco PIK relies on the opco being permitted to distribute cash upward. That permission lives in the opco restricted-payments covenant, which the holdco lender does not control and cannot amend.
• Structural subordination beats contractual subordination for the senior lender, because it does not depend on a subordination agreement being honoured or construed. There is simply nothing to subordinate: the holdco creditor is outside the entity that holds the assets.

Preferred equity in a credit structure

Equity of the issuer carrying a stated accruing return and a liquidation preference ahead of common, but no principal, no maturity, no lien, and no right to accelerate or enforce. It sits below every debt claim and is treated as equity for leverage covenant purposes if drafted correctly.

Field	Value
Formula	Preferred entitlement = min(x*I + accrued, max(0, EV - all debt claims)); the accrual is a preference, not an obligation
Worked	EV = 420, total debt = 380. Residual = 40. Preferred of 50 with a 1.5x preference and 12 of accrued: entitlement = min(87, 40) = 40, a 46.0 percent recovery on the 87 claimed.
Remedy set	Typically a dividend rate step-up, board rights on non-payment, and a redemption right that is itself unenforceable if the issuer has no cash

• The reason a sponsor uses preferred rather than a holdco note is covenant treatment: preferred that cannot be redeemed before the debt matures and whose return can be deferred without a default is not debt in the leverage definition, so it does not consume debt capacity. Get any one of those features wrong and the rating and the covenant both re-characterise it.
• Preferred equity has debt-like return targets and equity-like remedies. That asymmetry is the entire risk: a preferred holder in distress has a claim, a coupon, and no leverage.
• Whether preferred sits at the opco or at a holdco changes almost nothing for the preferred holder, because it is already behind all debt at either level. It changes a great deal for the debt, which is why the debt documents police it.

ABL revolver and the borrowing base

An asset-based revolving facility sized not to EBITDA but to a formula applied to eligible receivables and inventory, less reserves, and recalculated on each borrowing base certificate. Availability, not a covenant, is the primary control.

Field	Value
Formula	BB = a_AR * Eligible AR + a_INV * NOLV_pct * Eligible Inventory - Reserves; Availability = min(Commitment, BB) - Drawn - LCs
Worked	Eligible AR 50 at 85 percent advance = 42.50. Eligible inventory 30 at 70 percent NOLV and an 85 percent advance = 30 * 0.70 * 0.85 = 17.85. Reserves 3.00. BB = 42.50 + 17.85 - 3.00 = 57.35 against a 75.00 commitment, so availability is capped by the base, not the commitment.
Sensitivity	A 10 percent fall in eligible AR removes 4.25 of availability; the same 10 percent fall in inventory removes 1.79. Advance rates make receivables roughly 2.4 times as availability-productive per dollar here.

• The lender's real control is the reserve. Reserves are discretionary in most ABL documents, so the lender can reduce availability without amending anything and without declaring a default. Borrowers negotiating an ABL should spend their effort on the reserve definition, not the advance rates.
• Eligibility criteria - concentration limits, ineligibles, cross-ageing, dilution - remove more availability in practice than the advance rates do, and they tighten automatically as the business deteriorates. A borrowing base is procyclical by construction.
• A springing fixed-charge covenant that triggers below an availability threshold means the covenant appears exactly when the borrower can least satisfy it. The threshold is the covenant.

NAV loan (fund-level facility)

A loan to a fund or a holding vehicle, secured by the fund's portfolio of investments or the equity of the vehicles that hold them, sized to a loan-to-value against net asset value rather than to any portfolio company's cash flow. Distinct from a subscription line, which is secured by uncalled LP commitments.

Field	Value
Formula	LTV = D / NAV. Covenant breach when NAV < D / LTV_max. Permitted NAV decline before breach = 1 - (D / LTV_max) / NAV_0
Worked	NAV 500, loan 100, so LTV = 20.0 percent. With a 35 percent LTV covenant, breach occurs when NAV falls below 100 / 0.35 = 285.71. Permitted decline = (500 - 285.71) / 500 = 42.9 percent.
After a distribution	Distributing 100 of realisations without prepaying takes NAV to 400 and LTV to 25.0 percent, cutting the permitted decline to (400 - 285.71) / 400 = 28.6 percent

• The covenant is measured against a NAV the borrower marks. That is the structural weakness of the instrument and the reason lenders negotiate independent valuation triggers, concentration limits, and cash-sweep tests rather than relying on LTV alone.
• The dangerous case is a NAV loan used to fund distributions rather than investments. It converts unrealised value into realised DPI while leaving the LP economically long the same portfolio plus a senior claim ahead of them. DPI ceases to mean what an allocator reads it to mean.
• Because a NAV facility is senior to LP capital at the fund level, LP loss is levered by it. The right disclosure question is not the LTV but the NAV decline at which LP equity is impaired.
• Subscription lines and NAV loans are frequently discussed together and have opposite risk. A subscription line is secured by uncalled commitments and is a credit exposure to the LPs; a NAV loan is secured by assets and is an exposure to the portfolio.

Source: ILPA guidance on subscription lines of credit and on NAV-based facilities addresses disclosure of both.

Recurring revenue loan

A term loan to a business with contracted recurring revenue and negative or immaterial EBITDA, sized to a multiple of annual recurring revenue and governed by revenue, liquidity, and retention covenants rather than leverage. Documents specify a conversion date or trigger after which the tests become EBITDA-based.

Field	Value
Formula	Debt / ARR at origination; at conversion the binding test becomes Debt / EBITDA <= L_max, which implies a required EBITDA margin m* = (Debt / L_max) / ARR
Worked	ARR 60, debt 30, so 0.50x ARR. Conversion covenant is 5.00x total leverage. Required EBITDA = 30 / 5.00 = 6.00, which on 60 of ARR is a 10.00 percent EBITDA margin the business must reach by the conversion date.
If ARR grows	At ARR 90 the same 30 of debt needs the same 6.00 of EBITDA, a 6.67 percent margin. Growth relaxes the conversion test without any change to profitability.

• Translating the ARR multiple into the implied margin at conversion is the single most useful piece of arithmetic on these loans, and it is rarely in the credit paper. It converts an unfamiliar metric into the familiar question of whether the company can plausibly be that profitable by that date.
• The covenants that actually protect the lender are net revenue retention and a minimum liquidity test, because they fail before revenue does. A gross ARR covenant can be satisfied by discounted new bookings while the installed base is churning.
• ARR definitions in these documents are negotiated and non-uniform: annualisation window, treatment of non-recurring and usage-based revenue, and whether contracts in a notice period still count. Two loans quoted at the same ARR multiple can be at materially different real multiples.