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L.3 · ADVANCED · 2 MIN

Debt Structure in LBOs: Layers of the Capital Stack

LBO debt is not a single loan — it’s a layered capital stack where each layer has different priority, cost, and covenants. Understanding the stack is essential for both LBO modeling and credit analysis.

Quiz · 5 questions ↓

Compare

LayerCostCovenantsPriority
Revolving CreditSOFR + 200–300 bpsTightest (maintenance)First priority (but undrawn)
Term Loan ASOFR + 200–350 bpsMaintenance covenantsSenior secured
Term Loan BSOFR + 300–500 bpsIncurrence onlySenior secured
Senior Notes6–8% fixedIncurrence onlySenior unsecured
Mezzanine/Sub Notes10–14%MinimalSubordinated
Equity20–25% targeted IRRNone — residual claimLast

Key point

Maintenance covenants (tested quarterly) vs. incurrence covenants (tested only when taking new action) — this distinction is critical. Covenant-lite (cov-lite) deals with only incurrence covenants give borrowers more flexibility but less lender protection.

Try it

When reading about an LBO or leveraged loan, check whether the debt has maintenance or incurrence covenants. Cov-lite structures are more borrower-friendly but mean lenders have less early warning if things deteriorate.

Check-in

An LBO uses 4x senior secured, 2x subordinated, and 1x equity (7x total). If EBITDA drops 30%, which layer is at risk?

Key insight

In an LBO, the equity check is the shock absorber. If things go well, equity earns 20%+. If things go badly, equity is wiped out before any debt layer takes a loss. This is why PE firms demand such high returns — they’re bearing the first-loss risk.

Check-in

PE-backed company's capital stack: $500M senior secured debt (5% rate), $200M mezz (10% rate), $200M equity. Enterprise value $900M. Post-deal, EBITDA drops 20%. What's the 'danger tranche'?
Check your understanding

Sit with the ideas.

An LBO target has $150M EBITDA and $40M capex. The proposed debt structure is: $300M Term Loan at 7%, $200M Senior Notes at 9%, and $100M Mezzanine at 13%. Mandatory amortization is $30M/year. Can the company cover its debt service?

Why:
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Other lessons in this course.

  1. 01LBO Mechanics: How Financial Sponsors Create Returns
  2. 02LBO Return Decomposition: IRR Drill
  3. 03Debt Structure in LBOs: Layers of the Capital Stack— reading now
  4. 04IRR Math: What PE Firms Actually Target
  5. 05What Makes a Good LBO Candidate?
  6. 06LBO Sensitivity and Exit Analysis
  7. 07Sponsor Returns Structure
  8. 08Cash Sweep Mechanics: How FCF Routes to Debt Paydown
  9. 09PIK Toggles and Equity Kickers: Deal-Stress Signals
  10. 10MoIC vs IRR: Drivers of Divergence and Choosing the Right Metric
  11. 11Sponsor Fee Waterfall: Management, Transaction, and Monitoring Fees
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