Financing the Deal: Debt Types 101

Debt has always been a significant part of the capital structure when it comes to private equity deals. This is still the case today. However, as the private equity market has matured, different types of debt have become more acceptable in the market, giving private equity buyers and their portfolio companies more options.

What follows is an overview of debt that’s available and commonly used in private equity deals today.

Delayed Draw Term Loans: This is a special type of loan that stipulates that the borrower can withdraw predefined amounts of the total pre-approved amount of a term loan at contractual times. It requires special provisions be added to the borrowing terms of the agreement. These loans generally come with favorable interest rates.

First Lien Senior Secured Loans: Senior loans are the first money in and the first money out. Senior debt has greater seniority in the capital structure than subordinated or junior debt. In the event the borrower goes bankrupt, senior debt should be repaid before any other creditors receive payment.

Mezzanine Capital: Also known as subordinated debt or junior capital, mezz is sometimes used by private equity firms to reduce the amount of equity capital required to finance a leveraged buyout. These loans allow borrowers to borrow additional capital beyond the levels a traditional lender is willing to lend. Mezz lenders require higher returns because the loan is riskier, as it is junior to the senior lenders, who will recoup any losses first if there is an issue with payments.

Revolving Loan: A revolving loan allows borrowers to have flexibility on the drawdown and repayment schedule. Borrowers borrow money as needed and usually use the money for working capital. This can be helpful when unexpected expenses occur or if there are income fluctuations. Revolvers don’t have a fixed number of payments and the loan can be withdrawn, repaid, and withdrawn again. Flexibility is the key here.

Second Lien Loans: This term refers to the ranking of debt in the event of bankruptcy and liquidation. It is the same as junior debt and these debts have lower priority of repayment than senior or higher-ranked debt. Junior or second lien debt typically come with a higher interest rate than traditional fixed-rate debt.

Stretch Senior Loans: A senior stretch loan is a hybrid loan that is similar to unitranche financing. It combines senior debt and junior debt into one package, typically at a lower cost to the borrower. These loans “stretch” to accommodate the financing needs of the borrower at a higher risk to the lender than a conventional senior loan. These loans have become popular in the middle market because they are typically speedy and convenient. The borrower only has to negotiate the one loan with one lender saving time and money.

Term Loans: Unlike a revolving loan, term loans have terms in regard to a specific amount borrowed and a repayment schedule with either a fixed or floating interest rate. Borrowers typically use term loans to purchase equipment or real estate.

Unitranche Loans: Unitranche loans give borrowers one loan that combines the senior and junior debt at a blended cost. Unitranche has become more widely used over the years and is in favor with borrowers as it saves on expenses and time.