Deal Structuring

The Capital Stack: From Senior Debt to Common Equity

The capital stack is the ordered set of claims that finance an asset or company, from senior secured debt at the bottom through subordinated debt, mezzanine and preferred equity to common equity at the top. Lower positions are paid first and earn less; higher positions absorb losses first and demand higher returns for that risk.

What is the capital stack?

The capital stack describes every source of capital in a deal and the order in which each is repaid. It is usually drawn as a vertical bar with senior debt at the bottom and common equity at the top. Cash flow and liquidation proceeds move upward through the stack: each layer must be satisfied before the next receives anything. Losses move the other way, wiping out common equity first, then preferred equity and mezzanine, and reaching senior debt only after everything above it is gone. Understanding the stack is essential because the same asset can be a safe or a risky investment depending on where in the stack the capital sits.

The stack also governs control. Senior lenders usually hold the most powerful remedies, including foreclosure, cash management and approval rights over major decisions, even though their economic upside is capped. Common equity controls the business day to day while things go well but can lose control quickly after a default. Junior positions sit in between, with negotiated rights to cure, purchase or step into the owner's shoes. When evaluating any layer, the question is not only how much loss it can absorb, but also who decides what happens to the asset when performance falls short of plan.

What sits in each layer of the stack?

Senior debt holds a first priority claim, usually secured by a first lien on the collateral, and carries the lowest cost. Second lien or subordinated debt sits behind it, with a junior lien or no lien and a higher rate. Mezzanine debt in real estate is typically secured by a pledge of the equity interests in the property owning entity rather than the property itself, while in corporate finance it is often unsecured subordinated debt with an equity kicker. Preferred equity has priority over common equity for distributions and return of capital but is not debt, so its remedies come from the partnership or operating agreement rather than a mortgage.

Common equity is the residual claim. It receives whatever remains after all senior claims are paid, so it captures all upside beyond the fixed returns promised to the layers below, and it bears the first dollar of loss. Sponsors and operators typically hold common equity alongside outside investors, sometimes with a promoted interest that enlarges their share of profits. The labels on each layer can mislead, so an analyst should always read the governing documents: a security called preferred equity may carry a mandatory redemption date and fixed return that make it behave much like debt, while a so called senior loan may be structurally subordinated to obligations at operating subsidiaries.

• Senior secured debt: first lien, lowest cost, tightest covenants
• Second lien or subordinated debt: junior claim, higher coupon
• Mezzanine debt: pledge of equity or unsecured, often with fees or warrants
• Preferred equity: priority distributions, partnership remedies, higher return target
• Common equity: residual claim, first loss, uncapped upside

What are attachment and detachment points?

Each layer can be described by where it attaches and detaches as a percentage of value. Senior debt at 55% of value attaches at 0% and detaches at 55%. A mezzanine loan of 15% attaches at 55% and detaches at 70%. Attachment is the cumulative capital that must be lost before that layer takes a loss, measured from the top down, which is the cushion beneath the investor's money. Expressing the stack this way makes it easy to see how much value decline each investor can absorb and to compare positions across different deals on a consistent basis.

How is each layer priced?

Pricing rises with subordination because expected loss and loss volatility rise as the cushion shrinks. Senior debt prices off a base rate plus a spread that reflects default probability and a modest loss given default. Mezzanine pricing combines a higher cash coupon, sometimes a payment in kind component, origination and exit fees and occasionally warrants. Preferred equity targets returns closer to equity but with a fixed preferred return and a priority claim. Common equity has no promised return at all; investors underwrite to a target internal rate of return that compensates for being first loss.

The weighted average cost of the stack is the blended cost of all layers. Adding a cheaper senior layer lowers the blended cost until the additional leverage raises the risk and required return of every junior layer. That tension defines the optimal structure: enough debt to improve equity returns, but not so much that junior capital becomes expensive or the asset cannot withstand a downturn. Fixed claims also reduce flexibility, since every dollar of required debt service is a dollar unavailable for capital projects, leasing costs or simply riding out a soft year without a default.

How do intercreditor arrangements protect each layer?

When more than one lender is involved, an intercreditor agreement governs their relationship. It sets payment priority, standstill periods during which junior lenders cannot enforce remedies, rights of junior lenders to cure senior defaults or buy out the senior loan, and restrictions on amendments that would harm the other party. In real estate, the mezzanine lender's key right is the ability to foreclose on the pledged equity quickly through a sale under commercial law, taking control of the property owner without disturbing the mortgage. These terms often matter more to junior capital than the headline coupon, because they determine what the junior lender can actually do when the deal goes wrong.

How should an underwriter evaluate a position in the stack?

An underwriter evaluating any layer should start from the full stack rather than the position in isolation. The key questions are how much value sits below the position, how much cash flow is consumed by senior claims, and what control rights the position carries in distress. A senior loan behind a thin equity layer may be riskier than a mezzanine loan behind a large, committed equity check. The analyst should model the stack under a value decline and a cash flow decline, confirm which layer controls decisions in each scenario, and price the position for both expected loss and the cost of enforcing rights.

Allocating a 25% value decline through the stack

1. A $100,000,000 acquisition is financed with $55,000,000 senior debt, $15,000,000 mezzanine, $10,000,000 preferred equity and $20,000,000 common equity.
2. Attachment and detachment points: senior 0% to 55%, mezzanine 55% to 70%, preferred 70% to 80%, common 80% to 100%.
3. Value falls 25% to $75,000,000. Senior is repaid first: $75,000,000 - $55,000,000 = $20,000,000 remains.
4. Mezzanine is repaid next: $20,000,000 - $15,000,000 = $5,000,000 remains.
5. Preferred equity receives the remaining $5,000,000 of its $10,000,000, a 50% loss. Common equity receives $0, a 100% loss. Senior and mezzanine are whole because the decline did not reach their detachment points.

How underwriters apply this

• Map every position by attachment and detachment point before comparing returns across layers.
• Judge a layer by the equity and junior capital beneath it, not by its label.
• Read the intercreditor or recognition agreement for standstill, cure and purchase option rights.
• Model value and cash flow declines separately, since a position can be safe on one and exposed on the other.
• Confirm that common equity is committed cash at risk; thin equity raises the risk of every layer.
• Price junior capital for enforcement cost and control, not only for expected loss.

Frequently asked questions

Keep reading

Educational content written by practitioners. Not investment, accounting, legal or tax advice.