A buyout sponsor needs $400M to acquire a mid-market manufacturer. The bank syndicate offers $250M senior with tight covenants. The remaining $150M can come from a unitranche facility, mezzanine plus a high-yield bond, or a convertible note plus a smaller mezz tranche. Each path changes leverage, covenant package, return economics, and exit flexibility. This lesson maps those choices.
Private market borrowers use different debt instruments at different stages. The instrument fits the cash flow profile, asset base, and risk tolerance at each phase.
Seed and early-stage venture. Companies generate negative earnings before interest, taxes, depreciation, and amortization (EBITDA), hold few tangible assets, and rely on equity. Venture debt appears alongside Series A or B rounds: 8-14% coupons, 5-20% warrant coverage, underwritten on the sponsor's willingness to fund the next round. The loan extends the equity runway 6-12 months without dilution.
Growth stage. The company reaches positive EBITDA. Revenue-based financing, asset-based lending against receivables, and growth direct loans appear. Leverage stays modest (1.5-3.0x EBITDA) because earnings volatility is still high.
Common mistakes
- Counting PIK interest in cash coverage ratios. PIK accrues to principal, it is not a cash obligation. A loan with 8% cash and 4% PIK creates a 12% stated rate but only an 8% cash demand. Trap: candidates include the full 12% in cash interest coverage and overstate distress risk.
- Confusing covenant-lite with no covenants. Covenant-lite means no maintenance covenants; incurrence covenants remain. Borrowers can still trigger default by issuing new debt or paying dividends beyond restricted payment baskets. Trap: "covenant-lite means the borrower has no obligations" is wrong.
- Treating unitranche as cheaper than separate tranches. Unitranche blends senior and subordinated economics, so its rate sits between pure senior and the combined senior plus mezz cost. It is rarely the cheapest option. Its advantage is execution speed. Trap: "unitranche minimizes cost" is incorrect.
Bottom line
- Debt scales across the life cycle: venture debt at startup, leveraged loans and HY bonds at buyout or refinancing, convertibles at late-stage equity transition, with exit via refinance or repayment
- Leveraged loans are senior secured, floating-rate (SOFR + 300-700bp), with maintenance or incurrence covenants depending on segment; broadly syndicated form is covenant-lite while middle-market direct keeps maintenance covenants
- High-yield bonds are fixed-rate, unsecured, longer-tenor with incurrence-only covenants and meaningful call protection; convertibles trade coupon for an embedded equity option
- Unitranche = one tranche, one rate, one set of docs for speed (rate sits between senior and combined senior-plus-mezz, not cheapest); Mezzanine = subordinated PIK tranche with warrants for equity upside
Exam shortcut
When a vignette presents a buyout capital structure, compute leverage and coverage first, then check covenant cushion before debating tranche choice. The binding constraint is almost always whichever ratio sits closest to its covenant threshold. For mezzanine versus unitranche fact patterns, use the shorthand: speed and simplicity favor unitranche; lower blended cost with an equity sweetener favors mezzanine. Speed-sensitive add-on acquisitions and small middle-market sponsors prefer unitranche.
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