Debt Tranches Explained: Senior Debt, Unitranche, High Yield, Mezzanine and PIK

If you're recruiting for investment banking, sooner or later someone will ask you to walk through a capital structure. "What's the difference between a term loan and a high yield bond?" or "Why would a sponsor use a unitranche?" are fair game in technical interviews, especially for leveraged finance, sponsors coverage, or restructuring.

The good news: every debt tranche can be explained with the same few questions. Who gets paid first? Is it secured? Is the rate fixed or floating? Can you repay it early? How is interest paid? Once you can answer those for each layer, you've got the topic down.

Let's go through each tranche, then put them together in a worked LBO example.

The Big Idea: Risk Goes Up, So Does the Price

Think of a capital structure as a stack. The higher you sit in the stack, the earlier you get paid if things go wrong, and the less return you demand.

• Top of the stack: senior secured loans. Lowest risk, lowest cost.
• Middle: high yield bonds and mezzanine. More risk, higher cost.
• Bottom: equity. Last to get paid, highest expected return.

Every tranche is a tradeoff between cost to the borrower and flexibility. Cheap debt comes with strings attached (security, covenants, amortization). Expensive debt gives the company more breathing room.

Senior Secured Debt (Bank Debt)

This is the foundation of most leveraged deals. It's secured by the company's assets, sits at the top of the repayment waterfall, and almost always carries a floating rate, quoted as a benchmark (SOFR in the US) plus a spread.

Revolving Credit Facility (Revolver)

A revolver works like a corporate credit card. The company draws when it needs cash and repays when it can.

• Usually undrawn or lightly drawn at closing
• Borrower pays interest on drawn amounts and a smaller commitment fee on the undrawn portion
• Used for working capital swings, not to fund the purchase price

Term Loan A (TLA)

• Typically held by banks
• Meaningful amortization, so a chunk of principal is repaid every year
• Usually shorter maturity than other term debt
• Comes with maintenance covenants, meaning the company must pass tests like a maximum leverage ratio every quarter

Term Loan B (TLB)

This is the workhorse of sponsor-backed deals.

• Sold to institutional investors like CLOs and loan funds
• Minimal amortization, commonly 1% per year, with the rest due at maturity (a "bullet")
• Longer maturity than a TLA
• Often covenant-lite, meaning no quarterly maintenance tests
• Usually prepayable at or near par, sometimes with a small soft-call premium for a short period after closing

Why sponsors love TLBs: cheap, flexible, and they can refinance or pay them down without big penalties.

Quick Note on Second Lien

A second lien term loan is secured by the same collateral as the first lien, but it only gets paid from that collateral after the first lien is made whole. It's more expensive than first lien and usually has call protection. Interviewers sometimes slip this in, so know it exists.

Unitranche

A unitranche is one loan that replaces what would otherwise be separate senior and subordinated tranches. Instead of a TLB plus a bond, the company borrows one big chunk from a single lender or small club.

Who Provides It?

Mostly direct lenders and private credit funds, not banks syndicating to the market.

Why Would a Borrower Choose One?

• Speed and certainty: no syndication process, no marketing to dozens of investors, no risk of the market souring mid-deal
• One set of documents: simpler negotiation, one interest rate
• Confidentiality: you're dealing with a handful of lenders instead of the public market
• Easier amendments later: negotiating with one or two lenders beats herding a syndicate

What's the Catch?

• Pricing: the blended rate usually lands above a senior loan and below mezzanine. For a company that could easily access the syndicated market, it can be more expensive.
• Covenants: unitranche lenders often want maintenance covenants, so it can be tighter than a cov-lite TLB.

First-Out / Last-Out

Behind the scenes, lenders sometimes split a unitranche into a first-out piece (paid first, lower return) and a last-out piece (paid second, higher return) via an agreement among lenders. The borrower still sees one loan and one rate.

High Yield Bonds

High yield bonds (also called junk bonds) are rated below investment grade, meaning below BBB- by S&P/Fitch or Baa3 by Moody's.

Key Features

• Fixed coupon, unlike floating rate loans
• Bullet maturity, often longer than the term loans
• Can be secured or unsecured, and senior or subordinated. Many LBO bonds are senior unsecured notes, which rank behind secured loans in a recovery.
• Incurrence covenants instead of maintenance covenants. The company only gets tested when it takes a specific action, like issuing more debt or paying a dividend.
• Usually sold to institutional investors, commonly through a Rule 144A offering, and they trade in the secondary market

Call Protection

This is a favorite interview detail. Bondholders don't want to be refinanced the moment rates fall, so high yield bonds typically have:

• A non-call period at the start (e.g., an 8-year bond that's non-callable for 3 years, written "NC3")
• After that, call premiums that step down over time until the bond can be redeemed at par

Translation: bonds are less flexible than term loans. That's the price of a fixed rate, looser covenants and no amortization.

Mezzanine Debt

Mezzanine sits between senior debt and equity. It's usually subordinated and unsecured (or deeply junior in security), and it's often privately negotiated with a small group of investors rather than sold in the public markets.

How Mezz Investors Get Paid

Because they're so far down the stack, mezz lenders want returns that start to look equity-like. They get there through a combination of:

• Cash interest
• PIK interest (more on this below)
• Equity kickers, such as warrants that let them buy a small slice of the company's equity

When Does Mezz Show Up?

• Middle-market deals that are too small for the high yield bond market
• Deals where the sponsor wants to stretch leverage beyond what senior lenders will provide without writing a bigger equity check
• Situations where a company needs flexible, patient capital

Mezz is expensive, but it's still often cheaper than the sponsor's own required return on equity, which is why sponsors use it.

PIK (Payment-in-Kind)

PIK isn't really a separate seat in the stack. It's a way of paying interest. Instead of paying cash, the borrower adds the interest to the principal balance. The debt grows every period.

Worked Example

Say a company issues $100m of PIK notes at 12%, compounding annually, with everything due in 5 years.

The company paid zero cash interest for five years, but now owes about $176m, roughly 76% more than it borrowed. That compounding is the whole story.

Flavors of PIK

• Full PIK: all interest is paid in kind
• Cash + PIK split: common in mezzanine (e.g., part of the coupon in cash, part PIK)
• PIK toggle: the borrower can choose each period whether to pay cash or PIK, usually with a higher rate if it picks PIK

Holdco PIK

PIK notes are often issued at a holding company above the operating company. Since the holdco's only asset is its equity in the opco, holdco lenders are structurally subordinated: every opco creditor gets paid before any value flows up to them. This makes holdco PIK one of the riskiest debt instruments around.

Why Use PIK at All?

• It preserves cash for operations, capex or paying down senior debt
• It lets sponsors add leverage without straining interest coverage
• It can fund a dividend recap at the holdco level

Side-by-Side Comparison

Terms vary deal by deal, so treat this as the typical pattern, not a law of nature.

Putting It Together: An LBO Example

Let's build a capital structure for a sponsor buying a company with $100m of EBITDA at 10.0x, so a $1,000m purchase price (ignoring fees to keep it clean).

All interest rates below are illustrative, chosen to show the ordering, not to quote today's market.

Option 1: Syndicated Structure

Quick checks an interviewer might want:

• Total leverage: $600m / $100m = 6.0x
• Senior secured leverage: $400m / $100m = 4.0x
• Equity contribution: $400m / $1,000m = 40%
• Cash interest coverage: $100m / $49.5m ≈ 2.0x

Notice the mezz PIK: the $2.0m isn't paid in cash, so it helps coverage today but adds to the balance owed later.

Option 2: Unitranche Structure

Now swap the TLB and the bonds for a single $550m unitranche at an illustrative 9.5%, keeping the mezz and equity the same.

• Unitranche cash interest: $550m × 9.5% = $52.25m
• Plus mezz cash interest of $4.0m = $56.25m total
• Coverage: $100m / $56.25m ≈ 1.8x

So in this example the unitranche costs more. Why might the sponsor still pick it? Certainty and speed. If the market is choppy or the deal is competitive, knowing the financing is locked with one lender can be worth the extra spread.

What Happens If Things Go Wrong?

Say the business stumbles and the company restructures with an enterprise value of $500m. Using the syndicated structure and a simplified waterfall (ignoring admin claims, fees and accrued interest):

1. Term Loan B ($400m): paid in full, 100% recovery. $100m left.
2. Senior Notes ($150m): get the remaining $100m, so $100m / $150m ≈ 67% recovery
3. Mezzanine ($50m, plus accrued PIK): 0% recovery
4. Equity: wiped out

This is exactly why the mezz lender demanded a higher return and why the TLB was the cheapest debt in the stack.

How to Answer These in an Interview

A few questions you should be ready for:

"Walk me through the differences between bank debt and high yield bonds." Hit the five points: bank debt is secured, floating, has some amortization, tighter covenants and is easy to prepay. High yield is often unsecured, fixed rate, bullet maturity, incurrence covenants and has call protection.

"Why would a company issue PIK debt?" To preserve cash and increase leverage without hurting cash interest coverage. Then mention the downside: the balance compounds, and holdco PIK is structurally subordinated.

"Why use a unitranche instead of a TLB and bonds?" Speed, certainty of execution, one set of documents, fewer lenders to deal with. Tradeoff is usually a higher blended rate and sometimes tighter covenants.

"Where does mezzanine fit and why is it expensive?" Between senior debt and equity, usually subordinated and unsecured. Lenders take more risk, so they get cash plus PIK interest and often warrants.

"Why would a sponsor add more expensive debt instead of more equity?" Because even pricey mezz or PIK is typically cheaper than the sponsor's target return on equity. Less equity in means a higher potential IRR, at the cost of more risk.

The Takeaway

Don't memorize tranches as a list of random facts. Run every one through the same filter: seniority, security, rate type, amortization, covenants, prepayment and how interest is paid. Once you can do that, you can explain any capital structure an interviewer throws at you, including the weird hybrid ones.

Then practice building a simple stack like the one above from scratch. If you can size the tranches, calculate leverage and coverage, and run a quick recovery waterfall, you'll be ahead of most candidates in the room.