CAPITAL STRUCTURE – DEBT AND EQUITY

What are the Components?

Senior Debt: A class of loans with priority on the repayment list if a company goes bankrupt.
Holders of this form of financing have first right on a company’s assets. This means that in a
liquidation event, lenders holding subordinated notes are not paid out until senior creditors
are paid in full. Because of the minimal risk that accompanies this block of the capital
structure, senior lenders loan money at lower rates (i.e., lower interest payments and less
restrictive debt covenants) relative to more junior tiers.

Subordinated Debt: A class of loans that ranks below senior debt with regard to claims on
assets. For this reason, this block of the capital structure is more risky than senior borrowings.
However it also comes with commensurately higher returns, usually in the form of higher
interest payments. For more, see our piece on drivers behind the rebounding popularity of
subordinated debt.

Mezzanine Debt: A class of subordinated debt that blends equity and debt features. It
therefore receives liquidation after senior capital and is generally used when traditional
funding is insufficient or unavailable. Correspondingly, mezzanine firms lend at higher
interest rates than traditional debt providers, and usually reserve the right to trade some of
their debt for equity. Though mezzanine financing exhibits both equity- and debt-like
characteristics, it’s usually classified as a category within subordinated debt. For more
details, see our overview of mezzanine debt.

Hybrid Financing: A class of the capital structure in publicly-traded companies that also
blends equity and debt features. By definition, hybrid securities are bought and sold through
brokers on an exchange. Hybrid financing can come with fixed or floating returns, and can
pay interest or dividends.

Convertible Debt: A class of hybrid financing. Convertible bonds are the most common type
of hybrid financing, and usually take the form of a bonds that can be converted to equity. The
conversion can only happen at certain points in the firm’s life, the equity amount is usually
predetermined, and the act of converting is almost always up to the discretion of the debt
holder.

Convertible Equity: A class of hybrid financing. Convertible equity usually takes the form
of convertible preferred shares, which is preferred equity that can be converted to common
equity. Like convertible debt, convertible preferred shares convert into common shares at a
predetermined fixed rate, and the decision to convert is typically at the owner’s discretion.
Importantly, the value of a firm’s convertible preferred shares is usually dependent on the
market performance of its common shares.

Preferred Equity: A class of financing representing ownership interest in a company. As

opposed to fixed income assets (e.g., debt), equity is a variable return asset. However,
preferred equity has both debt and equity characteristics in the form of fixed dividends (debt)
and future earnings potential (equity). Correspondingly, it gives the holder upside and
downside exposure. Its claims on the company’s assets and profits come behind those of debt
holders and ahead those of common stock holders. Generally, preferred equity obligates
management to pay its holders a predetermined dividend before paying dividends to common
shareholders. On the flipside, preferred equity typically comes without voting rights.

Common Equity: Also a class of financing representing ownership interest. Common equity
is the junior-most block of the capital structure and therefore represents ownership in an
business after all other obligations have been paid off. For this reason, it comes with the
highest risk and the highest potential returns of any tier in the capital structure.

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