7 Steps to Structure Sponsor Mezzanine Debt Under Senior Facilities

Mezzanine Debt: Structure, Terms, and Execution Guide

Mezzanine debt is junior capital that sits below a senior secured facility in payment priority and often in lien priority. It fills the gap between senior loans and equity when a sponsor wants to stretch proceeds or reduce dilution. Common tools are second-lien term loans, unsecured subordinated notes, and holding company payment-in-kind notes.

The goal is simple: add a junior layer that clears the senior documents, protects priority in enforcement, and cash-flows under the covenants the borrower actually has. You get there by mapping senior constraints first, fixing the intercreditor guardrails early, and then writing junior terms that survive legal, tax, accounting, and regulatory review. If you start with a pretty term sheet and only later read the senior credit agreement, you are negotiating with yourself.

Why sponsors use mezzanine and what it must achieve

Sponsors use mezzanine to fund acquisitions, growth, and shareholder distributions when senior capacity tops out. The trade is a higher yield for a junior position and delayed control in a downside. The craft is in threading baskets, liens, and payments so junior interest flows when the plan is on track and the senior agent still sleeps at night. Speed matters in competitive processes, and certainty matters when ratings, regulators, or boards are watching. For readers new to the topic, this primer complements a broader overview of the strategy in mezzanine financing explained.

Step 1: Choose the mezzanine form and issuer perimeter

Form follows use of proceeds, senior headroom, and timing. The issuer location determines which covenants bind the junior debt and how fast you can close.

Second-lien at OpCo: Pros include collateral, higher recovery, and lower coupon. Cons include full intercreditor and perfection work, plus most-favored-nation and anti-layering provisions in the senior that can bite on timing and risk.
Unsecured subordinated at OpCo: Pros are simpler perfection and flexible covenants. Cons are deeper subordination with payment blocks and a higher coupon.
Holdco PIK notes: Pros are outside the restricted group, faster closing, and minimal collateral work. Cons are structural subordination, limited covenants, higher pricing, and dependence on upstream capacity for cash pay.

Pick the issuer perimeter deliberately. If the senior documents define a restricted group, a holdco issuer above it avoids debt and lien covenants but shifts the constraint to restricted payments and dividends. If the junior sits inside the restricted group, you must live within permitted debt, lien, and prepayment baskets and deliver an intercreditor agreement acceptable to the senior agent.

Kill tests that save weeks

Senior bans: If senior documents ban junior lien or subordinated debt, only holdco PIK or preferred equity works without a senior amendment.
Basket sizing: If baskets do not size the ask and ratio tests fail, either resize or pivot to holdco.
Cash pay need: If the sponsor needs cash pay and near-term prepay but senior has blocks or sweeps that trap cash, holdco PIK with a toggle is often the only workable path.

Step 2: Map senior facility constraints and capacity

Read the senior credit agreement end-to-end before trading a term sheet. Focus on debt, liens, restricted payments, investments, prepayments, definitions, and amendment mechanics. Translate that into capacity and blocks you can live with.

Debt capacity: Identify fixed, grower, and ratio baskets. Note caps tied to Consolidated Secured Debt, First Lien Debt, or Total Debt. Watch anti-layering language that restricts junior liens if no pari capacity exists. Ratio debt requires pro forma leverage compliance and no defaults.
Lien capacity: Confirm a second-lien basket or the ability to designate an incremental as junior lien. “Permitted Liens” should include liens securing subordinated debt subject to an intercreditor agreement acceptable to the senior agent.
Payment subordination: Many senior documents define subordinated indebtedness and restrict cash interest and principal until leverage or time tests are met. Align the junior coupon, PIK toggle, and redemption terms to fit that regime.
Maturity profile: Seniors often require junior maturity at least 91 to 180 days after senior maturity. Add the buffer and align any springing maturities or change-of-control puts.
Sweeps and blockers: Excess cash flow sweeps and voluntary prepayment blocks on subordinated debt are common. Draft optional redemption provisions to avoid tripping a block.
Incremental and MFN: Tapping senior incrementals can trigger MFN pricing limits. Keeping mezz outside the incremental avoids MFN but needs baskets.

With most new U.S. institutional loans running covenant-lite, protection sits in definitions and incurrence tests, not maintenance covenants. Your ratio debt and restricted payment headroom rests on EBITDA addbacks, pro forma adjustments, and netting. Negotiate those early so the math works when you need it.

Step 3: Engineer the intercreditor and subordination framework

The intercreditor agreement governs collateral, enforcement, and payment priority. Senior lenders will not rely on the junior indenture. For deeper drafting tips, see this practical guide to intercreditor agreements.

Subordination type: Second-lien uses lien and payment subordination; unsecured subordinated uses payment only. Holdco PIK relies on structural subordination and usually stays outside the intercreditor unless it seeks information access.
Collateral and guarantees: If secured, mirror senior collateral scope except for legal or practical exclusions. Use a common collateral agent to simplify releases and foreclosures.
Enforcement standstill: Typical second-lien standstills run 90 to 180 days after senior acceleration. Define clear triggers, bankruptcy carve-outs, and automatic end on senior pay-off. Prohibit juniors from opposing senior debtor-in-possession financing absent consent.
Payment blockage: Block junior cash interest, principal, and fees during senior defaults and standstills. Allow PIK unless prohibited. Turn over any payments received in violation.
Amendment rights: Preserve lien priority, collateral release limits, and pro rata treatment. Protect against uptiering, non-pro rata exchanges, and unrestricted subsidiary drop-downs or require junior consent.
Proceeds waterfall: Seniors take 100 percent until paid in full. Define “paid in full” precisely to avoid fights over contingent indemnities and post-petition interest.
Information and transfers: Provide juniors financials and default notices subject to confidentiality. Limit transfers to exclude competitors and disqualified institutions; align lists across senior and junior documents.

Step 4: Set economics and the fee stack

Price to structural position, cash flow volatility, covenant protection, and sponsor quality. Mechanics matter as much as headline yield and can drive effective return more than a few basis points of coupon. For related concepts on prepayment math, see this explainer on call protection and OID.

Coupon mix: Blend cash and PIK with a toggle. Upper mid-market often lands at 10 to 14 percent total yield; holdco PIK trends higher.
OID and fees: Use original issue discount and upfront fees. Add a ticking fee for delayed draws.
Call protection: No-call one year is common, then 102 to 101 declining premiums.
Prepayment gates: Condition on senior compliance and intercreditor gates.
Equity kickers: Rarer in competitive sponsor deals but still used in smaller or hairier credits.

Concise example

Size: 100 million mezz under a 600 million senior first-lien. Form: unsecured subordinated at OpCo with intercreditor. Pricing: 12 percent total yield (5 percent cash, 7 percent PIK), 2 percent OID, 1 percent arrangement fee, and 50 basis points ticking after 30 days. Call: no-call one year, then 102, 101, par. Maturity: six years, 180-day cushion past senior. Covenants: incurrence-based leverage and restricted payments aligned to senior, plus a minimum liquidity to protect cash interest. Prepayments: permitted when no senior default and pro forma leverage compliance; a PIK stopper flips the toggle if leverage drifts beyond an agreed threshold. Cash impact year one is 5 million cash interest and 7 million PIK accretion. Include an automatic toggle with a 50 basis point step-up during blocks so economics hold when cash pay is paused.

Step 5: Documentation map and closing deliverables

Draft junior documents alongside the intercreditor. Use senior definitions to avoid interpretive gaps and close faster.

Core documents: Mezzanine credit or note purchase agreement, intercreditor and subordination agreement, security documents and guarantees if secured, any warrant or equity instrument, fee letter, and optional sponsor support letter.
Closing deliverables: Solvency certificate, board approvals, officer’s certificates, legal opinions, UCC filings and local registrations, perfection certificates, insurance evidence, KYC and AML packages, FATCA forms, and any senior agent consents.
Execution sequence: Lock the intercreditor term sheet first, converge definitions across senior and junior, finalize collateral and guarantors using senior schedules, clear tax and regulatory treatment of PIK, OID, and any warrants before printing, and obtain senior acknowledgements where required.
Local filings: Mind Companies House charge registration in England and Wales within 21 days, UCC and IP filings in the U.S., and notarial steps in civil law jurisdictions.

Step 6: Accounting, tax, and regulatory treatment

Accounting – issuer: Under U.S. GAAP, classify as debt unless ASC 480 or embedded features say otherwise. Book OID and fees as a discount. PIK accrues to principal. Under IFRS, if solely payments of principal and interest and hold-to-collect, measure at amortized cost; otherwise, fair value through P&L.
Accounting – lender: Private funds typically carry at fair value. Others apply CECL or IFRS 9 expected credit loss models. PIK accretion increases basis and can affect expected loss.
Tax – issuer: In the U.S., Section 163(j) caps interest deductibility; PIK is still interest. OID deducts over time. Withholding may apply to non-U.S. lenders unless treaty or portfolio interest exemption applies; keep W-8s current.
Tax – lender: U.S. lenders pick up OID and PIK accruals regardless of cash. Non-U.S. lenders rely on treaty or portfolio interest; equity kickers may create separate capital gains treatment.
Regulatory: Loans generally pass the Reves test. Junior notes and warrants rely on private placement exemptions under Regulation D or Regulation S. Build KYC, AML, sanctions, beneficial ownership, and state usury checks into closing and ongoing reporting.

Step 7: Execution plan, governance, and risk controls

Run a realistic timeline and assign clear owners to cut friction and keep certainty high.

Timeline: Weeks 1 to 2 select structure, quantify baskets, line up intercreditor asks, and start tax and accounting work. Weeks 2 to 3 agree mezz and intercreditor term sheets and fix definitions. Weeks 3 to 5 draft documents, run diligence and perfection, and prepare tax forms. Weeks 4 to 6 clear conditions precedent and obtain senior consents. Weeks 6 to 8 sign, fund, and file.
Owners: Sponsor handles structure, economics, tax and accounting, and solvency; borrower counsel handles borrower documents, approvals, and perfection; junior lender counsel handles mezzanine documents and intercreditor negotiation; senior agent counsel handles intercreditor and senior protections; collateral agent coordinates lien sharing and perfection; tax adviser handles deductibility and withholding; auditor or valuation adviser addresses classification and fair value policy; administrator manages reporting and interest calculations.
Governance: Set reporting that respects senior sharing limits but keeps juniors informed: monthly liquidity and KPIs, quarterly financials and compliance certificates, audited annuals, and budgets. Use observer rights carefully. Reserve consent for material asset sales, junior incurrence, restricted payments beyond baskets, and senior amendments that affect junior priority.

Key risks and practical mitigants

Structural subordination: Holdco PIK lives on upstream capacity. Lock a distribution path at signing with permitted payment definitions and blocker carve-outs.
Intercreditor leakage: Tighten sacred rights against uptiers, drop-downs, and non-pro rata exchanges.
Cash blocks: Senior sweeps and default blocks can choke cash pay. Use toggles and define “Permitted Junior Payments” precisely.
Tax leakage: Unexpected withholding on interest or PIK hurts returns. Obtain treaty clearances and portfolio interest documentation up front.
Enforcement friction: Multi-jurisdiction collateral and long standstills depress recoveries. Use common security structures and clear release mechanics.
Accounting surprises: Embedded derivatives and warrants can trigger fair value volatility. Pre-clear with auditors and keep features simple.

Comparisons and alternatives to consider

Unitranche: Faster and fewer documents but gives the last-out less independent leverage and may constrain future layering. See how unitranche loans compare.
Second-lien vs. unsecured: Second-lien usually delivers better recovery but needs lien capacity and heavier diligence. Unsecured fits more baskets but accepts deeper blocks. Explore second-lien loans when determining fit.
Preferred equity: Eases debt constraints and avoids intercreditors; loses tax shield and can raise governance sensitivities. Learn the trade-offs in preferred equity.
NAV or asset-backed at fund or holdco: Useful when OpCo is boxed in; shifts risk to the portfolio or asset base and may price tighter if diversified.

Common pitfalls that kill deals

Maturity misalignment: Junior maturity inside or equal to senior maturity is a deal breaker. Fix with a 91 to 180 day buffer.
No acceptable intercreditor: If you cannot reach agreement, pivot to holdco PIK or amend senior.
Misaligned definitions: Adopt senior definitions or add an overlay to ensure consistency.
Insufficient upstream capacity: If holdco cash pay depends on dividends that are not permitted, go PIK-only or resize.
Tax and OID surprises: Lock forms and treaty positions early to avoid later-model shocks.
Perfection gaps: Missing UCCs, pledges, or local registrations undermine security.
Conflicting transfer restrictions: Align transfer provisions across senior and junior to preserve liquidity.

Mechanics, cash flow, and legal forms

At funding, lenders wire to the borrower or acquisition SPV, with OID and fees settled per the fee letter. Interest accrues each period. Cash pay occurs only if senior conditions are met; PIK accretes when toggled or blocked. Optional prepayments require senior compliance. After an enforcement trigger, the intercreditor routes all recoveries to senior until paid in full as defined; juniors get the residue. Use New York law for U.S. deals and English law for Europe. In Europe, rely on an English law intercreditor and local law security via a security agent. Perfect under Article 9 in the U.S. and complete IP and share pledge formalities in each jurisdiction.

Model-first checklist to validate collectability

A small but powerful addition is a model-first test of what you can actually collect. Build a three-tab workbook that runs the math before you argue term sheets.

Waterfall tab: Simulate ECF sweeps, restricted payments, and prepayment blocks to validate optional redemption language and cash pay capacity.
Covenant tab: Tie incurrence tests to the exact EBITDA addbacks and netting in the senior. Stress-test 10 percent EBITDA downside and delayed synergies.
Liquidity tab: Forecast minimum cash, revolver availability, and springing covenants. Add a toggle to switch between cash and PIK and compute effective yield.

Decision framework you can run in one meeting

Enough senior baskets and lien capacity? Choose second-lien for cost and recovery and align to second-lien structuring.
No lien capacity but subordinated allowed? Use unsecured subordinated at OpCo with a tight intercreditor.
Senior blocks both or timing tight? Use holdco PIK notes and live within upstream limits.
Dividend capacity and tax efficiency prioritized? Consider holdco PIK or preferred equity with an equity kicker.

Closing Thoughts

In short, read the senior documents like your return depends on them because it does. Lock the intercreditor early, price what you can collect, and draft so the paperwork works on a rainy day, not just at kick-off. That is how mezzanine debt earns its keep for sponsors. For further context on adjacent structures, see a detailed look at private credit market trends.