Mezzanine debt is junior capital that sits between senior loans and common equity. It is typically unsecured, contractually subordinated to the senior lenders, and often structurally subordinated by being issued at a holding company. It earns a higher coupon and sometimes an equity-linked kicker to compensate for its position. It is not second-lien or unitranche: second-lien shares collateral at the operating company, and unitranche blends first-out and last-out senior risk. Classic mezz ranks below both and leans on equity value for repayment.
Where Mezzanine Still Fits in Today’s Private Credit Market
Mezzanine is a niche within private credit, and its share has shrunk as blended senior solutions expanded. Preqin estimates mezzanine and subordinated strategies at roughly 6% of global private debt AUM as of December 2023. As unitranche grew and senior documentation absorbed features once found only in mezz, traditional mezz tightened its footprint. Yet it remains relevant when sponsors want more leverage than seniors will support, prefer holding company solutions, or aim to limit dilution.
The regional ecosystems diverge. The United States retains a deep lower mid-market mezz community made up of SBIC-backed funds, BDCs, and sponsor-owned platforms. Europe leaned into unitranche for most sponsor deals; mezz tends to reappear in larger or complex stacks, above regulated assets, or in minority and growth situations where senior leverage caps block the path. Bain’s 2023 leverage data shows average debt to EBITDA around 5.3x in North America and 4.9x in Europe. When senior or unitranche caps sit at those levels, mezz commonly fills the incremental turns to meet price expectations or fund dividend recaps, trading higher all-in cost for preserved control.
Instruments and Legal Forms You Will See
US structures span several forms, each mapping to a different level of subordination and control. Subordinated unsecured notes at the operating company are governed by New York law and paired with a subordination agreement vis-a-vis the senior agent. Senior unsecured or second-out notes at a holdco are often PIK, creating structural subordination to operating company lenders. Preferred equity with debt-like economics can substitute where legal or tax constraints exist, even though the form is equity. Security at the mezz level in the US is uncommon unless it is true second-lien; when secured, intercreditor terms follow standard LSTA schemes and Section 510(a) supports enforceability of contractual subordination in bankruptcy.
European cross-border deals usually run on English law and LMA frameworks. Mezz is commonly issued at a holdco to create structural subordination without clashing with senior intercreditor limits. Security, if any, is often limited to share pledges at the mezz level or narrow upstream guarantees, given financial assistance and corporate benefit rules. In Germany, capital maintenance rules constrain upstream support, so holdco issuance avoids those traps. In France, fiducie-surete exists but is rarely used in mezz. Sponsors often compare holdco mezz with holdco PIK notes and preferred equity to balance flexibility, coupon, and governance.
How Mezzanine Cash Flows Actually Work
Mezz proceeds finance acquisitions, growth capex, or shareholder distributions. Cash-pay interest, when used, sits behind senior interest and amortization. PIK interest accrues to principal and compounds until maturity or a step-up date, which keeps early years cash-light but increases the balance at takeout. For a deeper dive into PIK mechanics and issuer trade-offs, see this guide to PIK interest in private equity.
Intercreditor agreements control the waterfall. Senior lenders take all enforcement recoveries until they are fully repaid. Mezz receives nothing until senior discharge is certified. Holdco mezz relies on upstream dividends and intercompany distributions, which can be blocked by senior leverage and RCF tests. These blocks can persist for quarters, not weeks, making modeling of upstream capacity a critical diligence step.
Standstills govern speed. In the US, mezz enforcement standstills typically run 60 to 180 days; in Europe they run longer under LMA-style agreements. Sponsors may push equity cure rights on senior maintenance tests, but cures rarely apply to mezz incurrence tests at holdco.
Intercreditor Terms That Decide Outcomes
US operating company mezz uses subordination and intercreditor agreements negotiated alongside the senior credit agreement. LSTA templates cover payment blockages, enforcement standstills, turnover, and amendment vetoes. Second-lien intercreditors are more prescriptive, while classic mezz intercreditors rely more on subordination and standstill mechanics.
European LMA intercreditors recognize separate obligor groups, define distressed disposal processes, and restrict mezz from obstructing senior enforcement. If mezz includes warrants or equity, voting rights and drag or tag alignment are documented to avoid governance friction during exits.
Leverage, Structure, and Covenant Philosophy
US mezz providers often underwrite to total leverage with a required equity cushion. In the lower mid-market, mezz commonly sits one to two turns of EBITDA above senior debt. In larger deals, mezz more often sits at holdco as PIK to preserve operating company headroom.
Europe is more constrained by unitranche and bank policies, with total leverage often capped around or below 6x EBITDA in resilient sectors. Mezz above that line appears where cash flow is durable or where asset-light models support higher multiples. Sponsors use mezz to avoid breaching senior incurrence baskets and to protect bank relationships.
US holdco mezz rarely includes full maintenance covenants. Instead, it polices behavior via incurrence tests tied to senior leverage and fixed charge coverage. US opco mezz, when present, may track the senior maintenance covenant with wider cushions. Europe favors incurrence-style covenants at holdco with tight restricted payment and debt baskets and grower components. Definitions matter, so sponsors should harmonize EBITDA addbacks, run-rate synergies, and revenue credit across senior and mezz to prevent cross-defaults from math differences.
Pricing, Equity Kickers, and Call Protection
Mezz return is a stack: cash coupon, PIK, original issue discount, call protection, and sometimes warrants. US deals often combine cash-pay and PIK with step-ups if not refinanced on schedule. Fees and OID calibrate total yield and smooth headline optics. Equity participation splits by region. US lower mid-market investors still use warrants when coverage is thin or leverage is stretched; larger US deals often skip warrants and lean on PIK step-ups. In Europe, sponsor mezz rarely includes warrants today; upside comes via higher PIK and robust call premia.
Call protection is stronger than in senior debt. Non-call for two to three years is common, followed by 103 or 102 or 101 premia or a make-whole. English law documents lean on make-whole constructs recognized by the courts, while NY-law deals use discounted cash flow at a treasury spread. For a calculation refresher, see this explainer on call protection and OID in private lending. Illustration: on a 100 note at a 12% total coupon with 2% OID and NC-2, a month-30 takeout pays accrued PIK principal, a 3% call premium, and unamortized OID, which can swing returns by 100 to 200 bps based on timing.
Information Rights and Governance Protections
US lower mid-market mezz holders often negotiate quarterly reporting plus board observer rights at holdco, especially where warrants are present. These rights offer early warning but should be calibrated to avoid consolidating control or triggering variable interest entity analysis. Europe generally provides timely financial reporting without board presence, aligning with sponsor norms and senior consent pathways. Protective vetoes cover priming debt, liens, fundamental changes, and leakage beyond baskets. Acceleration and enforcement are subordinated to intercreditor terms.
Enforcement Paths: US vs Europe
US outcomes run through Chapter 11 and UCC remedies. Seniors control collateral. Mezz holders influence plan outcomes through class votes, trading into the fulcrum tranche, or negotiating reinstated paper with extended maturities and PIK toggles. Article 9 sales can be quick when collateral is discrete. Europe relies on court-led processes. English schemes and Part 26A plans enable cross-class cram-down and are used to refine debt stacks. Continental regimes like German StaRUG and French safeguard offer pre-insolvency tools, but timing and outcomes vary by jurisdiction.
Holdco mezz creates a separate pressure point. If upstreaming is blocked, mezz receives no cash and often shifts to consensual PIK accruals or amend-to-extend. Sponsors may partially take out mezz with preferred equity or toggles to preserve flexibility and avoid litigation that could complicate senior refinancings.
Accounting, Tax, and Regulatory Considerations
Under US GAAP, most mezz with fixed coupons or mandatory redemption is a liability. Warrants may be freestanding equity or derivatives if settlement features trigger ASC 815. Under IFRS, most mezz is a financial liability at amortized cost. Funds typically carry mezz at amortized cost using an effective interest rate or at fair value if the mandate requires it. PIK toggles and change-of-control premia can create embedded derivatives under US GAAP; IFRS often treats them as closely related if basic lending features dominate.
Tax drives structure. The US portfolio interest exemption can eliminate 30% withholding for qualifying foreign lenders with proper forms, and OID is taxable as it accrues. Section 163(j) limits interest deductions to 30% of adjusted taxable income, which can bite PIK-heavy issuers. In the UK and EU, withholding depends on exemptions, treaties, or quoted Eurobond status. ATAD interest caps mirror the 30% EBITDA principle, with group ratio relief. Hybrid instruments risk deduction denial, so preferred equity with debt-like features needs early testing.
US mezz funds typically fall under the Advisers Act. BDCs operate under the Investment Company Act with periodic reporting. State usury laws can be a constraint for operating company mezz when nexus exists. Sanctions, know-your-customer, and beneficial ownership checks apply at close and transfer. In Europe, AIFMD governs manager registration and reporting, and security interests and share charges require local filings.
Key Risks, Edge Cases, and Simple Rules of Thumb
Several recurring risks deserve upfront attention. Structural leakage through unrestricted subsidiaries or non-guarantor baskets can drain value above mezz. EBITDA inflation from aggressive addbacks can delay triggers and reduce recovery. Cross-default traps from misaligned definitions can create avoidable technical defaults. Withholding on PIK or OID and interest limitation caps can create cash tax friction. Long standstills or broad senior amendment rights can weaken remedies.
Edge cases complicate baselines. Asset-light software warrants using ARR or net retention tests as adjuncts to fixed charge coverage. Regulated assets often require holdco mezz with narrow consent regimes because pledgeability is limited. Sponsor clubs must align intercreditor terms across multiple senior agents early to prevent divergent processes.
Two practical heuristics help underwriting discipline: first, target free cash flow that covers all mezz cash-pay by at least 1.5x under downside cases. Second, if upstream capacity under senior covenants is uncertain within the next 24 months, price for a PIK-heavy path or choose a holdco instrument that tolerates blocks, such as mezzanine debt with higher PIK or preferred equity with cash deferral features.
Execution Guidance for Sponsors and Lenders
Decide early whether the instrument sits at the operating company or holdco. Operating company mezz increases intercreditor complexity and can crowd senior capacity. Holdco mezz eases that tension but makes you dependent on free cash flow and upstream baskets, so confirm feasibility within the first week.
Align intercreditor principles before pricing. Lock down standstill length, junior buyout rights, consent thresholds, and vetoes that matter in downside scenarios. Model tax and accounting at term sheet. Withholding on PIK dates, OID accrual, and interest caps can swing IRR by 100 to 200 bps, and classification affects covenants and auditor comfort with dividends and redemptions. Use covenants to steer behavior rather than trigger fees. Tighten leakage, incremental debt, and non-core M&A at holdco, and keep definitions harmonized across senior and mezz to avoid surprise cross-defaults.
Investor Takeaways
Price to the realistic enforcement path. In the US, you can underwrite to a workable Chapter 11 outcome and consider trading into the fulcrum to protect value. In Europe, slower processes and more uncertainty argue for tighter leakage controls, higher PIK, and stronger call protection. When sponsor relationships are strategic, protect upside through PIK and call premia and use warrants selectively. Maintain documentation discipline around EBITDA, MFN, incremental baskets, portability, and cures, and watch for hidden priming via super-senior RCFs or asset-based lines.
US vs Europe: Practical Differences in One View
The differences are practical, not philosophical. US sponsors often secure higher total leverage thanks to deeper direct lending markets and cov-lite seniors, so operating company mezz can fit when carefully drafted. Europe is tighter, pushing mezz to holdco with heavy dependence on upstreaming. US lower mid-market still uses warrants, while Europe typically replaces them with higher PIK and robust call protection. US intercreditors are shorter and focus on turnover and standstill; Europe’s are more detailed with trust structures and release mechanics. US Chapter 11 allows faster resets and reinstatement options; European plans enable cram-downs but often sideline out-of-the-money mezz unless new money arrives.
Closing Thoughts
Mezzanine in the US and Europe shares the same core bargain: a subordination premium in exchange for flexibility, with PIK and leakage control doing most of the work. The winning package is the one that clears senior intercreditor constraints, passes tax and accounting tests, and preserves sponsor options when growth slows. Discipline on structure and definitions separates capital that quietly compounds from capital that merely postpones a problem.