The priority of payments from EBITDA to equity — how to trace cash through the capital structure, build a waterfall model, and understand who gets paid first.
A cash flow waterfall is the ordered sequence in which cash generated by a business is allocated to obligations before any remainder reaches equity holders. Think of it as water flowing down a series of pools: each pool must fill completely before cash spills over to the next level. The metaphor is apt because no pool gets skipped — you cannot pay a dividend to equity before the interest expense has been paid, any more than water can flow uphill.
Understanding the waterfall is essential for credit analysis because it tells you how much cushion exists between the cash a business generates and the claims that must be satisfied before your tranche gets repaid. A first lien lender sitting at the top of the waterfall is in a fundamentally different risk position than a second lien lender receiving whatever is left after the first lien's claims are fully satisfied. The waterfall also determines whether equity can receive distributions — and in many leveraged buyouts, the equity holders' ability to extract cash through dividends is more constrained by the waterfall than by the absolute quantum of leverage.
Throughout this guide we'll use a single $150M EBITDA company as our working example, with a capital structure representative of a typical sponsor-backed mid-market business.
| Tranche | Amount ($M) | Rate | Annual Interest ($M) | Amortization |
|---|---|---|---|---|
| Revolving Credit Facility | $75M (undrawn) | SOFR+300 | — | — |
| 1st Lien Term Loan B | $600M | SOFR+375 (~8.0%) | $48.0M | 1% / $6.0M |
| 2nd Lien Term Loan | $150M | 11.0% fixed | $16.5M | None (bullet) |
| Total Debt | $750M | $64.5M | $6.0M | |
| Net Leverage (Entry) | 5.0x | |||
| Interest Coverage | 2.3x |
We start at EBITDA and trace every dollar down to whatever is left for equity holders. Each step below corresponds to a line in the waterfall model.
EBITDA is the top of the waterfall. It represents earnings before interest, taxes, depreciation, and amortization — the pre-financing, pre-tax operating profit of the business. All subsequent deductions flow from here.
Capital expenditures required to maintain the current productive capacity of the business are deducted first. Growth capex (investments to expand capacity) is a separate category and treated differently depending on the lender's definition, but maintenance capex is always deducted before interest because it represents a real cash cost of keeping the business running. For our example company — a software-enabled services business — maintenance capex is $20M.
Cash interest is paid to all debt holders in priority order, but typically consolidated into a single payment date. Our capital structure carries $48.0M of interest on the 1st lien term loan (SOFR + 375bps, assuming 4.25% SOFR) and $16.5M of interest on the 2nd lien ($150M × 11%). Total cash interest expense is $64.5M per year.
Term loan B facilities typically require 1% annual amortization of the original principal balance, paid quarterly. On our $600M term loan, this is $6.0M per year. The 2nd lien is a bullet — no required amortization until maturity. This $6.0M is a mandatory cash outflow; failure to pay is an event of default.
Taxes are calculated on taxable income, not EBITDA. Taxable income starts with EBITDA and deducts depreciation and amortization (D&A creates a tax shield), interest expense, and any other deductible items. In our example, D&A is $22M. Taxable income = $150M EBITDA − $22M D&A − $64.5M interest = $63.5M. Cash taxes at a 25% blended effective rate = $15.9M.
Most leveraged loan credit agreements include an excess cash flow (ECF) sweep provision. When net leverage exceeds a defined threshold (commonly 4.5x), the borrower must use a percentage of annual free cash flow (commonly 50%) to prepay term loans. This accelerates deleveraging and protects lenders. In our base case, net leverage is 5.0x — above the 4.5x trigger — so 50% of FCF must be swept.
After the mandatory sweep, the borrower may choose to make additional voluntary prepayments on the term loan. The sponsor may also elect to pay down the revolver (if drawn) to preserve liquidity. These are discretionary, subject to prepayment premiums (typically a 1% soft call premium in year one on term loans).
Whatever remains after all obligations is theoretically available to equity holders. In our base case, that is approximately $21.8M. However, the credit agreement's restricted payments basket determines whether this cash can actually flow to equity. Most credit agreements permit dividends only if: (a) no default or event of default exists, (b) pro forma leverage does not exceed a defined threshold, and (c) the company meets a minimum liquidity test. If any condition is not met, the cash stays on the balance sheet — it accumulates but cannot be distributed.
| Line Item | Base Case ($M) | Notes |
|---|---|---|
| EBITDA | $150.0 | Starting point |
| Less: Maintenance Capex | ($20.0) | 13% of EBITDA |
| EBITDA minus Capex | $130.0 | |
| Less: 1st Lien Interest | ($48.0) | $600M @ ~8.0% |
| Less: 2nd Lien Interest | ($16.5) | $150M @ 11.0% |
| After Total Interest | $65.5 | Interest coverage: 2.3x |
| Less: Mandatory Amortization | ($6.0) | 1% of TLB balance |
| After Amortization | $59.5 | |
| Less: Cash Taxes | ($15.9) | 25% on $63.5M taxable income |
| After-Tax Free Cash Flow | $43.6 | FCF conversion: 29% |
| Less: ECF Sweep (50%) | ($21.8) | Triggered at >4.5x leverage |
| Cash Available for Equity | $21.8 | Subject to basket conditions |
The ordering of the waterfall is not administrative — it determines the risk profile of each debt tranche. First lien lenders sit at the top: they receive their interest and principal before the second lien sees a single dollar of principal repayment. In a scenario where EBITDA declines, cash flows down the waterfall and gets exhausted at higher levels, leaving lower tranches unfunded. This is why lenders analyze the waterfall in stress cases more carefully than in the base case.
Consider what happens if the ECF sweep applies entirely to the 2nd lien: after one year, the 2nd lien balance has dropped from $150M to $128.2M ($150M − $21.8M sweep). The 1st lien balance has dropped from $600M to $594M (from mandatory amortization only). Net leverage moves from 5.0x to approximately $722.2M / $150M = 4.8x — modest delevering, but the structure is working as designed. After four or five years of consistent sweeps, the 2nd lien begins to burn down meaningfully and leverage approaches the 4.5x threshold at which the sweep mechanism steps down to 25%.
The existence of cash at the bottom of the waterfall does not mean equity holders can access it. Credit agreements contain restricted payments covenants that define when the company can pay dividends, make equity distributions, or repurchase shares. The standard conditions are: no event of default (or event that would constitute a default with notice or passage of time), pro forma net leverage below a specified level after giving effect to the payment, and often a minimum liquidity test (e.g., at least $25M of unrestricted cash plus revolver availability). Even in our base case, where $21.8M is theoretically available, the sponsor cannot extract it as a dividend if leverage remains at 5.0x and the covenant threshold for restricted payments is 4.5x or lower.
This is one of the most important structural protections in leveraged finance. Without it, a sponsor could drain cash from a highly levered company even while lenders are absorbing elevated risk. The restricted payments basket aligns sponsor and lender incentives: if the sponsor wants liquidity, they need to deleverage first.
Our example company has a $75M undrawn revolving credit facility. The revolver functions as a liquidity buffer — it can be drawn in periods of cash need (working capital seasonality, unexpected capex) and repaid when cash is available. An undrawn revolver is essentially free insurance: the company pays a commitment fee (typically 50 basis points) on the undrawn balance, which at $75M is $375,000 per year — a trivial cost for the protection it provides. A drawn revolver, however, adds to the interest burden and should appear in the waterfall as an additional interest deduction.
Lenders look at revolver availability as an indicator of short-term liquidity health. A company that has its revolver fully drawn is signaling that its operating cash flows are insufficient to cover working capital needs — a yellow flag that often appears before a more formal credit deterioration.
Now apply a 33% EBITDA stress — perhaps the business loses a major customer, faces a pricing headwind, or hits a cyclical downturn. EBITDA drops from $150M to $100M. The interest and amortization obligations are fixed regardless. What happens to the waterfall?
Cash interest is still $64.5M. After capex of $20M, we have $80M. After interest we have $15.5M. After mandatory amortization we have $9.5M. Taxable income has dropped sharply (EBITDA $100M − D&A $22M − interest $64.5M = $13.5M), so cash taxes are only $3.4M. After-tax FCF: approximately $6.1M. The ECF sweep trigger is still in effect at 5x+ leverage — but 50% of $6.1M is only $3.1M, a negligible sweep. The company has essentially $3M of free cash at the bottom of the waterfall, and the equity is economically worthless until the business recovers.
More critically: net leverage has jumped from 5.0x to approximately $744M / $100M = 7.4x (debt has barely moved, EBITDA collapsed). If the credit agreement contains a maximum leverage maintenance covenant of 6.5x, the company is in breach. This stress case is why covenant cushion analysis is so important — a business that looks fine at 5.0x entry leverage can trip a covenant with a single bad year.
| Line Item | Base Case | Stress Case | Change |
|---|---|---|---|
| EBITDA | $150.0 | $100.0 | −$50.0 |
| Less: Maintenance Capex | ($20.0) | ($20.0) | — |
| After Capex | $130.0 | $80.0 | −$50.0 |
| Less: Total Cash Interest | ($64.5) | ($64.5) | — |
| After Interest | $65.5 | $15.5 | −$50.0 |
| Less: Mandatory Amortization | ($6.0) | ($6.0) | — |
| Before Taxes | $59.5 | $9.5 | −$50.0 |
| Less: Cash Taxes | ($15.9) | ($3.4) | +$12.5 |
| After-Tax FCF | $43.6 | $6.1 | −$37.5 |
| Less: ECF Sweep (50%) | ($21.8) | ($3.1) | +$18.8 |
| Cash Available for Equity | $21.8 | $3.1 | −$18.8 |
| Net Leverage | 5.0x | 7.4x | +2.4x |
| Interest Coverage | 2.3x | 1.2x | −1.1x |
| Covenant Status (6.5x max) | Compliant | Breach | — |
Sponsors want maximum flexibility at the bottom of the waterfall — broad restricted payments baskets, high dividend triggers, and limited sweep obligations. Lenders want the opposite: narrow baskets, low dividend thresholds, and aggressive sweep provisions that accelerate deleveraging. The negotiation happens at document execution, and the outcome depends entirely on market conditions. In a hot deal market (2018-2021), sponsors won almost every concession. In tighter markets (2023-2024 as rates rose), lenders recaptured some ground. The terms in any given credit agreement reflect that negotiating dynamic, not a theoretically optimal structure — which is why reading the actual credit agreement is non-negotiable before investing.
Start at EBITDA, deduct maintenance capex to get to unlevered free cash flow, deduct total cash interest, deduct mandatory amortization, deduct cash taxes, apply the ECF sweep if leverage exceeds the trigger, and whatever remains is available for equity subject to the restricted payments basket. Emphasize that the sequence is contractual — the credit agreement defines each step, and deviating from it is an event of default.
In our base case example, $150M EBITDA converted to $21.8M of cash available for equity — an 85% reduction. The gap includes $20M capex, $64.5M interest, $6M amortization, and $15.9M taxes. Understanding this gap is critical: a sponsor earning a 20% return on equity is actually generating a modest cash-on-cash yield at the portfolio company level, and any deterioration in EBITDA disproportionately destroys equity value because the debt obligations are fixed.
ECF sweep is mandatory — once triggered, the borrower must apply the calculated amount to term loan prepayment. Voluntary prepayments can be made in addition or in lieu of the sweep, subject to prepayment premiums. In year one of many TLBs, there is a 1% soft call premium on voluntary prepayments, meaning the borrower pays $1 per $100 prepaid as a penalty — designed to discourage immediate refinancing at lower rates. Mandatory amortization and ECF sweeps are exempt from prepayment premiums.