When direct lenders use each instrument, how they're priced, what covenants attach, and how subordination works — with real market rates for 2025.
A leveraged capital structure is not a single loan — it is a layered set of instruments with different priorities, rates, maturities, and protections. Understanding when each instrument is used, and why, is fundamental to both credit analysis and structuring. The table below maps the primary debt instruments from most senior to most junior.
| Instrument | Purpose | Typical Size | Rate (2025) | Amortization | Covenants |
|---|---|---|---|---|---|
| Revolving Credit | Liquidity / working capital | 15–25% of cap | SOFR + 200–300bps | None | Springing financial |
| Term Loan A (TLA) | Bank market acquisition debt | 20–40% of cap | SOFR + 200–350bps | 5% / year | Maintenance |
| Term Loan B (TLB) | Institutional acquisition debt | 40–70% of cap | SOFR + 300–450bps | 1% / year | Incurrence only |
| Second Lien TL | Incremental leverage | 10–25% of cap | SOFR + 600–800bps | Bullet | Incurrence only |
| Mezzanine | Subordinated / equity bridge | 5–20% of cap | 12–15% (cash + PIK) | Bullet / PIK | Maintenance + equity kicker |
| PIK Notes | Holding co. / sponsor-level | 5–15% of cap | 14–18% (all PIK) | None (accretes) | Minimal |
A revolving credit facility is a committed line of credit the borrower can draw, repay, and redraw repeatedly over the facility's life — typically 5 years. It sits at the top of the seniority stack and is the first claim on assets in any enforcement. Despite this priority, revolver lenders earn the lowest return because the line is often undrawn for long stretches.
| Component | Typical Range | Notes |
|---|---|---|
| Drawn Rate | SOFR + 200–300bps | On outstanding drawn balance only |
| Undrawn Commitment Fee | 25–50bps | On available (undrawn) balance |
| Upfront Arrangement Fee | 50–150bps | Paid at close on total commitment |
| Letter of Credit Fee | Same as drawn rate | LCs reduce available revolver capacity |
The revolver typically represents 20–35% of total capitalization. It is usually undrawn at close — a deal where the revolver is drawn from day one suggests the business requires external liquidity support immediately, which is a credit concern. The springing financial covenant on most TLB revolvers activates only when the revolver is drawn above 35–40% of commitment, giving the borrower flexibility without removing all lender protection.
Term Loan A is the traditional bank market term loan — held by commercial banks, subject to regulatory capital constraints, and priced cheaper than TLB due to the relationship dynamic. TLA requires meaningful amortization because bank credit committees focus on scheduled debt reduction.
Term Loan B is the institutional workhorse of leveraged finance. Held by CLOs, hedge funds, and loan mutual funds rather than commercial banks, it is structured as a near-bullet (1% annual amortization) with incurrence-only covenants, commanding a spread premium over TLA in exchange for its lender-friendly structural protections being lower.
| Feature | Typical Terms | Notes |
|---|---|---|
| Spread | SOFR + 300–450bps | Tiered by credit quality and sector |
| SOFR Floor | 0% – 0.5% | Protects lender if base rate falls sharply |
| OID (Original Issue Discount) | 98–99.5 cents | 99 OID on 2-yr avg life = ~50bps effective yield pickup |
| Amortization | 1% / year | Effectively a bullet; minimal cash drain |
| Maturity | 5–7 years | 7-year for investment-grade adjacent; 5-year for higher risk |
| Soft Call Protection | 101% for 6 months | Borrower pays 101 cents if refinancing within 6 months |
| Covenant Package | Incurrence only | No ongoing financial maintenance tests |
The incurrence-only covenant package is the most critical structural distinction. A TLB borrower whose EBITDA declines 30% has no automatic covenant breach as long as it takes no new leveraging actions. This means direct lenders with maintenance covenants (more common in TLA and direct lending unitranche structures) have an earlier warning system and a contractual seat at the table when performance deteriorates — something TLB lenders lack until the borrower defaults outright.
Second lien debt is secured but subordinated to first lien in the collateral waterfall. It earns a 300–400bps premium over first lien in exchange for its lower recovery position. Second lien lenders are essentially making a bet that even in distress, the enterprise value exceeds the first lien — and they collect the excess.
When first and second lien debt exist in the same capital structure, their relationship is governed by an intercreditor agreement. This document determines who can act and when in a default scenario.
Mezzanine is unsecured subordinated debt sitting between second lien and equity in the capital structure. It carries the highest interest burden of any debt instrument — typically 12–15% total return combining cash interest and PIK (payment-in-kind) accrual — and often includes an equity kicker (warrant or conversion right) to compensate for the risk.
Unitranche loans — a single first-lien instrument that blends first and second lien economics into one facility — have largely displaced mezzanine in the direct lending market. A unitranche at SOFR + 550bps (blending first and second lien rates) is simpler, has one set of covenants, one set of lender relationships, and avoids the intercreditor complexity of a split structure. Sponsors prefer fewer tranches; borrowers prefer lower administrative burden. Mezzanine persists primarily in situations where the total leverage requirement exceeds what any single direct lender will hold on its balance sheet, requiring a distinct second capital source.
| Instrument | Amount | Leverage Turn | Rate | Annual Interest |
|---|---|---|---|---|
| Revolving Credit (undrawn) | $250M | — | SOFR + 275bps (undrawn: 37.5bps) | $0.9M |
| Term Loan B (First Lien) | $1,750M | 3.5x | SOFR + 375bps (~8.6%) | $150.5M |
| Second Lien Term Loan | $750M | 1.5x | SOFR + 700bps (~11.9%) | $89.3M |
| Sponsor Equity | $500M | — | Target 20%+ IRR | — |
| Total Enterprise Value | $3,000M | 6.0x EV/EBITDA | Blended debt: 9.5% | $240.7M |
| Credit Metric | Value | Assessment |
|---|---|---|
| Total Leverage (funded debt) | 5.0x | Revolver undrawn; TLB + 2L only |
| First Lien Only Leverage | 3.5x | Conservative first lien sizing |
| Interest Coverage (EBITDA / Interest) | 2.1x | $500M / $240M total interest |
| Total Debt / EV | 83.3% | $2,500M / $3,000M |
PIK (payment-in-kind) notes are the most junior form of debt — typically issued at the holding company level (above the operating company), subordinated to all operating company debt. Interest accretes to principal rather than being paid in cash, meaning the face value of the note compounds over time. A $100M PIK note at 15% becomes $115M after year one, $132M after year two, and $201M after year five — without a single dollar of cash interest paid.
PIK notes are used when the operating company is at maximum cash leverage and the sponsor needs additional acquisition financing that cannot be serviced with operating cash flow. They represent pure credit risk with no cash flow validation of repayment capacity — lenders in PIK notes are effectively equity-like investors who happen to sit above true equity in the capital structure.
Term Loan B has become the default instrument in leveraged buyouts because it aligns incentives between sponsors and institutional lenders better than any alternative. Sponsors want minimal amortization (preserves cash for operations and bolt-ons), incurrence-only covenants (operational flexibility), and a long maturity (time for value creation before refinancing). Institutional lenders want floating rate (protects against rising rates), traded liquidity (CLO managers can rebalance portfolios), and a spread premium over investment grade. TLB delivers all of this. The rise of direct lending unitranche is the one structural shift threatening TLB dominance — a single lender holding an entire unitranche eliminates the syndication process and often delivers faster execution, tighter documentation, and more flexibility on structure in exchange for a modestly higher all-in rate.
A maintenance covenant is tested every quarter regardless of borrower activity. The borrower must demonstrate that it is in compliance — for example, that leverage does not exceed 6.0x — even if it has not taken any new leveraging actions. If EBITDA declines and leverage drifts above the threshold, the borrower is in default and the lender can accelerate the loan or demand a waiver. An incurrence covenant is only tested when the borrower takes a specific action — issuing new debt, paying a restricted payment, making an acquisition. If the borrower is not doing any of these things, incurrence covenants are irrelevant regardless of how far financial metrics have deteriorated. Maintenance covenants give lenders an early intervention mechanism; incurrence covenants protect lenders from borrowers actively leveraging up but provide no protection against passive deterioration.
A split first/second lien structure is chosen when total leverage exceeds what any single direct lender will hold — typically above $500M–$750M of total debt for most mid-market funds. By splitting the structure, the sponsor accesses two distinct lender pools (first lien direct lending funds and second lien / opportunity funds), potentially getting tighter pricing on each tranche versus a single unitranche rate that blends both risks. The tradeoff is documentation complexity, intercreditor agreement negotiation, and the coordination cost of managing two lender groups. Unitranche wins on speed, simplicity, and relationship — it is often preferred when the deal size is within one fund's capacity.
The intercreditor agreement gives the first lien lender three critical protections. First, a standstill period — second lien lenders cannot enforce against collateral for 90–180 days after first lien default, giving the first lien control over the restructuring process. Second, enforcement rights — the first lien lender directs the collateral agent and controls the sale or foreclosure of collateral; second lien lenders can object but cannot independently execute. Third, DIP priority — in a Chapter 11 bankruptcy, the intercreditor typically allows the first lien lender to provide debtor-in-possession financing that primes the second lien, further securing the first lien position during reorganization. The intercreditor turns the multi-lien structure from a potential conflict into an ordered queue of priority.