Understanding the Layers of Debt: Senior, Mezzanine and Unitranche Financing

When a private equity sponsor acquires a company, the purchase price is rarely funded entirely with equity. Debt can reduce the amount of capital the sponsor needs to contribute, but not all debt carries the same cost, risk or repayment priority.

Senior, mezzanine and unitranche financing represent three different approaches to allocating that risk. Understanding the distinction is important not only for investors and lenders, but also for the lawyers responsible for documenting the transaction.

This seems simple enough. However, the complexity for corporate lawyers and bankers comes in when deciding what type of debt should be used, and the percentage of the total debt that each type will make up.

This article will focus on senior debt, mezzanine debt and unitranche financing, which are not the only three debt instruments used in M&A and LBOs, but provide an interesting lens through which to understand how businesses, particularly private equity-backed companies, structure their financing.

Senior Debt

Senior debt is one of the most common forms of lending for businesses, PE-backed or otherwise. Senior debt generally ranks ahead of subordinated debt in the contractual payment hierarchy and, where secured, benefits from security over specified assets. Because senior lenders typically take less risk than junior creditors, senior debt generally carries a lower cost of borrowing than some of its more risky counterparts.

The lower cost associated with senior debt, however, can come with a potential downside: companies may not always be able to borrow as much as they require. Banks will often be reluctant to lend unlimited amounts of senior debt because increasing the amount of leverage can increase the lender's exposure to losses if the borrower defaults. As a result, senior lenders may impose borrowing limits, financial covenants and other protections to manage their risk.

Mezzanine Debt

Where senior lenders are unwilling to provide the full amount of debt required for a transaction, mezzanine financing can provide an additional layer of capital beneath the senior facilities.

Mezzanine debt sits between senior debt and equity. One of its defining characteristics is its position in the contractual payment hierarchy: it generally ranks behind senior debt but ahead of equity.

Because mezzanine debt generally ranks behind senior debt, the risk to the lender is higher, as there may not always be sufficient funds to repay both. This higher risk is reflected in the higher interest rates typically associated with mezzanine financing, making it more costly than senior debt.

Another important aspect of mezzanine debt is how it can be structured to give a lender some of the benefits associated with equity. For instance, the lender may receive warrants or options alongside the interest, giving them the right to purchase a specified number of the company's shares at a predetermined price, which can become more valuable as the company grows.

Another equity-like benefit is that a mezzanine loan can sometimes include a conversion feature. Put simply, this is where the lender retains the right to convert some of their debt into shares and potentially become an equity holder in the company.

A further benefit, which is not exactly equity-like but is very common in mezzanine financing, is PIK interest, or payment-in-kind interest. Essentially, what happens here is that instead of paying all interest in cash, the borrower adds the interest onto the debt amount, and this allows them to defer interest payments to preserve cash in the short term. The downside is that the outstanding debt increases, potentially making the financing more expensive over time and increasing the borrower's leverage.

As mentioned, the higher risk taken by mezzanine lenders is generally reflected in the higher returns they require. Despite having more risk appetite, mezzanine debt is also limited because of the lower repayment priority alongside the minimal collateral requirements in some structures, which are not particularly attractive to lenders. The higher cost of mezzanine financing, together with any equity-linked features, can therefore make borrowers cautious about how much mezzanine debt they use.

Unitranche Financing

The final financing structure discussed in this article is unitranche financing. It is a single debt facility that combines characteristics traditionally associated with senior and junior debt, rather than requiring the borrower to arrange separate senior and mezzanine facilities.

Unitranche financing is commonly provided by private credit funds or other institutional lenders and, at times, the borrower may benefit from the convenience and speed of arranging a single integrated facility, particularly where there is a single lender. Because unitranche financing can expose the lender or lending group to risks associated with different layers of the capital structure, it generally carries a higher cost than conventional senior debt.

Interestingly, unitranche financing does not always mean one lender, but rather one loan facility that many lenders can participate in. What this means is that participating lenders may enter into an agreement among lenders (AAL) governing their respective rights, including matters such as voting, enforcement and the allocation of recoveries. The agreement may establish first-out and last-out positions, determining how recoveries are allocated among the participating lenders.

More importantly, unitranche is not simply another level in the debt hierarchy. Its ranking relative to other debt depends on the contractual arrangements governing the particular transaction.

Putting It Into Practice: A £100 Million Acquisition

To understand how these structures can work in practice, consider a simplified £100 million acquisition by a private equity sponsor.

Under a traditional structure, the acquisition could be financed with £60 million of senior debt, £20 million of mezzanine debt and £20 million of sponsor equity.

The senior lender provides the largest portion of the debt and generally has the highest contractual priority among the debt providers. The mezzanine lender provides additional capital beneath the senior debt, taking greater risk in exchange for higher returns and potentially equity-linked benefits. The sponsor contributes £20 million of equity and retains the residual economic interest in the business.

Alternatively, the sponsor could use an £80 million unitranche facility alongside £20 million of sponsor equity. Rather than arranging separate senior and mezzanine facilities, the borrower has one integrated debt facility, potentially simplifying the financing structure.

The choice between these structures involves more than simply comparing interest rates. The parties must consider the amount of leverage, the cost of borrowing, repayment priority, flexibility, lender risk and the amount of equity the sponsor is willing to contribute.

Why Does This Concern Lawyers?

This is one of the key areas where lawyers assist with financing. If the borrower defaults, lawyers will need to consider a number of issues, including the priority of repayment, which depends on the specific security, contractual arrangements and documents governing the transaction.

Where a unitranche facility is provided by a single institution, lawyers will still negotiate and document the facility terms, including pricing, covenants, security, guarantees, repayment provisions and events of default. Where multiple institutions participate, the legal structure may become more complex, with an AAL governing matters such as voting, enforcement and the allocation of recoveries between first-out and last-out lenders.

A solicitor's job can be vastly different depending on whether they act for the lender or the borrower. For example, in terms of interest rates or the structure of the mezzanine, acting on the borrower's side would see a lawyer negotiating for lower interest rates or less equity-linked benefits for the financial institutions, while the lender's lawyer would do the exact opposite. Because of this, commercial negotiation is essential and can significantly impact the cost and flexibility of borrowing. Lawyers also negotiate and document covenants, which establish the obligations and restrictions that apply to the borrower throughout the life of the financing.

Points to Remember

Source: Capital & Counsel article manuscript, September 2026. This article is intended as educational analysis and does not constitute legal or investment advice.