Debt Structures in an LBO

Step 1: Blended Cost of Debt

Blended Cost of Debt = Σ(Tranche Amount × Interest Rate) / Total Debt

Plugging in the three tranches: ($200m × 6.0%) + ($100m × 10.0%) + ($50m × 12.0%) = $12.0m + $10.0m + $6.0m = $28.0m of total annual interest on $350m of debt.

Blended Cost of Debt = $28.0m / $350m = 8.0%

This weighted average tells the sponsor what the debt stack actually costs on a blended basis, even though no single tranche prices at 8.0%. It's the number used to size interest coverage, compare against the unlevered cost of capital, and sanity-check whether the deal's cash flows can service the debt load.

Step 2: Year 1 Cash Interest Expense

Cash Interest Expense = Σ(Amount × Interest Rate) for cash-pay tranches only

Only the Senior Secured Term Loan and the Mezzanine Notes pay cash interest; the PIK Notes require no cash outlay in Year 1.

Cash Interest = ($200m × 6.0%) + ($100m × 10.0%) = $12.0m + $10.0m = $22.0m

This is the figure that actually drains cash from the business each year — it's what matters for covenant compliance and for how much free cash flow is left over for debt paydown or dividends, regardless of what the blended 8.0% rate suggests.

Step 3: PIK Notes Balance After Year 1

Ending PIK Balance = Beginning PIK Balance × (1 + PIK Interest Rate)

Using the $50m starting balance and the 12.0% PIK rate:

Ending PIK Balance = $50m × 1.12 = $56.0m

The $6.0m difference is PIK accretion — interest that is added to principal instead of paid in cash. It preserves liquidity today, but it compounds: every future year's PIK interest is calculated on the new, larger balance, so the amount the sponsor eventually has to repay (or refinance) at exit grows faster than the coupon rate alone suggests.

Step 4: Allocating the Year 1 Cash Flow Sweep

Sweep Allocation Order = Senior Secured → Mezzanine → PIK Notes → Sponsor Equity

With $30m of free cash flow available for prepayment, the subordination terms require the full amount to go to the most senior tranche outstanding before any junior tranche receives a dollar.

The entire $30m sweep goes to the Senior Secured Term Loan because it sits first in the waterfall. This is the practical meaning of "seniority" beyond a liquidation scenario: even in a healthy, cash-generative year, subordination agreements typically block mezzanine or PIK holders from receiving any prepayment until the senior lender has been paid down (a "payment blockage" or "standstill" provision) — exactly why senior lenders accept a lower coupon in exchange for that priority.

Final Results

• Blended Cost of Debt: 8.0%
• Year 1 Cash Interest Expense: $22.0m
• PIK Notes Balance After Year 1: $56.0m
• Year 1 Cash Flow Sweep: $30.0m to the Senior Secured Term Loan

These figures feed directly into the full LBO debt schedule and the sponsor's IRR waterfall: the cash interest reduces available free cash flow each year, the PIK accretion silently increases the balance that must be repaid or refinanced at exit, and the sweep priority determines how quickly leverage actually delevers.

Would you like to explore how this waterfall changes if the mezzanine notes included a cash sweep once senior leverage falls below a specific covenant threshold?