Key Takeaways
- The capital stack ranks every claim on a business or asset pool, from senior secured debt at the top to common equity at the bottom, and that ranking decides who is paid first.
- Losses work upwards from the bottom: equity absorbs them first, then preferred equity, then mezzanine, with senior lenders impaired last.
- Long-run data shows first-lien loans recovering roughly 70–80 cents on the dollar in default, against about 30–45 cents for second-lien debt.
- A coupon only means something once you know what sits beneath it; the same 10% yield can be generous at the senior level and thin at the mezzanine level.
- In structured credit the stack is written into the documents, so investors can see their position, their cushion and the waterfall before they commit.
Two investors can each be offered 10% from the same company and own completely different risks. One holds a senior secured loan with first call on the assets. The other holds an unsecured mezzanine note that is paid only after the senior lender has been made whole. In a good year their experience is identical. In a bad year one is repaid in full and the other may recover very little.
The difference is their place in the capital stack. The capital stack is the ranking of every source of money in a company, property or loan pool, ordered by who gets paid first and who absorbs losses first. It is the map behind every private credit deal, and the first thing an allocator should look at before the yield.
This guide explains the layers of the capital stack, how losses and recoveries move through them, and how to judge whether a return is fair for the position you are being offered.
What is the capital stack?
The capital stack is the structure of debt and equity used to finance a business or asset, arranged by seniority. Capital at the top has the strongest claim on cashflows and collateral and the lowest expected return. Capital at the bottom has the weakest claim, takes the first loss and keeps whatever upside is left.
Every layer is a trade between protection and return. The stack describes that trade in one picture, which is why lenders, rating agencies and investors all start there.
The four layers of the capital stack
| Layer | Repayment priority | Security | Typical return profile | Main risk |
|---|---|---|---|---|
| Senior secured debt | First | First-ranking charge over assets | Lowest; contractual interest | Collateral value falls below the loan |
| Mezzanine debt | After senior debt | Usually unsecured or second-ranking | Higher coupon, sometimes warrants | Impairment when senior claims absorb recoveries |
| Preferred equity | After all debt | None | Fixed preferred return plus some upside | Distributions suspended under stress |
| Common equity | Last | None | Residual; uncapped upside | First loss, can be wiped out |
Senior debt
Senior secured debt is first-ranking and contractual. It has a direct claim on collateral and first access to cashflows, and it usually carries the tightest covenants. Its return is the most modest in the stack, and that is the point: senior debt is bought for stability and capital preservation. For most allocators it is the core income sleeve of a private credit portfolio.
Mezzanine debt
Mezzanine debt ranks behind senior claims and is typically unsecured or holds only a second charge. Lenders are compensated with higher coupons and sometimes equity conversion rights. It is used to bridge funding gaps, add leverage or fund growth. Returns are attractive in good conditions; the risk of impairment rises sharply when a borrower runs into trouble.
Preferred equity
Preferred equity is hybrid capital that ranks above common equity but below all debt. Holders receive priority distributions, often structured like a fixed dividend, with some participation in upside. It has no security, and distributions can usually be deferred without triggering a default.
Common equity
Common equity is the residual capital. It absorbs the first loss and keeps everything that remains after all other claims are paid. For a credit investor, the equity beneath them is their margin of safety, and the size of a sponsor's equity stake is one of the clearest signals of alignment.
How losses and recoveries move through the stack
When a borrower defaults, losses are absorbed from the bottom up. Common equity is wiped out first, then preferred equity, then mezzanine. Senior lenders are impaired only once every layer beneath them has gone. Recoveries flow the other way: whatever is realised from the assets goes to the top of the stack first.
The data bears this out. Long-run figures drawn from Moody's and S&P recovery studies show first-lien loans recovering roughly 70–80 cents on the dollar after default, while second-lien loans recover around 30–45 cents, according to an ABF Journal review of subordinate debt recoveries published in September 2026. Moody's current expectation for first-lien recoveries sits nearer 68%, below the long-run average, a reminder that weaker documentation erodes the protection seniority is supposed to bring.
That matters more now than it did a few years ago. Fitch's US private credit default rate reached a record 6.3% in the twelve months to August 2026. When defaults rise, the gap between the top and the middle of the stack stops being theoretical.
Why stack position matters in private credit
The capital stack is the lens through which every private credit allocation should be assessed. Four things follow from it.
- Risk pricing: coupons only make sense in the context of subordination. A 10% yield at the senior level is generous; at the mezzanine level it may be inadequate.
- Governance: rights, covenants and control differ by layer. Senior lenders set terms and can act early; mezzanine and preferred holders accept limited influence in exchange for yield.
- Recovery: in default, position decides how much comes back and how quickly.
- Portfolio construction: allocators blend positions to balance contractual income, diversification and opportunistic return. Judging that blend is the work of risk-adjusted returns, not headline yield.
Position also interacts with liquidity. A junior position that cannot be sold before maturity carries two risks at once, and investors should be paid for both. Our guide to the illiquidity premium separates the reward for lock-up from the reward for credit risk.
The capital stack in structured credit
In structured credit, the stack is written into the transaction itself. A pool of loans or receivables is financed by tranches of notes, each with a defined rank, and a payment waterfall sets out exactly who is paid, in what order, from which cashflows. Investors can choose a tranche to suit their mandate: senior for predictable income, mezzanine for enhanced yield.
The advantage is clarity. Tranche documents, collateral pools and waterfalls show investors precisely where they sit and how much capital sits beneath them, a level of definition often missing in bilateral lending. Our piece on private credit through structured credit explains how these layers are built, and a credit linked note is one of the most common ways a single position in that stack is delivered to investors.
Asset-based lending adds another layer of protection. A senior facility to a lender is typically advanced against a pool of loans worth more than the facility, so the borrower's own equity and the excess collateral both sit beneath the senior lender. Our investor's guide to asset-based lending covers how advance rates and borrowing bases work.
At Kingsbury & Partners we lend to lenders, providing senior secured facilities to non-bank and specialty lenders, and we start every credit decision with the stack: what ranks ahead, what sits beneath, and what happens to our position if the assets underperform. That is what "protection by design" means in practice.
What this means for investors
For family offices, wealth managers and private clients, the capital stack turns a yield into a question that can be answered. Before committing, ask:
- Where do I rank? What is my tranche or lien position, and what ranks ahead of me?
- How thick is my cushion? How much equity and subordinated capital will absorb losses before mine?
- What controls do I have? Do the covenants, security and reporting reflect my position, and can I act early if performance slips?
- What do I get back if it goes wrong? Look at collateral quality and historic recoveries for this position, not only default rates.
- How does it fit? How does this exposure combine with the rest of my credit portfolio?
Private credit rewards precision. The yield tells you what you are being paid; the capital stack tells you what you are being paid for.
Frequently Asked Questions
What are the layers of the capital stack?
From top to bottom: senior secured debt, mezzanine or subordinated debt, preferred equity and common equity. Each layer ranks behind the one above it for repayment and ahead of the one below it for losses.
Which part of the capital stack is the riskiest?
Common equity, because it absorbs losses first and is paid only after every other claim. In exchange, it keeps all the upside once the layers above it are repaid.
Is preferred equity debt or equity?
It is equity. It ranks above common equity and usually earns a fixed preferred return, but it has no security and sits behind all lenders in a default.
What is the difference between senior and subordinated debt?
Senior debt is repaid first and is usually secured on the borrower's assets. Subordinated debt, such as mezzanine, is repaid only after senior lenders and pays a higher coupon to compensate for the extra risk.
How does the capital stack work in structured credit?
The stack is built through tranches of notes backed by a pool of assets, with a written waterfall that pays senior tranches first and allocates losses to junior tranches first.
Why does capital stack position matter for private credit investors?
Position decides who is repaid first, how much is recovered in default and how much influence each lender has, so it is the first thing to check before comparing yields.
