The "middle" of a capital structure — between senior secured debt and common equity — encompasses a range of instruments collectively known as mezzanine finance or subordinated capital. These instruments include subordinated debt (notes with unsecured or junior-lien claims), mezzanine loans (subordinated debt often with equity warrants), preferred equity (equity with debt-like priority in distributions), and convertible notes (debt that can convert to equity).
Mezzanine finance is designed to bridge the gap between what a senior lender will provide and what an equity sponsor is willing to invest. If a company can support 4x EBITDA of senior secured debt and the total purchase price requires 7x EBITDA of capital, the remaining 3x might be financed with a combination of mezzanine debt and equity. Mezzanine fills this gap at rates between senior debt and equity returns — historically targeting 15–20% gross IRR through a combination of cash interest, PIK, and equity kickers (warrants or direct equity co-investments).
Preferred equity sits in the capital structure above common equity but below all debt — it has priority over common shareholders in distributions and in liquidation, but is junior to every debt claim. Preferred equity holders typically receive a fixed or accruing dividend (often PIK) and may have participation rights that allow them to share in upside alongside common shareholders. Real estate preferred equity — inserted between the senior mortgage and the sponsor's common equity — is a common structure in CRE transactions.
Mezzanine finance has become less common in broadly syndicated leveraged finance, where second-lien loans and PIK notes have largely displaced traditional subordinated debt. However, it remains prevalent in private credit transactions, particularly for middle-market companies where sponsors need flexible capital beyond what first-lien lenders will provide.
The key risk in mezzanine and preferred equity is recovery in distress. These instruments sit below all senior debt in the payment waterfall; in a bankruptcy or liquidation, recovery depends entirely on whether enterprise value exceeds the senior debt claims. In highly leveraged transactions, mezzanine and preferred equity are often subordinated out in restructuring, leaving holders with little or no recovery.