What is a Capital Stack?

The capital stack is a conceptual organization of real capital that is contributed to a transaction. The legal documents that represent these concepts also define variables such as ownership rights, the order in which these rights are exercised for distribution of cash flows, and the transfer of ownership in the event of a loan default. You won’t see a graphic like this in a common legal document, but it’s easier to depict relationships visually this way (the stack).

The capital contributed at closing comes from various sources. This capital is held on the balance sheet as liability and equity. It’s the right column, and this is the capital stack. The left column represents the uses of the same capital, held as assets on the balance sheet. The assets generate cash flow and value, but it’s the relationship of the liabilities and equities - the deal structure - that define how that cash flow and value is distributed. This order of equity distribution is commonly referred to as the waterfall. It’s important for every investing partner to understand the structure of the deal and where their equities lie in the waterfall. Each piece of the stack has a different risk profile along with a commensurate return profile, which we will explore further.

As the stack rises, so does risk, return, and the loss of priority.

Debt

At the bottom of the stack lies the debt instrument(s). The cost of debt to the investment is equal to the interest rate and any fees associated with originating the loan. The debt is the highest priority in the deal and is the first to receive cash generated from the asset. The lower the risk, the lower the return. Since the cost of debt is less than the cost of equity, debt commonly represents the majority of the capital stack. This increases the upside for the partners and “gooses” the return on equity. Sometimes there is another kind of debt instrument, called mezzanine debt, that is layered on top of the senior debt. Although it’s not shown here, mezzanine is subordinate to senior debt and costs more to the investment.

Preferred Equity

Preferred equity offers a hybrid risk/return profile. Simply put, the “pref” is equity that is treated preferentially. A part of the equity raise, pref has a higher priority than common equity. This means it receives its share of distributions after the debt is serviced and before any common equity is paid. Preferred equity can be a mitigator of risk for Limited Partners, as the returns are prioritized. It is similar to mezzanine debt, with a few standard differentiators. The first being it is not secured by the property, although it typically comes with the ability to force a sale in the event of non-payment. Effectively, the sponsor, or General Partner, puts up their share of the common equity as collateral.

Common Equity

At the top of the stack is the common equity. The last be be paid, this piece of the capital stack bears both the highest risk and the highest return. It’s only after the debt (senior and subordinate, if used) is paid, the preferred equity is paid, and capital expenditures and reserves are funded, that common equity can be paid. Sponsors commonly use preferred equity to gain higher leverage at a lower cost, which increases the return of the common equity provided the asset is well performing. Often times, a well performing asset produces most of the upside on behalf of the common equity.

As an investor it’s important to know how the deal structure aligns with your investment criteria. If you prioritize lower risk and more frequent cash flow distributions, you may be more interested in preferred equity. However, if you are less interested in cash flow and want more of the upside and the possibility of earning a 20%+ annual return, purchasing more common equity might be a better choice.