Have you ever wondered what happens to a company’s assets when it goes under?? Who gets what?
The Capital stack is important to understand, especially as fund managers. Investors will want to know where they stand in line!
…I’ll let you in on what it actually is and why it’s vital to understand!
What is the Capital Stack??
In the event that a company goes bankrupt or is liquidated, the capital stack tells us who gets which assets.
Who has collateral? Who gets paid first? Are you 7th in line or 2nd??
The position at the bottom of the capital stack is considered the most risky. However, as with all the highest-risk investments, it’s also one that has the potentially highest return.
“Lenders are typically the highest in the capital stack of an asset or business. Meaning lenders have the highest priority in the event of a liquidation. Conversely, common equity holders are usually the lowest part of the capital stack.”Capital Stack Guide
Types and Components of the Capital Stack
A Capital stack is typically synonymous across investment platforms; from a lending club, to real estate, to Private Equity. Each of them use capital stack! That is why it’s so essential to understand.
I think the following image does a good job at helping us better understand what we’re dealing with here.
Senior Debt will include things like Asset Based or Commercial bank loans. They obviously will have the lowest risk, and lowest return.
Following is Mezzanine debt which is also referred to as Junior Capital, includes preferred equity.
Lastly, common equity, is your regular share holders.
If a company files for Chapter 7 or Chapter 11 bankruptcy – all of the assets will be liquidated, and any remaining funds will be repaired to the debt holders before the equity holders.
Preferred stockholders will get paid out before common stockholders. This is one reason why stocks are more risky than bonds.
Capital stack can differ slightly depending on what you’re investing in. Find more information here.
Why the Capital Stack Matters
“The capital stack and its components are the backbone of any deal.”
BEFORE an investor will invest in you, they will have to know where they stand in the capital stack to be able to properly assess the risk and returns of the possible investment.
If an investor owns debt and stock in the same company, and that company goes bankrupt – debt gets paid off before equity does.
It is essential that you are able to explain things like this to them! The stack of your fund is crucial.
Now, funds are usually referred to as an investment pool… and there are import things to understand about an investment funds capital stack.
We talk about these things in our course. 🙂
If you have ANY questions concerning capital stack, or you fund in general, please reach out!
Thanks for the read!
DISCLAIMER: This content is for educational and informational purposes only. It is not to be taken as tax, financial, or legal advice. You should always consult a legal professional before taking action. Furthermore, this is not a recommendation to buy or sell any security. The content is solely just the opinion of the authors.