First-Out Financing Decoded

What is First-Out Financing?

First-out financing creates a payment priority system within what looks like a single debt facility.

Here's the key difference:

• Traditional structure: Senior lender vs. subordinated lender (separate agreements)

• First-out structure: Multiple lenders in one facility with different payment priorities

Think of it as a waterfall within a waterfall. Cash flows hit the facility, then get distributed according to predetermined priorities.

Why it emerged:

• Banks wanted lower-risk positions for regulatory requirements

• Non-bank lenders sought higher yields

• Traditional lending categories became too rigid

The beauty? Flexibility. Rather than forcing lenders into rigid senior/subordinated boxes, first-out structures let deal teams craft custom payment waterfalls.

The Anatomy of a First-Out Structure

Typical sizing:

• First-out tranche: 60-70% of total debt package

• Last-out tranche: 30-40% of total debt package

Pricing differentials:

• First-out: SOFR + 400 bps

• Last-out: SOFR + 650-800 bps

• Spread: Usually 200-400 basis points difference

Security provisions:

• Both tranches share same collateral package

• First-out lender gets priority in liquidation

• First-out receives priority on subsidiary guarantees

The complexity factor: Unlike separate facilities, first-out arrangements need detailed provisions governing:

• Cash flow distribution

• Voting rights

• Amendment procedures

• Integration with mezzanine debt and equity

Real-World Example: MidState Manufacturing Acquisition

The Deal: Regional industrial components producer, $25M annual revenue, $35M purchase price

Capital Structure:

• $15M first-out tranche

• $10M last-out tranche

• $5M rollover equity

• $5M sponsor equity

The Players:

• Regional Bank: $15M first-out at SOFR + 425 bps

• Mezzanine Lender: $10M last-out at SOFR + 775 bps

• PE Sponsor: Buyer providing $5M equity

How payments flow:

1. Monthly cash sweeps service first-out principal and interest first

2. Then last-out interest payments

3. Excess cash pays down first-out principal until retired

4. All remaining payments flow to last-out lender

The result: Regional Bank got full repayment in 18 months. Mezz lender continued earning attractive yields. PE buyer achieved 100 bps cost savings vs. separate facilities.

Why Everyone Wins

Banks love first-out because:

• Enhanced security reduces risk-weighted assets

• Better capital ratios

• Compete with non-banks while staying conservative

Non-bank lenders get:

• Higher yields than traditional senior debt

• Better security than typical subordinated financing

• Bank does underwriting and monitoring

Private equity firms enjoy:

• Higher total leverage than bank-only financing

• Lower blended cost of capital

• Execution certainty with committed facilities

Target companies benefit from:

• Larger debt packages

• Higher purchase prices possible

• Simplified lender relationships

The Downsides

Increased complexity:

• Documentation costs run 25-40% higher

• Sophisticated intercreditor agreements required

• More administrative burden

Workout challenges:

• First-out and last-out lenders may have conflicting interests

• Enforcement can be difficult when interests diverge

Ongoing operational costs:

• Managing cash flow waterfalls

• Separate reporting requirements

• Coordinating amendments across parties

Market Trends

First-out financing continues gaining traction as:

• Regulatory pressures drive banks toward capital-efficient structures

• Competition among lenders creates pricing innovation

• Middle market companies demand more flexible capital solutions

Coming innovations:

• Multiple first-out tranches

• Hybrid first-out/mezzanine structures

• Integration with alternative lending sources

Key Takeaways for Buyers

Should you consider first-out financing for your next acquisition?

It makes sense when:

• You need higher leverage than traditional bank financing allows

• You want execution certainty with committed lenders

• Deal size is $15M+ where complexity costs are justified

• You have a sophisticated finance team to manage ongoing requirements

Skip it when:

• Simple bank financing meets your needs

• Deal size is too small to justify added costs

• Your finance team lacks bandwidth for complex structures

• Target company has limited cash flow predictability

The bottom line: First-out financing isn't just a trendy structure – it's becoming a competitive necessity in today's acquisition market. Firms using these tools can access larger debt packages at lower costs, while those stuck with traditional financing may find themselves outbid.

Three questions to ask your lender:

1. Can first-out pricing beat separate senior/sub facilities?

2. What's the all-in execution timeline and cost?

3. How do workout provisions protect our interests?

Smart buyers are already incorporating first-out options into their financing playbook. The question isn't whether this structure will become mainstream, it's whether you'll master it before your competition does.

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