Mezzanine vs senior debt in project finance

Mezzanine vs Senior Debt in Project Finance compares first-ranking debt that is paid first with junior debt that accepts payment and recovery subordination in return for a higher contractual return. Both may sit in the same project capital structure, but they do not carry the same claim, control or loss position.

The distinction matters because project finance relies on a defined repayment perimeter. The OECD Arrangement describes project finance by reference to exports to an independent project company, legally and economically, where project cash flows or assets secure or repay the financing. The capital stack must therefore be read through the project company, its contracts, accounts and security documents.

Mezzanine vs Senior Debt in Project Finance priority

Senior debt normally occupies the first contractual debt position in the payment waterfall. Scheduled interest, principal and agreed fees are paid before distributions to equity and before payments to debt that is expressly subordinated. Senior lenders commonly receive the strongest package of security over project assets, shares, contracts and controlled accounts, subject to the negotiated documents and local law.

Mezzanine debt is debt in legal form, but it ranks behind senior debt for some or all payment and enforcement purposes. Subordination may be contractual, structural or both. Contractual subordination comes from an intercreditor agreement. Structural subordination arises where the mezzanine claim sits at a holding company while senior debt is borrowed by the project company. The documents determine the actual position.

Equity remains below both debt layers in the ordinary waterfall. It receives value after creditors have been paid and absorbs losses before creditors do. A mezzanine instrument can include equity-linked rights or a profit participation, but those features do not remove its debt ranking unless the documents create a different legal claim.

Security and enforcement controls

Senior lenders usually negotiate the controlling role in a shared security package. The intercreditor agreement can set standstill periods, voting rights, enforcement instructions, turnover obligations and release mechanics. A mezzanine creditor may have consultation rights or a right to purchase senior claims, while still being prevented from enforcing shared security independently during the agreed period.

The intercreditor agreement is consequently a central credit document. It should be read with the facility agreements, security documents, account bank agreement and direct agreements. The review should identify who can accelerate, who controls a standstill, how amendments are approved and how recoveries are distributed. A broad statement that senior debt is paid first is not enough where several secured claims exist.

Cash flow and covenant treatment

Project cash commonly passes through controlled accounts before it reaches the sponsors. Operating costs and other permitted payments are followed by debt service, reserve requirements and permitted distributions according to the agreed waterfall. Senior facilities often restrict distributions when debt service tests, reserve tests or other conditions are not satisfied.

The DSCR is relevant to both layers, but its calculation can differ from the legal priority of the claims. A senior DSCR may test cash available against senior debt service only. A wider test may include mezzanine current-pay interest. Payment in kind interest may not leave the project as cash, yet it can increase the mezzanine claim. The facility definitions control the result.

Mezzanine terms may allow interest to accrue when cash is trapped by senior tests. That flexibility protects short-term liquidity for the project, but it can increase the junior balance and reduce future recovery. A current-pay feature has the opposite cash effect and may be permitted only when senior covenants allow it. The treatment of each item should be stated in the model and the finance documents.

Pricing and return

Senior debt generally receives a lower contractual return because it benefits from payment priority, stronger control and better expected recovery. Mezzanine pricing compensates for subordination and for the possibility that senior enforcement will consume the available value. The comparison should consider the full economics rather than the cash coupon alone.

Official support and covered tranches

The OECD Arrangement distinguishes official support in the form of pure cover, such as insurance or a guarantee, from official financing support such as direct credit, refinancing or interest rate support. Where export credit support is included in a project financing, the covered obligation should be identified precisely.

Official support may attach to a senior loan, a defined tranche or another obligation. Mezzanine debt may remain outside that support and continue to rank behind the covered debt. A credit paper should not describe an entire capital structure as covered without identifying the lender, borrower, principal, interest, security and recovery provisions to which the support applies.

The covered lender's rights also depend on the policy or guarantee, finance documents and intercreditor terms. Claims procedures, exclusions, assignment, voting and recoveries can affect the practical benefit. Official support does not turn junior debt into senior debt, and it does not erase the need to analyse the uncovered layer.

Construction and operating periods

The ranking can have different practical importance before and after completion. During construction, value may depend on remaining sponsor support, contractor obligations, permits and the ability to complete the works. Senior lenders can require controls over drawdown, additional funding and project accounts. Mezzanine may provide supplementary capital while accepting that senior lenders control responses to a construction default.

After completion, the focus moves towards operating cash flow, contracted revenue, maintenance obligations and refinancing. A project may meet senior debt service requirements while mezzanine interest remains deferred. Conversely, a senior distribution lock can preserve cash that would otherwise be paid to junior creditors. The intercreditor agreement should describe these transitions rather than leaving them to informal practice.

Recovery analysis

Recovery begins with the assets and contracts that create value, not with the name of the instrument. A share pledge may provide control of the project company, but that control has limited value if permits, offtake rights or operating contracts cannot be transferred. A charge over an account matters only if the account contains cash and the lender can exercise the agreed control.

Senior creditors usually apply enforcement proceeds to their secured debt before the mezzanine class receives residual value. Mezzanine recovery can improve through a sale of the project as a going concern, a negotiated restructuring or a purchase of senior claims. Each route depends on the rights in the intercreditor agreement and the legal enforceability of the security.

Mezzanine vs Senior Debt in Project Finance is therefore a comparison of claims on the same project cash flow, not merely a comparison of interest rates. Senior debt supplies the primary secured funding layer. Mezzanine can fill a gap between senior leverage and sponsor equity, but it bears more severe subordination and recovery risk. The project finance structure, security package and SPV documents determine how those risks operate in the transaction.