What is the Capital Stack?

July 17, 20224 min read
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The capital stack is a concept used to convey the risks and rewards of an investment. For example, Yieldstreet often participates in the senior secured position of the capital stack, where there is less risk compared to the rest of the stack. Let’s dive further into what the capital stack is and how it works.

What is the capital stack?

The capital stack represents the capital invested from each lender of an investment and the relationship between each of those lenders. The higher you are on the capital stack the lower your risk profile and the lower your returns. Conversely, the lower you are on the capital stack, the higher your risk, but the greater your potential returns.

Depending on the investor and their financial portfolio, the capital stack would look different for each case or investor.

In this case, we see that there are four layers to the capital stack i.e., Common Equity, Preferred EquityMezzanine debt, and Senior debt.

If this structure is followed, it would mean that those at the top, common equity have a higher risk and less priority over those capital structures to follow.

Bottom capital stacks, such as Mezzanine debt and Senior debt have a higher priority and lower risk, as they can enjoy better cash flows and asset allocation.

The capital stack is a structure that’s used to ensure that in the event a company or investor defaults on their repayments, or files for bankruptcy, the underlying capital stacks will receive first claim and priority in obtaining their initial cash investments.

Usually, senior debt will have the highest priority or first claim on the remaining value of an investment property in the event of insolvency.

Afterward, mezzanine debt would then receive a second claim, followed by preferred equity investors and common inquiry investors.

On the other hand, oftentimes it’s been found that those levels higher at the top could enjoy better capital gains and returns if an investor does not default on the loan or the investment. They do however have higher risks, but for lower-lying levels, they are only offered the initial investment and interest repayments.

How does the capital stack work?

The easiest way to visualize the concept of the capital stack is through a champagne tower.

capital stack

The more metaphoric champagne that exists, the more glasses will be filled in the tower. This seems simple enough. But now let’s apply it in terms of an investor’s risk profile. 

As we mentioned earlier, the further towards the top of the capital stack—or the champagne tower in this case—the lower your risk but also the lower your return. If you’re in a senior secured position, as the borrower begins to pay back the loan, you are the first in line to have your champagne glass filled. However, if you’re in the mezzanine debt or common equity position, there are generally lenders that must be paid back before you.

In a healthy investment, there is plenty of champagne to fill all of the glasses, regardless of where your investment sits. But, if the borrower can’t make expected payments, the amount of champagne is limited. This means that some glasses may be partially filled, or even empty.

Then why would I want to take on greater risk?

Great question! In the capital stack, greater risk equates to potentially greater rewards. So depending on your risk profile, or willingness and ability to take on risk, you have the opportunity to earn higher interest on your investment. 

When investing with a higher risk profile, the key is to vet an investment to make sure the borrower, sponsor, and collateral are of a high enough quality to make you comfortable with the additional risk. At Yieldstreet, our investment opportunities adhere to our Investment Philosophy, which helps ensure a higher quality investment for investors like you. 

Initially, Yieldstreet only offered investment opportunities with yields between 8–15% that sat at or near the top of the capital stack. But sticking strictly to this structure limited the number of offers we could bring to our investors. We understand that each investor’s risk profile is specific to them and no two are exactly alike. Because of this, Yieldstreet now offers a variety of investments within the same yields range but that sit in different places within the capital stack.

Does this mean some offerings are better than others?

The answer is no. It’s important for investors to understand that sitting higher or lower on the capital stack is not better or worse, just different. We strive to offer our community of investors a variety of investments designed to suit a range of risk tolerances, while still adhering to our core investment philosophy.

How do I determine my risk profile?

Every investor’s risk profile is different. Factors that should be taken into account are both your risk capacity (what you’re financially able to take on in risk) and your risk tolerance (how much you feel comfortable taking on in risk). The combination of these two factors contributes to the creation of your risk profile. 

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