Tranches
Tranches are the slices into which a pool of loans or a financing is divided, each with its own priority of payment and its own risk: the senior tranche is paid first and loses last, the equity or first-loss tranche is paid last and loses first, and the mezzanine sits between. Tranching is how one portfolio of risk is sold to investors with different appetites — and, in a venture deal, how an investment is released in stages against milestones.
- Also known as
- Tranche, Tranching, Senior and junior tranches
- Used at
- securitisations of mortgages, loans, credit cards and receivables; synthetic risk transfers; leveraged buy-out debt; and, in the venture sense, staged funding rounds
- Binding
- yes — the priority of payments ("the waterfall") is written into the transaction documents and cannot be changed by one party
- Typical structure
- a senior tranche of 80–90% of the pool rated AAA or AA, a mezzanine tranche of 5–15% rated BBB to BB, and an unrated equity tranche of 3–8% retained by the originator or sold to a specialist investor
- Typical pricing
- the senior pays a small spread over the benchmark rate, the mezzanine several hundred basis points, the equity a residual that can be 10–20% or nothing
- Parties
- the originator, the arranging bank, rating agencies, investors in each tranche, a trustee who enforces the waterfall, and a servicer who collects the loans
How tranches work in practice
Take a pool of €500m of car loans with an expected loss of 2% over its life. No single investor wants all of it, but split it and every investor finds a slice. The equity tranche — the first 5%, €25m — absorbs the first losses; the mezzanine — the next 10%, €50m — absorbs losses only after the equity is gone; the senior €425m loses money only if losses exceed 15% of the pool, which on expected losses of 2% is a remote event, so it is rated AAA and pays little. Cash from the loans flows through the waterfall: senior interest and principal first, then mezzanine, then whatever remains to the equity. The equity holder therefore earns everything left over in a good year and nothing in a bad one.
The structure converts one credit risk into several instruments, each priced for its buyer: insurers and money-market funds buy the senior, credit funds the mezzanine, the originator or a hedge fund keeps the equity. It also concentrates risk. A 4% loss on the pool — twice the expected — costs the senior nothing and the mezzanine nothing, and wipes out 80% of the equity. The 2008 lesson was about tranches built on the wrong expected loss: senior tranches of subprime pools were rated AAA on assumptions the loans never met.
The venture usage is the same word for a different thing. A "tranched" Series A of $10m might pay $6m at closing and $4m when the company reaches a revenue milestone, so the investor's risk is staged rather than ranked.
Example
A €500m auto-loan securitisation is structured as €425m senior at a 1.0% spread, €50m mezzanine at 4.5% and €25m equity retained by the lender. In year one losses are 1.8%, €9m: the equity absorbs it, and its residual income — the pool's 6% yield less the senior and mezzanine coupons and the loss — is about €12m, a 48% return on €25m. In a recession year losses are 6%, €30m: the equity's €25m is gone, the mezzanine loses €5m of its €50m, and the senior is untouched. The lender, which kept the equity, has lost €25m on a pool it would otherwise have funded entirely on its own balance sheet — where a 6% loss would have cost it €30m.
Common mistakes
- Rating a senior tranche on an expected loss the underlying loans have never been tested against. - Buying mezzanine for its yield without modelling the loss rate at which it starts to take losses. - An originator selling the equity tranche and keeping none of the risk, so its underwriting has no owner. - A waterfall with triggers nobody modelled — a performance test that diverts cash from the equity in exactly the year it needs it. - Confusing a tranched venture investment (staged by milestone) with a tranched securitisation (ranked by loss).