INTM580030 - Thin capitalisation: private equity: Typical debt elements of a private equity buyout

As exemplified in INTM580520, various types of debt often feature in the debt element of a private equity buyout.

Senior debt

Senior debt sits highest in the capital structure and is secured on the assets of a business. It has first call (“lien”) on the assets of the business, ranking ahead of other creditors in the event of a financial failure. Senior facilities are generally sourced from a bank or a syndicate of banks.

Larger senior facilities may be sub-divided into tranches with different terms on each tranche, for instance;

• Senior A might be “amortising” where, in addition to interest payments, there is a capital repayment schedule over the life of the loan.
• Senior B and C may be “bullet”, meaning that interest only is paid over the duration of the loan and the capital is repaid at the end.

Interest rates are typically LIBOR plus a margin (which may differ on each tranche, with senior A, the most secure tranche, attracting the smallest margin).

There may also be a separate revolving facility to provide short-term working capital and/or a “capex” facility to provide funds for future capital expenditure. Although the revolving and capex facilities are often detailed in the loan agreements at the time the acquisition financing is arranged, they are distinct facilities drawn, as needed, according to specified conditions and do not normally form part of the acquisition finance. There might also be a “second lien” tranche which is secured on the business’s assets but has recourse to those assets only after the more senior tranches have been repaid. However, it ranks ahead of the mezzanine and other junior debt in the event that anything goes wrong and the lenders seek to recover their money.

Senior debt typically makes up the largest part of the capital structure. The interest on senior debt is payable as it falls due, often referred to as “cash pay”.

Mezzanine debt

Mezzanine debt sits between the senior lending and the equity - hence the term “mezzanine”. It is normally a single facility of fixed term, often provided by a specialist finance house rather than a bank. Mezzanine lending will not always be present, particularly in smaller buyouts.

Mezzanine lending is normally priced at LIBOR plus a margin. The margin on mezzanine lending will reflect its subordination, ranking behind the senior lending in terms of security, thus attracting a higher margin than senior debt.

It is not unusual for the interest which accrues on mezzanine lending not to be fully paid in cash. Where this happens, the interest will often be split into a “cash margin” and a “PIK (payment-in-kind) margin”, with only the interest at LIBOR + cash margin being cash-paid. The unpaid interest, the PIK margin, may be added to the amount owed, either directly by rolling up the interest and incorporating it into the capital amount owed, or by satisfying the interest liability through the issue of further loan notes called PIK notes. PIK notes are recognised as payments of interest for tax purposes, but are in effect further loans bearing interest themselves.

Interest met in this way is treated as paid for taxes act purposes - see the guidance on funding bonds in CFM17030 onwards.

Shareholder debt

Debt introduced by the shareholders is usually subordinate to both the senior and mezzanine lending. Often it is in the form of a single, unsecured, facility of fixed term and with a fixed interest rate. It is common for the interest on shareholder debt not to be paid in cash but to be paid in kind through the issue PIK notes (sometimes referred to as “funding bonds”).

The majority of shareholder debt will be provided by the private equity investors, although it is common for some also to be provided by the managers of the business. The management debt is usually on the same or similar terms to the rest of the shareholder debt, though shareholdings and debt need not be in the same proportions.

Alternatively, shareholder debt might be structured as a deep discount bond, although this has been less popular in recent years.