INTM580060 - Thin Capitalisation: private equity: Risk assessment - the basics

Background information

Given the typical structure of a private equity buyout, and the nature of the loans under consideration, the general guidance in INTM575020 is probably only of limited relevance. However, the points about potential sources of information do apply. Private equity buyouts are normally well-reported, particularly the larger ones and there will usually be background information and commentary on the buyout readily available online.

Basic Ratios

The buyout involves the purchase of the shares of the target business so the market value of the target business (“enterprise value”) is known at the time of the buyout. What can be more difficult to ascertain from publicly available information is the balance of debt and equity in the deal. This is because the term “equity” is often used by external commentators to describe all of the private equity house’s investment in the business even though some or all of that investment may be structured as debt. If risk assessment is being carried out after the relevant return has been filed, the position should be much clearer as the accounts should show the relevant balances and interest payments/accruals.

A high debt to equity ratio can be an initial risk indicator of non-arm’s length debt, although what is ‘high’ will depend on the borrower’s circumstances, particularly the nature of its business and when the loans were made.

As with thin capitalisation generally, other ratios that may be relevant to give an initial impression of the position are a leverage ratio such as debt to EBITDA and an interest cover ratio such as interest to EBITDA. Some of these are discussed at INTM578000 and INTM579000 

Small and medium-sized enterprises

Although a business that is the subject of a private equity buyout may have met the definition of a small or medium-sized enterprise as a stand-alone entity - see INTM432112 - it is very unlikely to satisfy the definition once linked and partner enterprises are taken into account, because these will include the private equity fund. Therefore, the exemption from the transfer pricing rules for small and medium-sized enterprises is unlikely to apply.