Thin capitalisation: practical guidance: introduction: forms of borrowing
Sources of funding
Intra-group funding - “mainstream” thin cap work, which mainly concerns the lending of funds between companies within the same group, can in most cases be distinguished from private equity financing which tends to be highly-leveraged (i.e. a deal heavily reliant on debt) and typically uses a combination of third party and connected party debt and is discussed from INTM519000.
In intra-group funding cases, the source of the funding is likely to be the ultimate parent or a group finance company, but unless it is substantial and very specific is unlikely to trace back to the group’s own third party funding. It will be group money. External funding in a large group will usually come from a mixture of sources, with tranches of debt on varying terms serving different purposes and expiring at different times, short- and long- term, flexible- and fixed-rate, with loans maturing and renewed at regular intervals. Lending within the group tends to be much more straightforward; usually a succession of large loans made according to need, or a perhaps a group facility provided by a group treasury company. A shared external facility may be available for working capital needs. Subsidiary funding seldom has the complexity of a group’s external funding arrangements; it does not need to and the complexity serves no purpose. It does however make it difficult and often misleading to compare the two.
What would a bank do?
This seems to be the default question where a non-arm’s length provision requires an arm’s length comparable. However, it is too narrow a question and does not reflect the real world choices of many companies.
A bank is a type of lender familiar to everyone, but may not be appropriate in every case. Major corporates have access to a variety of lending markets - corporate bonds, commercial paper, syndicated lending, etc, so it is useful to consider what the options of the UK borrower would have been had they gone to a third party for funding, and how that choice would have affected the provision. As discussed above, a major corporate will use a number of types of lender depending on the purpose, duration, etc.
The answer to this question will focus the search for comparable data and affect the nature of any adjustments made to produce an arm’s length solution. The answer may that a bank would be involved as an intermediary or not at all.
Banks do not lend their own money (certainly not to major corporates). They have to borrow it and therefore need to make a “turn” on the money as well as charging various fees when they lend it on to their customer. It is much more likely that companies looking to borrow substantial sums will look to capital markets, i.e. markets for securities where companies can secure long-term financing. The trend is towards disintermediation - in plainer terms, cutting out the intermediary - going to the market and borrowing from the investor directly.
Banks may be preferable to some borrowers; bank debt is more flexible than, say, corporate bonds, which have a defined term and repayment date, whereas bank debt is more likely to feature an option of early repayment and is therefore more flexible. Banks are also more willing to lend based on an ongoing relationship with a group. Banks also provide a wide range of money services. Companies will regularly use banks for overdraft facilities and for bridging finance; there is often a pattern in mergers and acquisitions, where the immediate purchase is made using short-term debt sourced by a bank or syndicate of banks, with that debt being replaced in due course by longer-term funding, perhaps through the bond market.
A bond is a type of security, a unit of debt, issued for a specific period, at the end of which it is repayable. The borrower issues the bond to the lender, who is the bondholder. Bonds carry a fixed rate of interest, or are issued at a discount and redeemed at face value (or some combination). The bond issue takes place in the primary market, where the bond passes from issuer to investor. However, there is a thriving secondary market within which bonds may change hands. This means that the borrower retains the money generated by the issue, but the investor does not necessarily have to keep their money tied up - they can sell the bond on. The issuer pays interest to whoever holds the bond when payment falls due.
A syndicate of banks will underwrite the bond issue to help bring it to the market; they will distribute the bond issue and buy any part of the bond issue not taken up by the market. Bonds are rated for their credit quality by the credit rating agencies, the main ones being Standard & Poor’s, Moody’s and Fitch Ratings. This rating attaches to the bond issue rather than to the issuer. The rating represents the agency’s assessment of the relative likelihood that the issue may default. The choice of ratings runs between “triple A” AAA (the highest investment grade) through BB or lower (speculative grade) to D (default grade). The full range of ratings and their definitions is set out for two of the rating agencies at INTM524140. The work of the rating agencies is considered in more detail from INTM524000 onwards.
A bond with a floating rate is known as a floating rate note (FRN). If it is secured, it is called a debenture.
This is a more restricted exercise than that described above for the bond market. It is the issue of debt to a single buyer or a small number of investors, usually with an investment bank acting as broker. It is not offered to the public generally and not registered on any exchange.
This is the term for debt instruments with a duration of less than a year, usually sold by large companies and banks to finance short-term obligations. They can serve as a cheaper alternative to a bank overdraft facility.
The above examples are mentioned not to give a comprehensive guide to borrowing types and conventions - the Corporate Finance Manual from CFM11060 onwards gives much more detail - but to underline that there are choices which would be available to an arm’s length borrower and these alternatives may have to be considered where the context is that of connected parties.