INTM511030 - 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 may be more leveraged 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 debt maturing and renewed at regular intervals. Lending within the group tends to be much more straightforward; usually a succession of large transactions made according to need, or a perhaps a group debt provided by a group treasury company. Shared external debt 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.

The below examples are not intended to give a comprehensive guide to borrowing types and conventions, but to underline that there are choices which would be available to an arm’s length borrower and that these alternatives may have to be considered where the context is that of connected parties. More detail on borrowing types and conventions can be found in the Corporate Finance Manual from CFM11030 onwards.

What would a bank do?

This often 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 lenders and forms of borrowing. It is therefore 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.

Bank borrowing

Banks generally do not lend their own money (certainly not to major corporates). They generally have to borrow it and therefore need to make a “turn” on the money.

Banks are willing to lend based on an ongoing relationship with a group because they are already aware of the credit risk of an established client borrower. Banks also provide a wide range of money services. Companies will regularly use banks for overdraft facilities and for bridging finance.

Bond markets

A bond is a type of debt instrument, a unit of debt, that can be issued for various maturity structures (e.g. bullet repayment, convertible, callable, putable). Bonds can carry a fixed or floating rate interest, or can be issued at a discount and redeemed at face value (or some combination). The bond issue takes place in the primary market, where the bond is issued by the borrower (the issuer) to the lender (the bondholder). The initial offer may be made to a limited number of lenders or to all lenders. For certain types of bonds 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 lender does not necessarily have to keep their money tied up - they can sell the bond on to another lender. The issuer pays interest (and, at the relevant contractual date, the principal repayment) to whomever holds the bond when payment falls due.

A syndicate of banks or a single bank might 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 may be 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” (the highest investment grade) through speculative grade to D (default grade). The full range of ratings and their definitions is set out for two of the main rating agencies at INTM524040. The work of the rating agencies is considered in more detail from INTM524000 onwards.

Private placement

This is a more restricted exercise than that described above for the bond market. It is the issue of debt to a single or a small number of lenders, with an investment bank acting as the intermediary agent.

Commercial paper

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 (usually between three to six months maturity).