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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: lending against asset values: lending against assets in general

Lenders have different attitudes to risk, but where they can they will seek to reduce it as far as possible. In order to minimise risk, in an arm’s length situation a lender is likely to require a borrower to provide assets as security for a loan. A secured lender will then be able to enforce its rights in the event of a default, by seizing and (in most cases) selling the property against which the debt is secured.

Enforcing such a right may spell the end for a struggling business, since realising these assets may take away the borrower’s means of trading. This is why there is sometimes an opportunity for the borrower to invoke legal restrictions on the ability of secured creditors to enforce their rights, such as administration in the UK and Chapter 11 bankruptcy in the USA, both of which offer periods of protection against creditors. Equally, if there is a chance of recovery, the lender may not want to “pull the plug”, because this is likely to deprive the company of trading assets or premises, and as a consequence, the lender will lose the value of any debt which exceeds the value of the security when it is realised. The existence of security does not therefore make a loan risk free, so any contention that assets of a company may be used as security for a loan from a connected party, and perhaps thereby increase the amount of the loan, needs to be looked at closely.

In all cases, consider what might happen if the borrower defaults on the loan. It is likely the lender will take possession of the assets which have been pledged as security, and arrange for their sale. Not only will there be expense incurred in doing this, but also the actual proceeds are unlikely to be known with any degree of certainty. This is for the following reasons:

  • the market may know the sale is forced, weakening the seller’s bargaining position
  • assets appropriate to a particular trade or industry may not be attractive to buyers if the economic circumstances which led to the business failure still apply
  • some assets may be so specialised that there is no market for them
  • assets such as retail trading sites may have had significant value with a successful name attached, but less so as vacant sites in unattractive areas
  • lenders are not in the business of buying and selling assets, so may be unable to obtain best value.

The amount which a lender will advance depends on the nature of the asset, however, a lender is unlikely to ever lend 100% of the value of an asset solely on the strength of its current value.. Plant and machinery in particular will be heavily discounted. Buildings and land on the other hand - while still being discounted to some extent, generally retain value and can attract a loan which represents a high proportion of the asset. High - or 100%, asset to loan values are occasionally seen, though this is likely to be because the lending is low risk.

Lenders sometimes refer to the loan-to-value ratio, or LTV ratio, in a particular case. This is the proportion of the value of the asset they are prepared to consider as the maximum amount of loan. For plant and machinery the LTV ratio will be quite low, while buildings and land can attract higher LTVs. The following pages of this chapter consider this in more detail.

In all cases where an LTV ratio is in point, it should be remembered that it is just one factor among several that a third party lender takes into account. Lenders will always be asset aware because they look for security, but the ability to service a debt - pay back both the interest and the borrowed capital - remain the key factors, to which an LTV ratio is just one contributor.

A lender will want to be able to satisfy themselves that cash flow is sufficiently healthy to service the debt, so other ratios are likely to be included in a loan agreement so this aspect can be monitored. LTV and interest cover covenants are typically seen in combination in third party loan agreements, and compliance with the interest cover covenant is likely to be of key importance to a lender.