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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: private equity: private equity buyout funding structures

The majority of private equity backed acquisitions are achieved through a management buyout (MBO). In an MBO some or all of the existing management team of the target business purchase a significant share in the ownership of the business from existing shareholders. Often, management will do this with the assistance of a private equity backer. Private equity funds use a combination of their own funds and bank debt to fund, along with the management team, a separate company (a new company created for the purpose) that acquires the shares of the target company. The overall financing package will rely heavily on debt funding or “leverage”, hence the broader term “leveraged buyout” (LBO).

Such buyouts are typically funded through a mixture of

  • third party debt, perhaps from unconnected banks, or specialist mezzanine lenders
  • shareholder debt, from the private equity fund, management team
  • equity, for example, ordinary shares

The third party debt is usually referred to as the ‘senior debt’ because it will have the best security. Third party debt may also include a further slice of debt that is subordinated to the senior debt. This is referred to as mezzanine debt (see INTM519030). This slice of debt is riskier than the senior debt because of the lack of appropriate security. It will therefore have a higher interest rate.

Sometimes, the vendors of the target business will also provide debt funding.

Not all deals will include all of these components and the relative proportions of the various tranches of debt will depend on a number of factors including the circumstances of the business and the state of the debt market at the time the deal was agreed.

The following diagram illustrates a typical debt buyout structure. It shows a target business being acquired for £100m with a mixture of senior, mezzanine and shareholder debt, and a small amount of equity.

The purpose of this diagram is to show a typical structure. Whether the funding is at arm’s length is a separate matter.

Use this link to view private equity buyout funding structures diagram