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HMRC internal manual

International Manual

HM Revenue & Customs
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Thin capitalisation: practical guidance: private equity: typical debt elements of a private equity buyout

Different types of debt feature in private equity buyouts (INTM519020).

Senior debt

Senior debt sits highest in the capital structure and is secured on the assets of a business. It has first call (“lien”) on the assets of the business, ranking ahead of other creditors in the event of a financial failure. Senior facilities are generally sourced from a bank or a syndicate of banks.

Larger senior facilities may be sub-divided into tranches with different terms on each tranche, for instance:

  • One tranche may be “amortising”. This means interest and capital is being paid the term of the loan.
  • One tranche may be “bullet”, meaning that interest only is paid over the term of the loan and the capital is repaid at the end.

Interest rates are typically LIBOR plus a margin (which may differ on each tranche, with amortising debt being the most secure and therefore attracting the smallest margin).

There may also be a separate revolving facility to provide short-term working capital and/or a “capex” facility to provide funds for capital expenditure. Although the revolving and capex facilities are often detailed in the loan agreements at the time the acquisition financing is arranged, they are distinct facilities drawn, as needed, according to specified conditions and do not normally form part of the acquisition finance. There may also be a “second lien” tranche which is secured on the business’s assets but has recourse to those assets only after the more senior tranches have been repaid. However, it ranks ahead of the mezzanine and other junior debt in the event that anything goes wrong and the lenders seek to recover their money.

Senior debt typically makes up the largest part of the capital structure. The interest on senior debt is payable as it falls due, often referred to as “cash pay”.

Mezzanine debt

Mezzanine debt sits between the senior lending and the equity - hence the term “mezzanine”. It is normally a single facility of fixed term, often provided by a specialist finance house rather than a bank, and is obviously subordinate to senior debt. Mezzanine lending will not always be present, particularly in smaller buyouts.

Mezzanine lending is normally priced at LIBOR plus a margin. Mezzanine lending will be more expensive than senior to reflect its riskier nature to the lender.

See INTM519035 regarding the payment in part or in full of interest on mezzanine or shareholder debt using PIK (payment-in-kind) notes

Shareholder debt

Debt introduced by the shareholders is usually subordinate to both the senior and mezzanine lending. Often it is in the form of a single, unsecured, facility of fixed term and with a fixed interest rate

The majority of shareholder debt will be provided by the private equity investors, although it is common for some also to be provided by the managers of the business. The management debt is usually on the same or similar terms to the rest of the shareholder debt, though shareholdings and debt need not be in the same proportions.

Alternatively, shareholder debt may be structured as a deep discount bond, although this type of debt has been less popular in recent years.