Thin capitalisation: practical guidance: private equity: issues to consider
As with thin capitalisation generally, the issues are:
- whether the borrower could have obtained the loans in question at arm’s length,
- if so, could the borrower done so on the terms agreed. In particular, whether the interest rate is excessive when compared with what would have been charged at arm’s length.
Determining what an arm’s length amount of debt in a specific instance can be difficult. It is necessary to take into account the facts and circumstances of the borrower at the time the loan was made. In trying to answer this question, one must consider what sources of finance would have been available to the borrower at arm’s length and what terms would have been acceptable to both parties.
When assessing these transactions it is also necessary to take account of the wider circumstances existing at the time of the deal, for example, liquidity and market confidence. In particular, the terms and conditions which are available and acceptable to both borrower and lender are sensitive to changes in the debt market. Interest rates, repayment terms and the various covenants applying to the loan are all subject to market fluctuation. For example, the amount that a lender might have advanced as part of a leveraged buyout in the pre-credit crunch peak is likely to differ markedly from the amount the same lender would advance to the same borrower in the post-crunch market.
This makes it particularly important to consider the time at which a transaction occurred. Where an uncontrolled transaction is being offered up as a potential comparable in support of an “arm’s length” position, its usefulness as a comparable may be seriously impaired if the timing of the transaction puts it in a period when market conditions differed significantly from those at the time of the transaction being examined.
Nevertheless, information can be obtained in order to build an overall picture.
Gathering preliminary information
The general guidance in INTM513010 on the preliminary information needed to consider either an ATCA application or a post-return enquiry largely holds good for private equity cases.
Specific information that will be particularly relevant to a private equity case and which should be part of an ATCA application includes:
- Loan agreements for each of the loan facilities providing funds for the relevant transactions, including the senior and mezzanine loan agreements and other related documents such as inter-creditor agreements.
- Copies of any financial projections relied upon by the lenders in arriving at their lending decision - in the case of senior and mezzanine lenders these will usually be the bank case or base case projections. See INTM519080.
- Confirmation of the date the deal completed.
- Reconciliation of the sources and use of funds. This is a simple reconciliation of the funding of the deal with the purchase price.