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HMRC internal manual

International Manual

HM Revenue & Customs
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Thin capitalisation: practical guidance: private equity: working the case: third party loan agreements

Senior and mezzanine lending facilities

A private equity buyout usually involves financing from senior lenders - and often mezzanine lenders too - who have no other interest in the business. This can normally be accepted as being at arm’s length - see INTM519030 and the proviso of the acting together rules at INTM519040.

The terms of the senior and mezzanine loan facilities can provide useful internal comparables in trying to establish the overall arm’s length position. Not only do they relate to the specific business in question but also to lending that was provided at the same time as the shareholder debt. They provide an indication of how an independent third-party lender viewed the borrower at the time, which is why it is crucial to obtain copies of all loan agreements when working a private equity thin capitalisation case.

INTM522000 onwards describes some of the more common features of third-party loan agreements. The following points may be relevant in helping to build a picture of a borrower’s overall arm’s length debt position.

Amount of senior and mezzanine debt

  • What proportions of the overall debt financing the buyout relates to third-party senior lending? One would normally expect a borrower to exhaust its capacity to obtain the cheaper senior debt before taking on more expensive mezzanine or other subordinated debt. A lower proportion of senior debt may tell us something about the senior lender’s attitude to the risk, based on the due diligence conducted, and can be an indicator of a lower overall debt capacity.
  • Factors that may influence the proportion of a deal that can be financed by senior lending will include the nature of the borrower’s business and the state of the debt markets. For example, a property company may be able to obtain a higher level of senior debt funding because of the existence of property assets that can be used as security. This would of course be dependent on the strength of those assets and the state of the property market.
  • How much third-party mezzanine debt is there, and in what proportion? One would expect a typical profile of third-party debt to show the amount of mezzanine debt as small relative to the amount of senior debt. If there is other subordinated debt but no mezzanine debt then why is this? Were the mezzanine markets available to the borrower at the time of the deal?

Rates of interest

  • The rate of interest charged on the senior and mezzanine debt can give an indication of the lenders’ perception of risk in lending to the particular borrower at that time. The margin on riskier third-party lending will normally be higher.
  • The rates charged on third-party loans can also give an indication whether shareholder debt interest rates are reasonable in comparison to what may be expected on debt provided at arm’s length. It is important to consider alongside this, whether the shareholder debt in question could and would be present in an arm’s length deal.

Financial conditions

Senior and mezzanine agreements normally contain financial covenants. These are financial conditions that the borrower undertakes to meet under the terms of the loan agreement and can be a useful guide to how an arm’s length lender views the borrower. Under the terms of the covenants, the borrower must keep within the limits of certain ratios or amounts specified in the covenant. The lender monitors compliance with the covenants through the borrower providing the relevant financial information on a regular basis. Breach of a covenant is typically taken very seriously by the lender and it will normally lead to consequences such as the borrower being required to remedy the breach through injection of more equity into the business, repayment of part of the loan, renegotiation of the facility or even the lender calling in the loan. See INTM520060 for HMRC’s view on breach of covenant.

The financial covenants are a good indication of what a third-party lender sees as important in monitoring its own exposure. For instance, if the covenants are based on EBITDA (see INTM515030), as they commonly are, then that points to EBITDA being an appropriate earnings measure to apply in considering overall borrowing capacity. But if the bank takes a more unusual measure such as EBITDAR (earnings before tax depreciation, amortisation and rent) then that points to taking that measure instead.

A typical senior or mezzanine loan agreement will include:

  • an interest cover covenant to monitor the borrower’s ability to service its debts - often the EBITDA:interest ratio is used,
  • a debt ratio or leverage covenant to monitor the borrower’s ability to repay its debts - often based on the Debt:EBITDA ratio.

There may also be a cash flow covenant based on a ratio of cash-flow to interest. Often this acts as a back-stop covenant to monitor that at a minimum the borrower has sufficient cash to meet its obligation to pay interest in cash as it falls due.

Loan agreements may include other covenants depending on the circumstances of the borrower and nature of its business. For instance, where the lending is secured against property, the agreement might include a covenant requiring the ratio of loan to value (LTV) of the property to remain above a certain level to protect the lender’s position if there is a significant fall in property values - INTM518000 onwards has guidance on lending against asset values. A lender would also require an interest cover or cash flow covenant to ensure the borrower had the funds to service the debt.

Where there is a mezzanine facility, the agreement will normally contain covenants monitoring the same type of ratios as in the senior agreement, for example, if the senior agreement contains an interest cover covenant based on EBITDA:interest then usually so will the mezzanine agreement. However, the covenant ratios that lenders require to be met may differ, with the mezzanine covenants often being slightly more relaxed than their senior equivalents.

Points to think about when considering the covenants in the third-party loan agreements include:

  • How do the covenants relate to the base case (that is, most likely) projections provided to the lender? What are they seeking to achieve? Do they represent a tight constraint on the borrower or a back-stop? What happens with the senior and mezzanine covenants over the course of the loan? How rapidly are interest cover ratios expected to rise or leverage ratios expected to fall? If the covenants show an expectation of rapid improvements then that is a reflection of how an arm’s length lender would want to protect its position.
  • If there is both a senior agreement and a mezzanine agreement, then how do the covenants compare?
  • The loan agreements contain definitions of the different elements making up the financial covenants, for example, net interest, senior interest, and exceptional items. These are often standard definitions but there are variations and it is important to understand how exactly the covenant operates.