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International Manual

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Thin capitalisation: practical guidance: private equity: working the case: other points

Purpose of the loans

It is important to establish the purpose of the loans, although this will normally be clear in a private equity context since the funds will usually be for acquisition of the target business and/or refinancing of any existing debt. The attitude of the lender will be influenced by the borrower’s intended strategy for the business; the lender will want to be satisfied that the borrower will be in a position to service and repay the loan, particularly if the interest is rolling-up (see INTM519035 on PIK notes).

Financial projections

Where the buyout includes financing from third-party lenders, the borrower will have been required to provide financial projections to the lender in support of the loan application. These will normally include key figures such as projections of earnings, interest cover and leverage, using relevant measures and are likely to have been subject to due diligence by the lender. Projections which have been audited and relied upon by an independent lender may be more readily accepted than, say, projections produced for purposes where assumptions will be less rigorously tested. The projections for the first three or four years are the most important, not only because of the difficulties inherent in projecting over longer periods but also because typically, a private equity investor has a three-to-five year exit strategy.

In working a private equity thin capitalisation case, it is important to check whether the financial projections provided are the projections on which the independent lender based their decision; these projections are usually referred to as the base case projections, which are the ones that are considered to be the most likely outcome in the circumstances. If not, obtain these projections. This is usually called the base case or banking case, as opposed to the management or equity case which is likely to be less conservative.

External comparables

The guidance at INTM514020 is as relevant for private equity cases as it is for thin capitalisation cases generally: it is difficult to find a reliable comparable. Sector and other generic data can only go so far in giving an indication of the general position at various points in time, and figures for individual potential comparables can be distorted by their own recent or prospective acquisition or investment activity. It is the facts and circumstances of the particular business under consideration that are most relevant in establishing the arm’s length position.

What is an arm’s length standard?

As with thin capitalisation generally, it is impossible to give hard-and-fast rules as to how the arm’s length is arrived at in any particular situation as each case must be judged according to its own facts and circumstances. While it may often be the case that companies that have been subject to a private equity buyout will be more highly leveraged than companies with a more traditional business model, it does not automatically follow that such companies will support a high level of arm’s length debt.

Terms of a thin capitalisation agreement - covenants

INTM520000 onwards describes what should be included in a thin capitalisation agreement and in particular, INTM520050 refers to the inclusion of covenants.

In a private equity case, the main issue is the amount of arm’s length debt taken on for the specific purpose of acquiring the target business, so it may be appropriate to include a covenant in the thin capitalisation agreement specifying an absolute cap to the amount of arm’s length debt.

It will also normally be appropriate to include interest cover and gearing covenants, particularly in larger cases or where there is no third-party lending. This is because in cases where there is no third party lending, projections will not have been subject to scrutiny by an independent lender.

Where there is third-party lending, senior and mezzanine agreements can provide a useful guide, both to the measures and ratios that are appropriate to be included in the terms of the covenants, and to the figures that should be included.

There may also be other circumstances - depending on the facts, where other covenants are appropriate.