INTM519030 - 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

Super senior (such as covered bonds) and senior debt are highest in rank in the capital structure and are secured on the assets of a business. It has first call on the assets of the business, ranking ahead of other creditors in the event of a financial failure. Senior debt is generally sourced from a bank or a syndicate of banks.

Larger senior debt 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 over the term of the debt.
• One tranche may be “bullet”, meaning that interest only is paid over the term of the debt and the capital is repaid at the end.
• Interest rates may be fixed or floating, and this may differ on each tranche.

There may also be a separate “revolving credit 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 debt 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 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 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.

Junior debt

Junior debt sits below senior lending - hence the term “junior” - but higher in rank than equity. The term “mezzanine” is also sometimes used, particularly in a private equity context, because it sits between the senior debt and equity. It is normally of a fixed term, often provided by a specialist lender, and is obviously subordinate to senior debt. Junior lending will not always be present, particularly in smaller buyouts.

Junior debt will be of smaller magnitudes and shorter maturities and senior debt because it is significantly more risky and lenders will limit how much and for how long it is available to a borrower.

Borrowers that can obtain junior debt tend to have low credit risk, and the most common borrower of junior debt are financial services firms.

Junior debt will be more expensive than otherwise comparable senior debt to reflect its riskier nature to the lender; however, this will adhere to the previously noted limites imposed by macroecoomic backdrop, currently, credit risk, amount, maturity and pricing.

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

Shareholder debt

Debt introduced by the shareholders is usually subordinate to both the senior and junior debt. Often it is in the form of a single, unsecured debt with a fixed term and 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 deeply discounted debt, although this type of debt has been less popular in recent years.