Private equity-owned companies are missing out on the wave of state-backed coronavirus loans because of the way the industry has relied on a model that can cut their tax bills but saddles them with debt.
Banks in the UK and across Europe are rejecting applications from some private equity-owned companies because of financial engineering that has left them falling foul of EU state-aid rules, said bankers who are administering state-aid schemes and private equity executives.
EU state-aid rules say companies deemed to be in financial distress, whose accumulated losses exceed 50 per cent of their share capital, should not be able to access the support.
Many private equity-backed companies fall into this category because buyout groups’ use of debt tends to minimise their share capital. Meanwhile, interest payments on that debt can result in statutory losses even if their operations are generating cash. That structure, which is typical in leveraged buyouts, has helped lower rates of corporate taxation.
“I can’t give a company a loan . . . if they don’t qualify, and many of them [private equity-owned companies] don’t,” said a senior banker helping oversee the UK’s coronavirus business interruption loans scheme (CBILS). Under the scheme, the government guarantees 80 per cent of the loan.
Hawksmoor, the UK steak house chain favoured by City traders, is among the private equity-backed companies to have fallen foul of the EU rules when applying for support.
Executives at the Italian restaurant chain Prezzo, which has applied for the (CBILS) scheme, are concerned the rule may also thwart its ability to access the programme, people familiar with the matter said. Prezzo, which is owned by the US private equity firm TPG, declined to comment.
The private equity industry has historically used an instrument known as shareholder loan notes when investing money from their own funds in acquisitions — essentially a loan from the buyout group to the company it is buying.
The notes impose hefty interest bills on the companies they acquire, though the interest is typically only repaid when the business is sold.
Shareholder loan notes have been favoured in part because the interest payments on the notes are tax-deductible. They are used in addition to external debt that buyout groups rely on to fund acquisitions.
Markus Golser, a managing partner at Graphite, the private equity firm that owns a majority stake in Hawksmoor, said the chain is “exactly the sort of situation in which government aid should apply, but it’s the application of technical rules that prevent it from happening”.
While the tax benefits of the buyout financing “remain attractive”, they are lower than in the past and are “not really the prime driver any more” behind the use of shareholder loan notes, Mr Golser added.
The rejections have dealt a blow to a number of private equity-owned companies in Europe. The industry has in recent years invested heavily in some of the sectors hardest hit by the pandemic, including restaurant chains and travel businesses.
The British Private Equity and Venture Capital Association and Invest Europe, some of the industry’s largest lobby groups, have called on the European Commission to relax the state-aid rules, which also affect other lossmaking companies not owned by buyout groups.
Several countries, including the UK, have cracked down on the tax breaks linked to loan notes in recent years, making them less valuable. While the notes are technically debt instruments, they rank below all other debts in a company’s capital structure and are not typically counted by credit rating agencies when calculating a group’s borrowings.
Several private equity executives and advisers said the tax benefits were no longer the main reason for using shareholder loan notes. They can also give buyout firms priority over a management team’s equity if a company goes bust.
Miles Otway, a private equity partner at Connection Capital, said many of his firm’s portfolio companies had applied for UK state-backed emergency loans but “the majority have been rejected in some way, shape or form”, primarily because of the use of shareholder loan notes. “It gets everyone in the market,” he said.
A related EU state-aid rule which stops aid to companies with more than 7.5 times debt to equity has also proved an obstacle for companies backed by buyout groups, said the senior banker administering the UK scheme.
The EU state-aid rules are affecting private equity-owned companies across the continent, but some have been able to secure state-backed loans in France and Germany.
Some lenders in those countries are taking a more flexible approach to the rules, one person familiar with the matter said. “They want the money to flow out and they think, all bets are off, we have a pandemic going on.”
Additional reporting by Alice Hancock