Hey guys - I'm trying to wrap my head around shareholder loans (appreciate there are a few posts on this, but they are quite old/don't address some key questions of mine) and wanted your help on a few key aspects.
Understand that this is a debt instrument that is the most junior form of debt in the capital structure (i.e. sits between PIK debt and common equity) and that it is a means by which shareholders can put in (quasi-)equity into the business while still benefiting from the tax deductability of interest expense on debt.
A few questions:
A) Why do we (or at least I...) not see this on more LBO structures used today? Seems like most mid-cap/large-cap transactions are structured using a standard first lien / second lien structure etc. and you see no mention of shareholder loans. Surely sponsors would be using this left, right and center if they could? B) What are the considerations around how the interest expense on shareholder loans is priced? C) What are the considerations around this converting into common equity? Is it the case that it converts to common equity right before exit to maximize equity value on exit and thus returns? D) Is there anything else I should know?
Thanks a lot and again, sorry if these are basic questions but it'd be awesome if someone could opine on these points
I spoke with someone who specialized in these products and can add a little information but definitely can't answer all of your questions. Figure something is better than nothing.
A) You can't issue a shareholder loan without having issued equity since there would be nothing to borrow against - therefore a shareholder loan has to be done after transaction is closed, equity contributed and shares issued. That said, if the Sponsor wants to take a dividend without impacting the Co's leverage, it could issue a shareholder loan against their equity after the tx closed and dividend the proceeds out to themselves. I was told that this practice is actually somewhat common and that lenders can't do anything about it since the equity shares are not held at the borrower.
B) My understanding is that loans against equity carry relatively low interest expense as a result of the instrument having a low LTV aka the value of the equity can cover the debt instrument multiples over. For this reason the coupon is closer to that of a revolver. The interest is meant to price in risk, but the issuer has reduced risk by lending against the lower LTV resulting in a low coupon.
"since the equity shares are not held at the borrower."
Can you explain what this means?
So I'll note that this is more in the context of PE than VC, but if you look at the org structure of a company in an LBO, the assets of the business are defined in the debt documents and are held at a borrowing entity. The equity shares have claim to the same assets (subordinated to the debt's claims) but are not actually held at the borrowing entity, they're owned by an entity owned by the fund. For this reason the fund could take a loan against the shares themselves without increasing leverage at the borrower.
I realize that VC firms will sometimes incorporate a shareholder loan into their financing which is closer to actual debt, but wanted to clarify what this version of equity-holder issued debt is since its something that occurs in PE.
Thanks for taking the time to explain this, this is helpful
Isnt SHL equity in the first place, despite it having PIK interest?
Some other users here also label it as equity. It should therefore also sit in the equity section on the balance sheet when doing adjustments to opening BS. Please correct me if i am wrong.
Also, some models treat it differently; some as debt some as equity. From my understanding, the Sponsor can label some of the equity he invested as SHL
Either the interest is not deductable at the target (all sorts of limitations to this, differing per country) or equity gains are taxed at lower rates than interest income (looking from perspective of the fund).
A follow-up question from based on a comment above - is it really true that a shareholder loan can only be issued once equity is injected? My rather rudimentary understanding was that private equity firms are able to acquire targets through "shareholder notes" which is essentially a shareholder loan in exchange for equity. Conceptually, equity in the balance sheet doesn't change (though ownership of it does) and cash is injected through the shareholder loan.
Appreciate if anyone could kindly help to provide any insights on the above. Thanks!
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