SGS 9 (PEF)

Question 1

How does the funding to acquire a Target trickle down into Newco 2?

Answer 1

MT and PEF subscribe for shares / loan notes in Newco 1.
Newco 1 loans Newco 2 money OR subscribes for shares in in Newco 2 in return for cash.
Bank lends balance of purchase price to Newco 2 (security over assets of both Newcos and the Target),

Question 2

Three risks for management for an MBO?

Answer 2

Invest large proportion of overall wealth (security over personal assets?) - risk losing if business fails.

Personal liability risk for breach of warranty

Shareholding could be diluted if ratchet triggered.

Question 3

Rewards for management?

Answer 3

Shares in Newco 1 and share capital growth on exit.

Control over direction of business

Dividends.

Question 4

Control risks for management?

Answer 4

Fund may obtain veto rights in investment agreement

Fund have certain controls in capacity as shareholder.s

Question 5

What are the two sources of potential conflict of interest for management?

Answer 5

CA 06 provisions

Service Agreement confidentiality obligations when disclosing information to PEF in due diligence process.

Question 6

Potential solution to confidentiality obligations in Service Agreement?

Answer 6

Limit to disclosing only info in public domain 
Get a confidentiality agreement for any info beyond this 
Shareholder consent (SH's may only give this if they get an NDA from fund)

Question 7

What are the issues re conflict ?

Answer 7

Negotiating price, warranty cover etc.

ss. 172, 174 and 177.
s. 175 not an issue due to care out in s.175(3).

Question 8

What does the IRR represent?

Answer 8

Measure by which the PEF assesses the return, represents the growth rate of the investment taking into account period for which money is invested and total return received through:

Dividends from preference and ordinary shares

Interest on loan notes (both income receipts)

Capital return on sale on exit (capital receipt)

Question 9

Three successful exit routes?

Answer 9

Flotation of Newco 1 on recognised exchange
Sale of Newco 1 to trade buyer
Secondary buy out.

Question 10

Unsuccessful exit strategies?

Answer 10

Sell Fund’s equity in Newco 1 to Management

Newco 1 into administration.

Question 11

What is the result of the BVCA Memorandum of Understanding conditions being met?

Answer 11

HMRC accepts that MT have paid full market value for Newco1 shares and no income tax charge arises in relation tot he shares, on acquisition or at a later date.

Beneficial as income tax rates are far higher than CGT.

Question 12

BVCA MOU Conditions for states subject to ratchet arrangement?

Answer 12

MT’s shares OS.

Funds preferences shares on commercial terms.

MT acquire shares at same time as fund.

MT fully remunerated by salary and bonuses in separate employment contract,

Ratchet arrangements vary according to performance of company (not individual).

Ratchet exists at time Fund acquires OS.

Price MT pay for shares is max economic entitlement they can achieve under ratchet.

Question 13

Conditions for shares not subject to ratchet

Answer 13

MTs shares are OS.

PEF’s preference on commercial terms.

Price paid by MT for ordinary shares not less that price paid by PEF for the same.

MT acquire shares at same time as PEF.

MT’s shares do not have any features giving them rights not available to other holders of OS.

MT’s work for Newco should be fully remunerated by salary and bonuses.

Question 14

What do management want in terms of interest relief?

Answer 14

to offset interest payments on loans taken out to fund the investment against income for income tax purposes.

Question 15

What conditions allow management to offset income on loans against income for income tax purposes?

Answer 15

Shares must be ordinary

At the time shares acquired, must be a close company.

company is carrying on commercial trade.

(from loan being made to interest being paid) individual must own shares in the co and work in the actual management or hold a material interest (5%) of the company.

Question 16

How is the close company requirement for interest relief met?

Answer 16

When Newco set up, managers invest nominal sum before loans or PEF.

At this point close company (if more than 50% of shares held by 5 or fewer managers OR by MT that have been appointed directors)

Managers then borrow and subscribe for rest of shares as do PEF.

Question 17

Why is issuing loan notes potentially advantageous?

Answer 17

Interest payments tax deductible

Set off interest payable to PEF on loan notes against taxable profits of Target business for corporation tax purposes.

Question 18

Why is loan notes not as tax beneficial as it prima facie seems?

Answer 18

TPR
If HMRC considers rate of interest paid by Newco to Fund is higher than would be paid to an unconnected party on arm’s length (i.e. a bank), may disallow difference between two rates in tax deduction.
If Fund has lent an amount to Newco that bank would not be willing to send, all interest to Fund may be disallowed.

Question 19

What must be ensured if PEF agrees to receive loan notes rather than preference shares?

Answer 19

That tax advisers on deal obtain evidence that similar debt finance would have bee available from an unconnected third party at a similar rate of interest.