Using preference shares in private equity transactions

Over the last few years there has been a trend towards the use of preference shares in private equity (PE) backed management buyout transactions.

Traditionally, a PE fund would invest via loan notes in a target company/group, due to the corporate tax interest deduction that the target company/group would receive on the interest payable on the loan notes held. However, over the years HMRC has introduced a number of rules limiting the amount of interest relief that a company/group can obtain on its leverage. For example, transfer pricing, anti-hybrid, corporate interest restriction and late payment interest rules. This has seen a rise in the use of preference shares in deal structures, particularly where loan notes held would not produce any corporation tax interest relief for the target company/group.

Why use preference shares?

Preference shares or preferred ordinary shares in a PE deal context usually mirror the terms of the debt held by the PE funds in the investment. Due to their form, they will rank behind any debt in the deal structure. However, from a tax perspective, preference shares can provide an advantage to their holders. This is normally achieved by the coupon on the preference share being rolled to exit and the share then being disposed of cum-div, meaning the coupon will therefore be subject to Capital Gains Tax as part of the disposal proceeds received. Such treatment of the coupon is not possible with loan notes, and the interest received on a loan note will always be taxed as income in the hands of an individual holder. 

This capital gains treatment will appeal to management of the target group, who typically receive a mirror instrument to the PE fund so that their interests are aligned with the PE fund. 

The managers of a PE fund, might also prefer to use preference shares in order to improve the effective tax rate of any carried interest they receive, as long there is no detriment to the target group.  

What else to consider

Despite the above noted tax benefits of using preference shares in such transactions, they also carry the following implications:

• stamp duty at 0.5% of the consideration value will be due on the acquisition of any preference shares
• in order to be redeemed a company will need to have distributable reserves, potentially making them less flexible than loan notes
• its use might impact the availability of Business Asset Disposal Relief (BADR) for management. If the preference shares are seen as ordinary share capital then management might not meet the 5% ownership criteria for BADR. However, since the reduction in the BADR lifetime limit from £10 million to £1 million this might not be deemed as critical a relief by management in the context of the deal.

In summary, preference shares can produce some significant tax advantages to their owners. Therefore, PE firms may wish to use preference share in the following deal scenarios: 

1. in deals that are towards the end of the investment phase of the PE fund
2. where the deal has a high amount of external third-party debt, meaning no/limited tax relief will be received on the PE fund debt 
3. when those involved in management have used their BADR lifetime limit.

For more information on the issues discussed in this article or to discuss individual circumstances, get in touch with Alex Conway or your usual Crowe contact.