What are “Shareholder Loans”?

Shareholder loans are debt-type financing provided by financial sponsors to companies. They sit between the most junior debt and equity, and often make up the largest part of the capital invested.  They are sometimes called “shareholder notes”, “preferred equity”, or the “institutional strip”. It is debatable whether the loans will qualify as debt in a bankruptcy court but their primary purpose is to guarantee the sponsors a rate of return on their investment and place them ahead of the other equity investors in case of liquidation.

Key Learning Points

  • Shareholder loans often represent the bulk of the investment by a financial sponsor in another company
  • The loans have a fixed coupon interest rate, often in the form of pay-in-kind (PIK) which functions as a guaranteed rate of return for the sponsor on the deal
  • The interest on shareholder loans is not tax deductible
  • A shareholder loan typically pays a low rate of interest over a very long period of time
  • It is debatable whether the loans would qualify as debt in a bankruptcy or liquidation since they often do not have a maturity
  • They do not count against the overall leverage of the company from the lenders perspective
  • Regardless, in the event of liquidation, the loans would qualify as preferred equity capital and would place the sponsor above the common equity in liquidation preference

Purpose

With more competition for private assets, financial sponsors have looked for ways to bolster returns and ensure they are compensated for both the capital invested and time spent on portfolio companies.  While investors have often made distinctions in private equity between common and preferred shares for the purpose of voting rights, etc, it is typical for sponsors to invest the bulk of their capital in a fixed coupon preferred instrument sometimes called a shareholder loan.

Unlike a true loan, it does not have a maturity date and the interest is PIK so the value of the investment grows over time. The coupon which can range between 8% and 12% acts as a hurdle rate for the common investors meaning that unless the overall return on the deal is greater than the hurdle rate, they will not see share appreciation. The preferred lender is guaranteed the rate of return on the loan, which is the coupon provided that the final sale of the company is great enough to pay back all lenders plus the outstanding balance of the shareholder loan.

Calculating the Shareholder Loan Return

The formula to calculate the value of shareholder loan over time is:

Loan Value = Capital invested *(1+Coupon)^n

The increased value each year is effectively the interest on the loan as shown in the following example:

Note: The sponsors will only receive cash in Year 5, and the exit value of the deal is greater than the value of the outstanding debt.

Terms

Shareholder loans do not have a maturity and they do not pay cash interest but rather PIK.  The interest, unlike PIK interest on mezzanine, is not tax deductible.  In order to not be capped by the return on the loan, sponsors will all invest in the common or ordinary equity of the company as well. This is sometimes called the investor strip and it is often where the management stake resides. If there is an upside on the deal, the sponsor will now benefit from that as well enhancing the overall return. Importantly, the shareholder loans do not count toward the overall leverage of the company for the purpose of defining leverage in the debt agreements.

Conclusion

Shareholder loans are a hybrid of debt and equity much like preferred stock.  They are used by sponsors in transactions as a vehicle to carry the bulk of their investment as they carry a fixed rate of return.