Financial structure was once a dominant driver of PE returns and tax was significantly mitigated by offsetting interest costs. Today, leverage is more expensive, lenders are more demanding, and LPs want to know where the alpha will come from. But financial structure and tax still need one eye on them throughout the hold because drift has a cost.
Capital structure tends to be the preserve of the sponsor in private equity, decided before the investment closes. The sponsor also leads any subsequent renegotiations. But the management team gets drawn in when covenant stress appears on the horizon, when a buy-and-build requires new debt, or when tax exposure needs proactive management. These are the moments where financial structure intersects with value creation.
Capital Structure: a Mexican standoff in IP financing
The case subject was a PE-backed IP-based portfolio company where the management team forecast covenant stress due to a delay in renegotiating a key contract. The underlying EBITDA outlook was unchanged. It was just a timing blip.
On the face of it, the bondholders had all the negotiating power. Theoretically, they could name their price for a covenants reset, or pursue a loan-to-own strategy by calling the debt and squeezing out equity. In practice, they had much less power than it seemed, for four reasons:
First, calling the debt would impair the loan, requiring the bondholders to mark it down on their balance sheets. This might result in the loan being transferred to a different book and a different lender team. Conversely, if the renegotiation resulted in a higher spread, the debt might actually be marked up. As is often said in leveraged finance, “a rolling loan gathers no loss.”
Second, the loan documentation established a process-based incentive to accept a reasonable deal. The underwriting bank was to put a proposal to the bondholder group and if a majority accepted, any who declined would be dragged in on less favourable terms than those who accepted. The documentation formalised a classic shootout mechanic, designed to make early acceptance the rational choice.
Third, TV production, an essential ongoing cost of this particular business, was capitalised under GAAP and therefore excluded from EBITDA. This meant the quality of loan was less than it seemed. There was much less interest cover and much higher quasi-fixed cost than the reported EBITDA suggested. While this was never expressly raised in the negotiation, it would potentially be an uncomfortable reality to surface for existing bondholders.
Fourth, and most critically, calling the debt risked triggering IP reversion. Licensing agreements typically revert underlying rights to the licensor on an insolvency event. The bondholders might find their primary negotiating lever, the threat of insolvency, would destroy the very asset they were trying to claim.
In the case example, the underwriting bank had these conversations behind the scenes before settling on the right premium to offer to bondholders. By a large majority, they took the increased spread and accepted the covenants variation.
Working Capital: a game of chicken with a single LP
This case comes from a family office set up to invest in early-stage digital media companies. There was a notional investment commitment, but the GP operated on a month-to-month basis as the LP was funding the GP out of cash generated by his other business interests. The investees, a mix of early stage companies and an incubated venture, were financed on the same short-term basis. This worked fine until the LP was hit by an unforeseen geo-political event, and then it became a serious problem.
When trouble hit, the LP did not formally withdraw. Instead, each week brought a fresh assurance to the GP that the problem was nearly resolved, and funding was imminent. The transfer would be made next week. Monday would pass, then Tuesday. By Friday it was clear nothing was arriving. And the conversation would begin again.
The GP team was caught in a game of chicken. Call insolvency too early and there could be no recovery, no going back, regardless of what cash became available. Trade while insolvent, and this risked the directors becoming personally liable to creditors.
The directors’ personal exposure wasn’t limited to trading-related liability. There was an additional wrinkle because instead of salary, the partners of the GP had been paid a “share of GP profits.” Were these recent profit share payments legitimate or would they need to be refunded? The team took advice. The profit shares had been paid out of profits recognised at the last P&L date, and at that time there had been no financial stress and no reasonable expectation that financial stress might be imminent. So the GP partners were OK.
The group was now in the “zone of insolvency,” the recognised legal threshold at which directors’ fiduciary duties shift from equity holders to creditors. The directors instituted weekly board meetings to consider and document the financials and funding outlook across the group, acting in the best interests of creditors.
Over three months, only two small creditors issued statutory demands. The GP paid these out, balancing its statutory obligation to consider the wider creditor pool without showing undue favour to any single creditor. Most creditors recognised that pushing the business into formal insolvency would adversely affect their own recovery prospects. Everyone was playing the same game: hold on a little longer, because calling it now makes everyone worse off. Everyone other than the LP, that is. The LP’s sole problem was liquidity access, and these investments were a rounding error.
Meanwhile the GP limped along, cutting staffing to a minimum, freezing further investment in its live-sports incubation, and setting cost reduction targets across the investee companies. Since all were early stage, cost reduction could extend the runway but could not resolve the situation. Revenues were not at a level where any investee could cover even pared-down costs.
After three months, the GP team made the call, appointing receivers.
The structural lesson is straightforward. Committed capital, drawdown notices and legal obligations offer limited recourse if a solo LP defaults. In a family office structure, the GP team is exposed to the LP’s unforeseen misfortunes, not just relationship risk.
Tax and Transfer Pricing: a saving sitting on nobody’s desk
The third case involves a multinational organisation with entities across several countries. Historically, most profit was generated in the US, through sales of advisory services, selling access to a diagnostic toolset (intellectual property) developed in the US and associated activities in the US. The other entities sold limited advisory services and performed supporting activities.
With this trading setup, transfer pricing had been set up by external advisers on a cost-plus basis with each entity reimbursed by the US for its net costs plus a markup, set at a level supported by market precedents at the time. The UK entity, for example, received revenues from the US equal to its net costs plus five percent. This was a reasonable and defensible arrangement.
Then the company won a major contract to deploy its toolset in a single country, establishing a local delivery entity. This entity was on track to deliver multi-million-dollar revenue within months of launch. Cross charging for fulfilment staff time from other entities would hardly dent the entity’s profitability. Without intervention, the corporation tax liability was likely to be material, potentially $1M or more.
This tax exposure came to light through a cross-functional review that sat outside the normal finance and legal reporting lines. Managing tax liabilities proactively did not sit in any individual’s job description, so it was nearly missed and by the time it surfaced, the window for mitigation was already narrow. The finance function had no tax people and neither did the legal function. Even once the exposure was highlighted, the finance function said, “this is a regulatory matter that legal needs to address” and the legal function said, “we can implement new transfer pricing, but finance needs to tell us the basis for charging.”
At the CEO’s request, legal took the lead, briefing specialist advisers.
If the organisation could justify 70-80% royalty, rather than the more typical 10%, the mitigation was potentially worth $1M annually, although the timeline was tight, and the outcome required confidence in the legal and factual basis for an assertive royalty claim. There was a helpful precedent available to help establish arm’s length pricing for the IP whereby consulting firms had been sold multi-site national licenses to deploy the IP. There was also a strong argument that if the new entity had sold a multi-million-dollar contract within months of being set up, there was legitimate cause for asserting this was entirely based on IP value sitting outside the entity.
A substantive corporate-wide transfer pricing review was required, since a single localised tweak would not carry weight with the relevant tax authority, and this needed to be complete in time for inclusion before the end-of-year accounts submission deadline for the new entity.
The lesson was not about the saving. It was about the gap. The organisation was set up to calculate and pay taxes, not to manage its liability proactively. A material tax exposure sat between the finance function and the legal function, belonging formally to neither, until it was almost too late.
Three cases, three different lessons.
Financial structure tends to sit upstream from the value creation director’s day-to-day work. But each of these cases delivered its own valuable lesson. In the covenant renegotiation, understanding the full structure turned an apparently weak position for the operating company into a negotiating position. In the working capital crisis, the structural flaw was in the fund itself, and no operational response could fix it. In the transfer pricing case, the exposure sat in a gap between functions, belonging formally to nobody. Different situations, different lessons. The common thread, if there is one, is that financial structure rewards ongoing attention and punishes the assumption that because it was set up correctly, it will look after itself.