1) Introduction
2) What are developer loan notes
3) Comparison with traditional forms of debt finance and equity raising
4) Convertible loan notes
5) The information memorandum
6) Secured and unsecured notes
7) Transfer, assignment, novation etc.
8) Regulatory matters
9) Tax Treatment
10) Process
"Recent developments in the property market have created renewed interest in loan notes issued by property developers."
Recent developments in the property market have created renewed interest in loan notes issued by property developers across a range of sectors: hotels, build-to-rent and private rent sector housing, traditional residential development and student accommodation. Structured properly, loan notes may offer certain advantages: they are a well-established alternative way of raising finance for property developments; they can be designed to fit in the capital stack alongside traditional debt finance and shareholder equity; if required, they can offer investors security over the developer’s assets; and they are typically repaid once the development is completed (for example, from the proceeds of a sale or refinance). In this article, we explore some of these themes in more detail.
A loan note is a financial instrument, best described as an IOU from a developer (being an “issuer”) to an investor (being a “noteholder”). The investor makes a loan to the developer, and the developer agrees to repay it at a future date, with fixed interest (known as the “coupon”). The typical investment term can be short (of around two years).
Loan notes can be flexible instruments. They can accommodate multiple lenders (being the investors), and bespoke repayment terms, interest provisions (such as bi-annual interest payments or interest being deferred to the end of the investment term), events of default, conversion terms, transfer provisions etc. Loan notes can also be “secured” (for example, against the property or other assets of the developer) or “unsecured”, and this usually has a bearing on risk and, therefore, the coupon.
On the date of issue of loan notes, investors receive loan note certificates evidencing the loan notes they hold. The developer should keep a register of the loan note certificates and investors.
Structured properly, loan notes may offer certain advantages to developers over other means of raising finance. These can include the following:
a) loan notes allow developers to use a multisource strategy utilising high net worth and sophisticated investors, institutions as well as private funds, in addition to traditional bank funding and shareholder arrangements. Subject to prospectus and other regulatory requirements, a developer can raise money from the public;
b) loan notes may be used to fund a development: (i) without giving away equity at all; or (ii) on the basis that equity will be given away at a future date and/or under prescribed circumstances (see “Convertible Loan Notes” below);
c) loan notes can be issued to multiple investors, and to new investors, over time. In addition, the overall amount borrowed can increase as new investors are found (see d) below). This flexibility in borrowing is not necessarily seen in a typical loan agreement;
"Structured properly, loan notes may offer certain advantages to developers over other means of raising finance."
d) loan notes can be issued up to a specified amount and need not all be issued at the same time (in other words, a developer may issue them at different times). Loan notes can therefore fund ongoing debt requirements via the issuance of notes over a longer period;
e) loan notes may offer more flexibility than that provided under a typical loan agreement when it comes to arrangements relating interest payments. Interest may be deferred or “rolled up” (in other words, capitalised with the principal). In addition, loan notes typically bear interest from the date of actual issue rather than from the date of the relevant loan note instrument;
f) terms and conditions attached to loan notes are typically less onerous than those that apply to loan agreements, particularly in relation to consents and information requirements;
g) unlike a bilateral loan agreement which will typically allow a single lender to take enforcement action, in the context of loan notes, such action is usually only possible where a specified majority of investors decide to take such action (subject to any rights of the minority investors, and the terms of any intercreditor documentation). This may be helpful to a developer because it not only takes such decisions out of the hands of a single entity (being the lender), but also allows a developer the opportunity to negotiate with individual investors;
h) again, unlike a bilateral loan agreement which will typically require the consent of a single lender (which may be withheld or delayed) to an important issue such as a restructuring, in the context of loan notes, such consent is usually required from a specified majority of investors only (and may be obtained even if not all investors are fully supportive, again, subject to any rights of the minority investors, and the terms of any intercreditor documentation);
i) loan notes can provide for pro rata early repayments, and payment of certain investors in priority to others, as well as providing a developer with discretion as regards which investors notes to repay and in which order. This flexibility is not usually found in a typical loan agreement;
j) loan notes can usually be transferred or assigned (in each case, partially or completely), amended and cancelled; and
k) specific tax planning concerns, arrangements or requirements may mean that loan notes are preferred over loan agreements.
The flexibility of loan notes extends to their ability to be converted into equity. In broad terms, convertible loan notes are loan notes which can convert into equity upon the occurrence of a specified future event (called a “conversion event”, such as the completion of a successful fundraising or financing or a change of control) and/or on a specific date (called a “conversion date”) and/or at a specific price after, if applicable, the application of a pre-determined or formulaic discount (called a “conversion discount”). Conditions which may attach to any conversion could include a long-stop date and the ability of the developer to repay the loan without any conversion taking place.
The Information Memorandum (“IM”) is an essential document in the context of loan notes. It is issued by the developer and expected to be read and (depending on the circumstances) relied upon by each investor prior to any investment decision being made.
The IM should be transparent and contain all relevant details about the loan notes being issued including, but not limited to, details of the developer (the issuer), the terms of the loan notes, the investment opportunity, security information, risk factors, etc.
Loan notes may offer more flexibility than that provided under a typical loan agreement.
Unless exemptions apply (see “Regulatory Matters” below), the IM will need to be reviewed by an FCA authorised person and approved under Section 21 of the Financial Services and Markets Act 2000 (FSMA) prior to being issued as it will constitute a financial promotion.
Obligations under loan notes can be secured or unsecured.
Unsecured loans are not secured against the developer’s (or any other) assets.
Secured loan notes are secured against the developer’s assets (or over certain key assets). Secured loan notes may be “first charge” or “second charge”, and this will also alter the risk attached to them, as the first charge secured loan notes will rank ahead of the second charge secured loan notes (and all secured loan notes will rank ahead of unsecured loan notes). Loan notes can be secured after they have been issued. In all cases, various issues will need to be considered, including any intercreditor arrangements (which may be necessary where the developer has granted security over the same assets to other creditors) and relevant negative pledge provisions.
Where there are multiple investors and the loan notes are secured, typically an independent security trustee is appointed to represent the interests of the investors. The security is vested in the trustee who then has a duty to enforce that security in accordance with the instructions of the investors. The terms of the security trust will be set out in a security trust deed, in a schedule in the loan note instrument, or the relevant security document.
Loan notes do not need to be registered at Companies House. However, if the loan notes are secured by a debenture or other security, this should be contained in a separate document and filed at Companies House.
Transfer and Assignments
Loan notes may be transferred if the terms and conditions applicable to them permit such transfer. Commonly, loan notes are transferable (usually subject to a minimum amount and/or specified multiples to avoid transfers of small amounts and limit future regulatory issues).
"Section 21 approval allows developers to deal with persons who are not sophisticated investors or high net worth individuals."
Similarly, loan notes may be assigned (wholly or partially), if the terms and conditions applicable to them permit such assignment (any assignment outside of this will only create a personal right for the transferee to enforce against the investor and will not create a direct right against the developer). In principle, if assignment is permitted, an investor may therefore assign all its right under a loan note, or only the right to receive interest under that note but not the right to receive the principal repayment. Any assignee of the investor will usually be required to accede to any applicable intercreditor arrangements. [NB – in a common corporate loan note, assignments would not be permitted, only transfers, including to allow maintenance of a clear register of noteholders.]
Novation
A developer is not usually allowed to novate its obligations under loan notes to another party, except perhaps in limited circumstances such as a company reorganisation where the new issuer will have a better and stronger covenant. It may be more efficient to document this new arrangement by redemption of the existing loan notes and issuance of new loan notes by the new issuer. Appropriate tax advice should be sought, and any security arrangements should be considered carefully.
Amendments
Subject to matters such as investor consent requirements, loan notes may usually be amended.
If amendment of the existing loan note instrument is not possible, a developer would typically be able to issue further loan notes on the same terms under a new loan note instrument without existing investor consent (but this would be subject to any security arrangements, negative pledges, and the terms of any applicable senior debt documents, constitutional documents, shareholder agreements and intercreditor arrangements).
Cancellation
When a loan note is redeemed, the investor should return the loan note certificate to the developer for cancellation. The developer should destroy the certificate and record the cancellation in its books.
Regulatory issues will need to be considered in connection with the marketing or issue of loan notes, including a review of securities laws in any relevant jurisdictions in which investors are based or roadshows are carried out. In the UK, the marketing of loan notes of this nature are controlled investments for the purposes of FSMA. This means a developer cannot invite or induce anyone to invest in them unless either the potential investors approached fall within exempted categories such as investment professionals, high net worth companies and certain specified types of sophisticated investors or high net worth individuals or the content of the communication has been approved by an “authorised person” (“Section 21 approval”).
A developer may seek a Section 21 approval from an authorised person (being an entity regulated for that activity by the Financial Conduct Authority) who will need to carry out appropriate due diligence and ensure the contents of the financial promotion are fair, clear and not misleading and comply with the Conduct of Business Sourcebook within the FCA Handbook. The cost and timetable for Section 21 approval would need to be taken into account if suitable exemptions are not being relied on. In addition, where the loan notes are transferable securities, the IM may constitute a prospectus which would need to satisfy the content requirements of the Prospectus Regulation. However, in most cases, the IM and loan notes offered would fall within an exemption from the Prospectus Regulation, for instance where (in the UK) the minimum investment is €100,000 or more or the total offering is less than €8 million (or their £ equivalents) or where the IM is issued only to “qualified investors” and a limited number (currently no more than 150) of other potential investors. The Prospectus Regulation applies across the EU but certain of these exemptions differ in countries other than than the UK.
Specific tax advice should be obtained in all transactions, including but not limited to matters such as qualifying (or non-qualifying) corporate bonds, capital gains tax, withholding tax and gross up.
As regards the usual steps for issuing developer loan notes, in broad terms these would include the following:
a) the developer determines the terms of the loan note instrument and loan notes (for example, amount, term, coupon etc.) and obtains any necessary approvals (e.g. shareholders’ consent);
b) the developer’s solicitors prepare the loan note instrument and loan notes, as well as the IM;
c) if applicable, the developer obtains Section 21 approval;
d) the developer issues the loan note certificates to investors and registers them in the loan note register;
e) in exchange for the loan notes, investors advance funds to the developer;
f) depending on the terms of the loan notes, investors receive a coupon at fixed intervals during the term of the loan notes; and
g) at the end of the term of the loan notes, the developer repays the investors the principal (or capital) plus any outstanding coupon.
Our real estate, tax, finance and corporate teams have advised companies, directors and noteholders on loan note structures including privately issued and publicly listed ones. Please contact the Watson Farley & Williams team for more information.
This article is provided for general, non-specific guidance only. It is not intended to be and should not be considered or relied upon as advice from Watson Farley & Williams LLP. Always seek professional financial and legal advice specific to your circumstances from an authorised and qualified individual.
Ranjeev Kumar, a former real estate partner in our London office, also contributed to this article.
