How Do Incumbent Loan Notes Work in M&A Transactions? (UK Focus)

Published in Finance

September 21, 2025

5 min read

Introduction

Mergers and acquisitions (M&A) are the lifeblood of corporate growth. In the United Kingdom, the M&A market continues to thrive as companies seek consolidation, private equity firms chase new opportunities, and entrepreneurs look for exits. While headlines often highlight multi-billion-pound deals paid in cash, the reality is far more nuanced. Deal structures are rarely simple, and one of the most fascinating financing tools used in the UK is the loan note.

Among the different variations of loan notes, incumbent loan notes stand out. They are less widely understood than vendor loan notes or convertible instruments but play a crucial role in bridging funding gaps, balancing risk, and making complex deals work. For corporate finance professionals, lawyers, sellers, and investors, understanding incumbent loan notes is essential.

This article explores the mechanics, benefits, risks, and tax implications of incumbent loan notes in UK M&A transactions. We’ll also look at practical examples, HMRC rules, and best practices to help demystify this financial instrument.

What Are Loan Notes in M&A?

In the simplest terms, a loan note is a form of debt instrument — essentially an IOU — issued by the buyer of a company instead of paying the entire purchase price in cash upfront. The seller, instead of receiving cash, accepts these loan notes, which represent a promise to pay at a future date.

Loan notes can carry:

An interest rate (fixed or floating).
A repayment date or schedule.
Security (secured or unsecured against assets).
Convertibility (sometimes they can convert into equity).

They allow buyers to reduce the immediate cash burden, while sellers may accept them for tax efficiency or as a way of bridging valuation gaps.

Loan notes can come in different forms in UK deals:

Vendor Loan Notes (VLNs): Issued by the buyer to the seller, usually when the buyer cannot or does not want to pay full cash.
Convertible Loan Notes: Loan notes that can convert into shares.
Incumbent Loan Notes: Our main subject, which involve existing lenders rolling over or restructuring debt during the M&A transaction.

What Are Incumbent Loan Notes?

Incumbent loan notes are debt instruments issued or maintained by the existing (incumbent) lender of the target company during an M&A transaction.

Here’s how it differs from other structures:

In a vendor loan note, the seller is effectively lending money to the buyer.
In a bank loan or mezzanine debt, an external new lender provides financing.
In an incumbent loan note, the existing lender of the target (e.g., a bank, private equity fund, or bondholders) agrees to restructure their existing loan into loan notes that remain in place after the deal.

This allows continuity of financing and helps the buyer avoid refinancing immediately. Essentially, the buyer inherits an agreed debt structure, documented via loan notes, which can be repaid or refinanced in the future.

Why Use Incumbent Loan Notes in UK M&A?

Why would a buyer or seller agree to use incumbent loan notes? In the UK deal market, several strategic advantages explain their popularity:

Flexibility in Financing Buyers don’t need to raise as much fresh capital since part of the consideration comes in the form of rolled-over debt.
Tax Efficiency For sellers, certain loan notes may qualify for loan note rollover relief under UK tax law, deferring Capital Gains Tax (CGT).
Bridging Valuation Gaps If buyer and seller disagree on valuation, loan notes can defer part of the consideration, giving both sides time.
Lower Risk for Incumbent Lenders Incumbent lenders are already familiar with the target company’s financials. Instead of exiting, they roll over their position in a controlled way.
Continuity in Operations For the target company, debt continuity avoids disruption of banking relationships.

Mechanics: How Incumbent Loan Notes Work in a Transaction

Let’s walk step by step through a typical UK M&A deal involving incumbent loan notes.

Purchase Price Agreement Buyer agrees to acquire TargetCo for £50 million.
Financing Structure
Buyer raises £30 million in equity and cash.

Seller accepts £10 million in vendor loan notes.

Incumbent lender rolls over £10 million of existing debt into incumbent loan notes.

Issuance of Loan Notes The incumbent lender converts its existing facility into formal loan notes issued by the new ownership structure.

Repayment Terms Loan notes carry a 5% fixed interest rate, repayable in 5 years, secured against TargetCo’s assets.
Outcome

Seller gets part cash, part vendor loan notes.
Buyer reduces upfront outlay.
Incumbent lender maintains exposure but under new terms.

Example Table: Deal Financing with Incumbent Loan Notes

Component	Amount (£m)	Structure
Buyer Cash/Equity	30	Upfront payment
Vendor Loan Notes	10	Deferred to seller
Incumbent Loan Notes	10	Rolled over by lender
Total Consideration	50

Key Terms in Incumbent Loan Notes

When structuring incumbent loan notes in UK M&A, several key terms must be negotiated:

Principal: The amount rolled over (e.g., £10 million).
Interest Rate: Fixed or floating (often linked to SONIA in the UK).
Redemption Date: Commonly 3–7 years.
Security: Secured against company assets or unsecured.
Ranking: Senior, subordinated, or mezzanine position.
Covenants: Financial ratios, restrictions on dividends, etc.

Advantages of Incumbent Loan Notes

For Buyers

Lower upfront cash requirement.
Avoids costly refinancing at completion.
Access to flexible repayment terms.

For Sellers

If seller also holds loan notes (via vendor notes), they may defer tax.
Higher chance of deal closing when financing gaps are bridged.

For Lenders

Continued relationship with the company.
Potential for higher yields than normal loans.
Lower due diligence costs since they already know the borrower.

Risks and Challenges on Incubent Loan Notes

For Buyers

Overleveraging: too much debt can strain the acquired company.
Restrictive covenants may limit operations.

For Sellers

Risk that loan notes are not repaid if company struggles.
Subordination to other creditors.

For Lenders

Exposure to buyer’s performance.
Risk that rolled-over terms are less favourable.

Regulatory and Tax Considerations in the UK

In the UK, loan notes are subject to complex HMRC rules. Key points include:

Capital Gains Tax (CGT) Rollover Relief If loan notes are “qualifying corporate bonds (QCBs)”, sellers may defer CGT until redemption.
Non-QCB Loan Notes If structured as non-QCBs, they may not benefit from CGT deferral, but sellers can sometimes access Business Asset Disposal Relief (BADR).
Stamp Duty Transfer of loan notes may attract stamp duty in some cases.
Withholding Tax Interest payments on loan notes may require withholding tax unless exemptions apply.

Loan Note Type	CGT Treatment	Other Considerations
QCB	CGT deferred until redemption	No indexation allowance
Non-QCB	CGT on disposal	May qualify for BADR
Convertible	Depends on terms	May be equity-linked

Case Study on Incubent Loan Notes: Hypothetical UK Deal

Scenario: TechCo Ltd is acquired by Private Equity Fund A for £100 million.

£60m in cash (funded by equity and new debt).
£20m in vendor loan notes.
£20m in incumbent loan notes from TargetCo’s existing bank.

Mechanics:

The incumbent bank rolls over its existing £20m facility into loan notes.
The seller accepts vendor loan notes for £20m.
Buyer only raises £60m upfront, lowering deal risk.

Outcome:

Seller gets a mix of cash and deferred notes.
Buyer secures financing without over-leveraging.
Bank continues lending relationship.

Best Practices in Using Incumbent Loan Notes

Early Negotiation with Lenders Secure agreement from incumbent lenders before signing the SPA.
Tax Structuring Ensure loan notes are structured for maximum tax efficiency.
Balance of Consideration Avoid overloading deal with too many deferred instruments.
Legal Protections Include strong covenants and security arrangements.
Exit Planning Align loan note redemption with buyer’s exit strategy (e.g., IPO, resale).

Conclusion

In UK M&A, incumbent loan notes are a flexible tool that allow buyers to reduce upfront costs, sellers to achieve smoother exits, and lenders to maintain valuable relationships. While they introduce risks — particularly around repayment and tax — their benefits often outweigh the drawbacks when structured properly.

For sellers, understanding the tax implications under HMRC rules is vital. For buyers, negotiating the right balance of security and flexibility with incumbent lenders can be the difference between a successful acquisition and a strained balance sheet.

Ultimately, incumbent loan notes are not just a niche instrument but a strategic financing tool that makes complex deals achievable in the UK’s vibrant M&A landscape.