A debt-to-equity swap is used for financial restructuring in companies. It is a transaction through which debts or obligations are swapped or exchanged for equity. In public companies, debt is swapped for stock bonds.
Typically, the value of the bonds or stocks that are swapped is determined by the current market rates.
Debt-to-equity can also be considered as the renegotiation of debt. The lender receives equity in exchange for the cancellation of any debt the company owes. A Company uses Debt-to-equity swaps when it falls into severe financial distress.
Debt vs. Equity
While debt and equity are both financial stakes within a company, the rate of return for debt is fixed, whereas the rate of return for equity varies. Debt holders do not carry any risk and have no say in the company’s affairs.
Equity holders, on the other hand, have voting rights and can determine how the company is run. When a company offers a debt-to-equity conversion, the indebted party gives up their fixed payment claims in return for variable claims in profits and voting rights.
How Does Debt-to-Equity Work?
Debt-to-equity swaps are commonly used in developing countries and the financial industry. It makes it possible for lenders to convert loans into equity or stock shares. After the debt has been exchanged, a financial institution will hold the new shares.
Typically, a debt-to-equity swap involves the lender converting a loan into equity shares. This converts debt to equity holdings. No money is exchanged. In this refinancing deal, the debt holder gets equity in exchange for debt cancellation.
This is usually done to help companies struggling with cash flow continue operations. In some cases, unscrupulous companies will use the debt-to-equity exchange to benefit from favorable market conditions.
To be clear, equity is money that owners invest in a company, becoming shareholders. Shareholders will usually have voting rights to determine any concerns that might affect the company. They also receive cash flow in the form of dividends from company profits.
On the downside, shareholders do not earn any money on their capital if the company suffers a loss, even if they decide to sell their shares.
In case of bankruptcy, a debt holder may not have a choice. However, businesses often offer enticing trade ratios to tempt people into debt-to-equity swaps.
For instance, a business may offer a 1:1 ratio where the bondholder will receive stocks worth the same amount as their bond.
Some companies may also offer a 1:2 ratio where the bondholder will receive stocks worth double their bonds.
Why Should You Use Debt-to-Equity Swaps?
Debt-to-equity swaps are useful because they help businesses that cannot pay the bonds they have issued. To delay payment, stock is issued in exchange.
In some cases, businesses may have to maintain pre-determined debt-to-equity ratios. Such companies invite debt holders to exchange their debt for equity to adjust the balance.
It also helps the companies meet financial requirements set out by lenders and can be used for bankruptcy restructuring.
Pros and Cons of a Debt-to-Equity Swap
Restructuring a company by offering debt-to-equity swaps offers some advantages and disadvantages. The main advantages are:
- Financial survival: Debt-to-equity swaps give a company the best chance of surviving financial challenges.
- Credit rating preservation: When a company defaults on its debts, it can suffer a bad credit rating. However, with debt-to-equity, it is easier to maintain its credit rating because the company does not default on its debts.
- Low-cost alternative: Debt-to-equity is a low-cost alternative for companies in debt that need capital.
- May not solve financial problems: A company can continue to suffer financial distress even after offering a debt-to-equity swap.
- Loss of equity: When companies give away some of their equity, they lose some control and interest in the firm. Consequently, the more debt-to-equity swaps offered, the fewer stakes the owners hold in the company.
- Costly: A lender may ask for equity that is much higher than the outstanding debt leading to losses.
- Liquidity: When a company accepts equity in exchange for debt, it affects its liquidity. This is because companies will usually impose restrictions on when the equity can be traded.
- Limited to companies with deep pockets: Most lenders prefer to be paid in cash so they can reinvest in their business. Debt-to-equity swaps are preferable for financial institutions with unlimited funding.
How Does Debt-to-Equity Swap Add Value?
Debt-to-equity swaps serve both parties. For starters, debtors receive greater value when they exchange debt for equity.
A company suffering cash flow shortages cannot afford to make payments with interest on late payments. Even if a company is viable, debt plus interests can end up crippling it financially.
When debtors accept equity in exchange for debt, the company may thrive and make substantial profits providing even higher rates of return than the debt interest rates. In this case, lenders benefit from more profits.
Debt-to-equity swap also frees up cash flow without creating any additional obligations. It allows the company to invest any profits into the company, increasing the bottom line.
Debt-to-Equity Swap Vs. Equity-to-Debt Swap
An equity-to-debt swap is where shareholders exchange equity for debt. In this case, stocks are swapped for bonds. An equity-to-debt swap is made to facilitate mergers or company restructuring.
Debt-to-Equity vs Bankruptcy
When a company declares bankruptcy, under Chapter 7, all its debts are eliminated, and the business is no longer in operation.
Under Chapter 11, it may continue operating as it restructures its finances. In this case, existing equity shares are canceled.
Companies may re-issue new shares to debt holders, while creditors and bondholders become new shareholders.