The Financial Times recently reported that UK business faces a potential debt burden of up to £105 billion with small and medium sized companies under most pressure. Such levels of corporate debt are likely to be unsustainable and create obvious issues for both borrowers and lenders. From a borrower's point of view, a weak balance sheet imposes restrictions on the ability to raise funds and lenders will need to be pragmatic in amending and/or waiving existing facilities, which may also include security packages.
For a company that is in financial difficulty, but which is still ultimately a viable going concern, a debt for equity swap can be an effective way to restructure its capital and borrowings and, in doing so, strengthen its balance sheet and deal with issues such as over gearing. In times of financial crisis, debt for equity swaps become an increasingly popular alternative to other forms of refinancing.
A debt for equity swap involves a creditor converting debt owed to it by a company into shares in that company. The effect of the swap is the issue of the equity to the creditor in satisfaction of the debt, such that the debt is discharged, released or extinguished. Although clearly beneficial to the company, the transaction can also be advantageous for a creditor as a debt for equity swap can be a way of avoiding the costs associated with commencing proceedings to recover the debt (which may not be fully recoverable in the current environment). It can also provide an avenue by which a creditor can participate in any future growth of the company.
Debt for equity swaps provide an opportunity for a company to deal proactively with creditors before creditors take steps to recover debts and, in the case of secured creditors, enforce its security and/or appoint an administrator. There is no prescribed structure for a debt for equity swap and each one will be driven by the specific circumstances but key terms to be decided will be: (i) the value of the company and whether equity is to be issued at a discount to that value; (ii) the amount of debt to be substituted for equity and the extent to which existing shareholders will be diluted; (iii) the type of shares which will be issued; (iv) the rights which will attach to the shares; and (v) the restrictions which will be imposed on the shares.
Once the above fundamental terms have been considered and the tax treatment of the debt-to-equity has been established, early and constructive engagement with shareholders and participating creditors is crucial for the transaction to be successful.
After the banking crisis in 2008, debt for equity swaps became popular as lenders came under pressure to ease the debt burden on struggling borrowers. We could be in a similar situation as we move out of the coronavirus pandemic as companies and creditors search for creative solutions to provide additional liquidity and restructure the company's borrowings.
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