Debt For Equity Substitutions/Swaps
It is a constant aim for companies to find ways to reduce their debt and strengthen their balance sheet. This is particularly the case for companies in financial difficulty. Similarly, where a company is having difficulties meeting its financial commitments it is a concern for creditors to ensure that that they obtain as much value as possible from that company. Debt for equity swaps can be used to achieve these goals, and this format is increasingly being used.
Debt for equity swaps
Converting debt into equity can be an important component of restructuring a company in financial difficulty.
A debt for equity swap involves a creditor converting debt owed to it by a company into equity in that company. A debt for equity swap may or may not be completed within the framework of a statutory procedure and often forms part of a corporate rescue.
A debt for equity swap may be appropriate where a company:
• is having solvency issues but is still effectively a viable entity
• is heavily or over geared
• is unable to obtain bank or private finance.
The key commercial issues for creditors, shareholders and the company will be:
• the valuation of the company
• how much of the debt owed is to be substituted for equity
• what type of equity interest the creditor will acquire.
Parties will also need to consider what structure best delivers the debt for equity conversion, keeping in mind that different structures require different levels of support from creditors and shareholders. The different structures include:
• the subordination of the debt
• contractual debt for equity restructuring
• a scheme of arrangement
• a company voluntary arrangement.
Companies will also need to consider the impact of applicable laws, rules and regulations and any competition, tax, accounting and pensions implications.
Type of equity interest
Any form of ‘equity’ interest may be used, such as ordinary shares, fixed coupon ordinary shares, preference shares or equity warrants.
In many cases the equity interest will try to replicate the terms of the debt facility (e.g. with respect to payment of interest/dividends and repayment date/redemption date), and it is common to create a new class of shares, such as preference shares.
Preference shares generally have some or all of the following features:
• priority over all other classes of shares as to income and capital return, such as fixed preferential dividends and a fixed date for redemption
• right to convert to ordinary shares in certain conditions, which can be seen as the ‘reward’ element of the debt for equity swap
• veto rights over certain matters, such as actions that may result in dilution or variation of class rights
• rights to appoint directors
• restrictions on transferability
• limited voting rights.
As dividends and redemption payments must be funded out of the company’s distributable reserves, consideration needs to be given to whether the company can service the preference share dividend and/or redemption obligations, and whether there are any dividend blocks within the group which need to be addressed (for example, by a capital reduction).
Equity in which entity?
Those parties involved will need to consider which entity will issue the equity interest. This may be the debtor entity, a parent of the debtor entity or a clean entity (such as a new holding or intermediate holding company requiring a more complex structure).
Which creditors can/will participate in the debt for equity swap?