Debt/Equity Swap

Debt/Equity Swap is an arrangement relating to financial restructuring in which the debts of the company are converted into stock. Such an arrangement is sought for when the company is into financial crisis and the existing lenders are given an option to get the debt given by them converted into equity at a pre-decided swap ratio.

Debt/equity swap is one of the means of debt restructuring using which firms exchange their debt obligations with equity or stocks. It is used by the government to exchange debt obligations from other nations by offering them a stake in a firm by private acquisition of it.

• A debt/equity swap involves exchanging existing debt obligations for equity ownership in a company. This financial arrangement allows a company or individual to convert debt into shares or other equity instruments.
• Financially distressed companies commonly employ debt/equity swaps as a strategic measure to alleviate their debt burdens, improve their financial health, and avoid the risk of bankruptcy.
• In a debt/equity swap, creditors agree to convert their outstanding debt into equity securities issued by the company. This conversion results in the creditors becoming shareholders or equity holders in the company.

Debt/equity Swap allows entities, including the government, to convert their debt obligations into equity ownership, thereby giving the lenders a stake in the firms the stocks belong to instead of paying them back.

When a company faces a serious financial crisis or is near to the situation of liquidation, then the company is not in a position to repay its debt. In such a situation, the company has to find ways of its financial restructuring. One of the ways for the same is an option for a debt-equity swap.

In the debt/equity swap, debt will be exchanged for equity. Thus, the company will offer the lenders to get the outstanding amount converted into the equivalent amount of equity shares of the company. The shares are issued in lieu of the outstanding debt in accordance with the predetermined ratio. The company is saved from immediate cash flows arising due to repayment.

Debt/equity swap is mostly used in those cases where the company is facing financial stress and is not having enough cash flows to make payments for the debt. In such situations, either the company itself may propose the debt/equity swap, or the debt holders may ask the company for the same in order to save themselves from the risk of failure of payments in the future.

Basically, a company opts for debt/equity when it is into long-term financial problems. In such a case the company knows that it will not be able to make the repayment of its outstanding debts, which will bring negative publicity for the company. In order to avoid such negative publicity, the company plans financial restructuring by way of a debt/ equity swap wherein it offers the debt holders to exchange the debt for equity so that it does not have to make repayments. Thus, a debt/equity swap helps the company in the sense that it is not required to make immediate repayments and financial stress is reduced to this extent.

The situation of debt/equity swap can be well understood by way of the following example.

Example 1

Let us say, a company ABC Ltd was facing a financial crisis, and it owes to its lender a total amount of $2,00,000. ABC Ltd offers its lender a 25% shareholding in the company in exchange for the existing amount of outstanding debt. This is a situation of debt/equity swap wherein the borrower asks its lender to exchange the existing debt for equity.

Example 2

In March 2023, China Evergrande Group, a real estate giant, revealed its plans for restructuring its debt obligations from different nations worth $22.7 billion. It offered creditors multiple options to convert their debt into equity backed by the group and its two listed companies – Evergrande New Energy Vehicle Group and Evergrande Property Services Group.

Debt equity swap works as one of the most useful means of settling their debt. It helps not only the private forms that have lenders scattered all around, but also the government which is burdened with billions of repayment obligations. Here is a list of benefits that these options offer to different entities:

• The company is saved from defaults in repayment of the loan and outstanding interest, which it may incur since it is facing financial stress.
• The company is also saved from the negative image that arises when it is not able to repay its debts.
• Since repayments are not to be done, the company is able to maintain its cash flows.
• A debt/equity swap is a cheap alternative as compared to other methods of financing in case of financial stress. The reason is that as soon as the debt market becomes aware of the fact that companies on a larger scale are incurring financial difficulties in a country, the rate of interest will tend to increase. Thus, the company is better off choosing a debt/equity swap rather than going for more debt.

Though there are multiple advantages of debt/equity swaps, it is not devoid of demerits. Listed below are some of the limitations of the process. Let us have a look:

• As the company offers its lenders to take ownership of its stock, it dilutes its control.
• The lenders may become demanding by asking for more than the fair value of the debt since they are giving away their ownership of the debt.
• The problem of financial stress is not entirely solved as cash flows still remain a problem.

This has been a guide to what is Debt/Equity Swap. Here, we explain the concept with examples, reasons, advantages, and disadvantages. You can learn more about financing from the following articles –

• Asset Swap
• Interpretation of Debt to Equity Ratio
• Meaning of Debt Consolidation
• Convertible Debt Definition
• Knock-Out Option