What is a debt / equity swap?
A debt / equity swap is a transaction in which the bonds or debts of a company or an individual are exchanged for something of value, equity. In the case of a listed company, this usually involves an exchange of bonds for shares. The value of the shares and bonds exchanged is generally determined by the market at the time of the swap.
Understanding debt / equity swaps
A debt / equity swap is a refinancing agreement in which a debt holder obtains a equity position in exchange for debt cancellation. The exchange is usually done to help a struggling business continue to operate. The logic behind this is that an insolvent business cannot pay its debts or improve its financial condition. However, a company may sometimes simply wish to take advantage of favorable market conditions. The restrictive clauses of the bond instrument can prevent a swap from occurring without consent.
In the event of bankruptcy, the debt holder has no choice whether or not to exchange debts / shares. However, in other cases, he may have a choice in the matter. To entice people into debt / equity swaps, companies often offer advantageous trading ratios. For example, if the company offers a 1: 1 swap ratio, the bond holder receives stocks of exactly the same value as their bonds, which is not a particularly profitable trade. However, if the company offers a 1: 2 ratio, the bond holder receives stocks valued at double their bonds, which makes trading more attractive.
Key points to remember
- Debt / share swaps involve the exchange of shares for debts in order to cancel the sums due to creditors.
- They are generally carried out in the event of bankruptcy and the exchange ratio between debt and equity may vary depending on the individual case.
Why use debt / equity swaps?
Debt / equity swaps can provide equity to its debt holders because the company is unwilling or unable to pay the face value of the bonds it has issued. To delay reimbursement, he instead offers stock.
In other cases, companies must maintain certain debt / equity ratios and invite debt holders to exchange their debt for equity if the company helps adjust this balance. These debt / equity ratios are often part of the financing requirements imposed by lenders. In other cases, companies use debt / equity swaps as part of their bankruptcy restructuring.
Debt / equity and bankruptcy
If a business decides to declare bankruptcy, they have a choice between Chapter 7 and Chapter 11. Under Chapter 7, all of the company’s debts are eliminated and the business no longer operates. Under Chapter 11, the business continues to operate while restructuring its finances. In many cases, the reorganization of Chapter 11 cancels the existing shares of the company. He then reissues new shares to the debt holders and the bondholders and creditors become the new shareholders of the company.
Debt / equity swaps vs Equity / debt swaps
A stock / debt swap is the opposite of a stock / debt swap. Instead of exchanging debt for shares, shareholders exchange shares for debt. Essentially, they trade stocks for bonds. Generally, share / debt swaps are made to facilitate smooth mergers or restructuring in a business.
Example of debt / equity swap
Suppose that ABC has a debt of $ 100 million that it cannot repay. The company offers 25% ownership to its two debtors in exchange for the cancellation of the total amount of debt. It is an exchange of debts for participations in which the company has exchanged its debt securities for participations by two lenders.