Debt-For-Equity Swap Essay

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A debt-for-equity  swap is a financial transaction  in which creditors  who have debt in a company  (such as loans or bonds) agree to have these debts canceled in exchange  for equity in the  business. Hence,  this transaction  alters  the  capital  structure  of the  firm. It does not generate any new cash flow for the business (although  there  are some considerable  administrative costs related to the transaction),  but it does improve the profitability of the business by lowering debt service payments and restructuring the current debt/assets  ratio. Companies do these swaps when in a favorable or difficult financial situation, depending on its strategic implications, but consequences on the company’s stock are usually negative, given the negative market perspective on this type of operation.

Typically, a company that wishes to initiate a debt-for-equity  swap will offer its investors  to exchange their debt for a predetermined amount  of equity (or stock). The amount  of equity given in a transaction is usually determined by current  market rates, but in some  cases, the  company’s management  may offer higher exchange values to convince debt holders  to participate  in the swap. If the investors agree to cancel their existing debt, they are given equity equivalent to the negotiated amount.

Motivations

Companies  that  are in a positive financial situation rarely use a debt-for-equity swap, as the cost of servicing bonds or loans is usually less than the long-term costs related to stocks. Nonetheless, some companies will do this type of transaction  to take advantage of specific tax provisions or if there is favorable internal information  about the Net Present  Value of existing and future  projects. A company might also proceed with this type of operation  to take advantage of current stock valuation. As for lenders, doing a debt-for-equity swap results in trading a fixed-rate debt for an asset whose return  is tied to company performance; if the  firm is doing  very well, the  lender  might  be enticed  by the  higher  return  potential.  In all cases, swaps  under   positive  financial  circumstances   are rather rare.

Most of the time, debt-for-equity  deals take place when a company has run into severe financial troubles, and the cost to service the debt is crippling the short-term functionality of the company, or the company feels it might be unable to make face value payments  in the  near  future.  Other  reasons  for swaps include a contractual  obligation to maintain a specific debt/equity  ratio or pressure from existing lenders to reimburse some amount that is currently due. Hence, facing bankruptcy, the company will try to arrange for a private reorganization  of its capital structure.

Lenders habitually accept these swaps because the current  debt is very large and the company’s remaining assets are worth  significantly less than  current assets and there is no advantage in driving the company into  bankruptcy.  Also, faced with a choice of writing  off the  debt  and getting  nothing  or writing off the debt and getting equity, lenders often prefer to get equity in the hope of recouping their investment. Hence,  debtors  participate  in these  transactions  to get an increased  level of control  over the company, so they are better positioned to recover some amount of capital.

During a favorable financial situation,  a debt-for-equity transaction  might  increase  stock values, but only to a small extent. Even if the firm is restructuring its capital structure  to take advantage of external events (such as higher stock prices or corporate  tax shields), market reactions are usually negative to this type of transaction,  perceiving it as masking an unfavorable internal financial situation.

When  used in a downturn  situation,  this type of transaction benefits the company by relieving some of the pressures  linked to servicing the debt. It can also be used in a defensive manner. For example, if a company has low market valuation, it could be worried about  being a target  of a hostile  takeover; by converting debt into shares, it could reduce the risk of hostile acquisition by increasing the total number of shares outstanding.

Responses

Existing shareholders  are usually displeased with the announcement of a swap. First, they may find their shares severely diluted as substantial amounts of new stock  are  issued, and  significant  debts  are  restructured into a deteriorating stock. Furthermore, several studies have demonstrated that the value of the stock declines at the announcement of a swap.

This is most  often  attributed to  an  information effect, whereas stockholders  find (or believe) that  a company’s financial condition is worse than expected. Sometimes,  it is possible for shareholders  to block these  transactions  if the  value of the  shares  being issued exceeds the value of the debt being written off, but in the case where the company has a net negative value, shareholder consent is usually not necessary to proceed.

By the  same token,  debt  holders,  seeing the  risk related to their investment  increase, may prevent the swap from occurring without their consent. As such, management  will often deploy extra incentives (such as a higher valuation of debt capital) as a necessary step  to  increase  the  likelihood  of this  transaction occurring.

Bibliography:   

  1. Don M. Chance, “Equity Swaps and Equity Investing,” Journal of Alternative Investments (v.7/1, 2004);
  2. Steven Graham and Wendy Pirie, “The Effect of Debt for Equity Swaps When Equity is Valued as an Option,” Managerial Finance (v.30/12, 2004);
  3. Elhanan Helpman,  “The Simple Analytics of Debt-Equity  Swaps,” American  Economic  Review (June 1989);
  4. Chris Rowley and  Malcolm Warner,  Globalization  and Competitiveness: Big Business in Asia (Routledge, 2005).

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