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.
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.
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.
- Don M. Chance, “Equity Swaps and Equity Investing,” Journal of Alternative Investments (v.7/1, 2004);
- 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);
- Elhanan Helpman, “The Simple Analytics of Debt-Equity Swaps,” American Economic Review (June 1989);
- Chris Rowley and Malcolm Warner, Globalization and Competitiveness: Big Business in Asia (Routledge, 2005).
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