Updated July 17, 2023
Definition of Debt Equity Swap
A debt-equity swap is a type of financial restructuring arrangement between the business’s lenders and the business’s owners through which the debt components convert into the business’s equity.
In other words, the debt providers become owners of the business. It usually happens in cases where the business is under financial stress and to make its debt component sustainable, a certain or complete portion of the debt restructuring by way of the debt-equity swap.
Explanation
The process of a debt-equity swap involves converting the debt portion, which carries fixed interest payout, into the equity portion, thereby reducing the interest outgo and making a business that is struggling financially to sustain and get back to normalcy.
Under this, the debt converts into Equity shares by deciding the price at mutual understanding in case of financial restructuring. However, if the conversion of debt to equity occurs due to Convertible Bonds, the issuer predefines the price when issuing such convertible bonds.
Why Does It Occur?
It usually happens in cases where lenders to the business see viability in the business model and the commitment of promoters. Businesses often impact due to high leverage or events outside their control (catastrophic events such as Covid 19), resulting in even viable business failure.
In such cases, lenders have to make a call about whether liquidating the business makes more sense or Debt/Equity swap will be more beneficial for all. Also, by entering into a debt/equity swap, the lenders to the business can gain more if the business turnaround is contrary to the fixed interest payment they would have received on their debt to the business in the ordinary course of business.
Examples
ABC Limited is under a debt obligation of 1 million dollars. The company is in the hospitality business, and due to the lockdown in the region, the company is unable to pay interest payments which have mounted on account of no revenues. The company foresaw the loss of business for the next year as well and decided, along with its lender, to undertake a Debt/Equity Swap under which the company would extinguish the 1 million dollars and, instead of that will, issue 0.1 million shares fully paid $10 each to the lenders.
By undertaking this exercise, the company will save yearly interest outgo of 0.1 million on its debt obligation, which will help the business to retain profits and improve its liquidity.
Accounting for Debt Equity Swap
The accounting treatment of debt-equity swap involves debiting the entire debt component of the business, which is earmarked for swap purposes,s and crediting the same into a new equity issue account.
This journal entry extinguishes the debt liability and generation of equity capital. Effectively reduced long-term liability (under liabilities head) and an equivalent increase in Equity Share Capital (under Capital Head).
Reasons for Debt Equity Swap
There are multiple reasons for the debt-equity swap.
- Suppose the business has issued convertible bonds with a predefined Equity price at maturity. In that case, the Equity price is above that level, then in such case debt/equity swap happens.
- In the case where the business has high leverage and due to low demand, internal mismanagement, or for that reason, an external factor results in non-sustainability for the business to make an interest payment and the lenders or debt holders are convinced about the viability of the business can be a ground for debt/equity swap.
Implications of Debt Equity Swap
It has various implications, which include dilution of equity interest in the business, impacting the earnings per share of the business (EPS), and reduction in fixed interest expense of the business on account of debt conversion into equity.
Uses of Debt Equity Swap
There are certain uses of Debt/Equity Swaps which it is one of important tools used by lenders and debt holders to navigate the business during stressful times or when the business is on the verge of bankruptcy.
It is important to understand that all business mostly thrives on debt to grow, which result in leverage, and at times certain unforeseen events such as War, a sudden business downturn, or a complete lockdown like the one observed during Covid times, can result in a business losing revenues substantially which jeopardize the repayment schedule and result in piling of debt and liquidity shortage. Its uses in such cases are to support viable businesses, avoid bankruptcy because of failure to make interest payment commitments, and allow such businesses to survive and regain the lost ground.
Advantages
It offers certain advantages to the business.
- It provides businesses with the much-needed capital required for survival.
- This reduces the interest component of the business, thereby enabling the business to generate sufficient free cash flow for equity and retention purposes.
- It helps businesses to avoid default which can make their credit rating non-investment grade or, worse, junk grade.
Disadvantages
Despite the advantages enumerated above, there are certain disadvantages that Debt/Equity swap brings for the business and its lenders as enumerated below:
- It results in the dilution of interest of equity stakeholders as more and more debt swaps for equity.
- It results in a distressed sale of equity of the business as lenders demand a huge discount on the intrinsic value of shares to compensate for the risk. This can be disadvantageous in cases where a business downturn is due to one-off events, and business will thrive back to normalcy sooner than expected. (Like the current Covid scenario for the Hospitality and Aviation industry).
Conclusion
A debt-equity swap is an important and frequently used financial restructuring tool under which lenders convert debt into the business’s equity to provide the much-needed liquidity and reduce the interest payment component on the business, which is already under financial stress. The conversion or swap is usually done at a deep discount to enable lenders to cover up for the risk they undertake by betting on the business on the verge of bankruptcy.
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This is a guide to Debt Equity Swaps. We also discuss the definition and reasons for debt-equity swaps, advantages, and disadvantages. You may also have a look at the following articles to learn more –
