Debt to equity conversions is one of the most commonly used tools in the bankruptcy universe. These transactions allow companies to convert their long outstanding debt into equity shares within the company. These transactions enable companies to better manage their cash flow during the bankruptcy process. The details about debt to equity conversions have been mentioned in the balance of this article.

Understanding the Difference between Debt and Equity

Debt and equity are both forms of taking a financial stake within a company. In the case of debt, the rate of return is fixed, whereas, in the case of equity, the rate of return is variable. Also, it needs to be understood that since debt holders are not taking any risk, they do not get any say in how the affairs of the company are run. On the other hand, the equity holders do have voting rights in the business.

Hence, when a debt to equity conversion happens, investors are essentially giving up their fixed payment claims in lieu of variable claims and voting rights!

Equity to Debt Swap Example

No actual cash is exchanged during a debt to equity swap. For instance, if a company A owed $10 million to a lender, it could choose to issue equity securities valued at $10 million or even more. In exchange, the debt holder will have to extinguish their rights to receive any interest and principal payments in the future.

Equity to debt swap is considered to be a risky maneuver since it is possible that the equity of the newly created company might also become worthless.

How do Debt to Equity Swaps Add Value?

Debt to equity swaps is common because they add value to both parties.

• For instance, debtors accept variable payments in lieu of fixed ones because they know that the expected value of the variable payments is greater than the fixed payments. For instance, if a company is facing a cash-flow shortage, it cannot afford to make interest payments. These interest payments are killing the company financially, even though it has a viable core business. Therefore, in the absence of these interest payments, the company could thrive financially, and within a few years, the profits will be substantial enough to provide a higher rate of return as compared to the agreed-upon interest rate.

• On the other hand, if the creditors continued to pressurize the company and exact their pound of flesh in the form of heavy interest and penalties, the core business of the company might collapse. Hence, the return on investment, as well as the return of investment, would be jeopardized in such cases. In many cases, it is in the interest of the debt holders to not think short term and pressurize the company. It is important to take into account the fact that the creditor company gets complete control of the debtor organization. Hence, they can implement and execute plans which they think are beneficial.

• From the debtor company’s point of view also, the debt to equity swap is a good deal. This is because the debtor company no longer has the compulsion to make immediate interest payments. This frees up additional cash flows without creating any corresponding obligations! The debtor company can invest this free cash flow to grow the business of the firm.

Limitations of Debt to Equity Swaps

The debt to equity swap procedure also has certain limitations. Some important ones have been listed in this article.

• Litigation by Existing Shareholders: Firstly, it needs to be known that in order to issue new equity, the existing equity which the shareholders of the company are holding has to be extinguished. The new equity which is issued may be less valuable to the current equity. This is because when a company swaps debt for equity, it is sending a negative signal to the entire market. As a result, the prices plummet even further. This is why a lot of minority shareholders often feel that their rights are being overlooked in the entire process. They believe that money is being forcibly taken from them in order to put it in the hands of the debt holders. As a result, they may file legal cases, making the process cumbersome and expensive.

• Deep Pockets: Not all investors are interested in debt for equity swaps. Most creditors want to be paid in cash because they want to invest it in their own business. Only financial institutions which do not have any specific business are happy to receive shares in lieu of debt. This is because even if they did receive cash, they would have probably invested them in financial securities. Therefore, if the company issues securities at a better valuation, they are happy to accept them.

• Liquidity: The newly issued equity shares are not as liquid. This is because the court does not allow these shares to be sold in the open market immediately. There is a restriction on the timing when these shares can be traded. Therefore, the shares are not very useful to investors who do not want their money to be tied down.

• Tax Implications: Lastly, interest payment provides a tax shield to the company since interest is a tax-deductible expense. Therefore debt holders get more even though the company pays less. The balance is provided by the tax authorities! After conversion from debt to equity, there will be no tax shield, and the company will have to pay significantly more to keep the debtors happy.