Definition of Debt Equity Swap
Debt equity swap is a type of financial restructuring arrangement between the lenders of the business and the owners of the business through which the debt components are converted into equity of the business. In other words, the debt providers become owners in the business. A debt-equity swap 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 is to be restructured by way of the debt-equity swap.
Explanation
The process of 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 is converted into Equity shares by deciding the price at mutual understanding in case of financial restructuring. However, if the conversion of debt to equity is happening on account of Convertible Bonds the price is predefined at the time of issue of such convertible bonds.
Why Does It Occur?
Debt equity swap usually happens in cases where lenders to the business see viability in the business model and the commitment of promoters. Many times business get impact due to high leverage or events which are outside their control (catastrophic events such as Covid 19 and so on) resulting in even viable business failing.
In such cases, lenders have to take a call that 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 business can gain more if business turnaround 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 lockdown in the region, the company is unable to pay interest payments which have mounted on account of no revenues. The company foresee the loss of business for the next year as well and decide along with its lender to undertake a Debt/Equity Swap under which the company will extinguish the 1 million dollars and instead of that will issue 0.1 million shares fully paid $10 each to the lenders.
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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 purpose and crediting the same into a new equity issue account.
This journal entry results in extinguishing the debt liability and generation of equity capital. Effectively resulting in a reduction in 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. A few noteworthy are enumerated below:
- In the case where the business has issued convertible bonds with a predefined Equity price and at the time of maturity the Equity price is above that level, then in such case debt/equity swap happens.
- In the case where the business is having high leverage and due to low demand, internal mismanagement or for that reason as an external factor has resulted in non-sustainability for 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
Debt equity swap has various implications which include dilution of equity interest in the business, impacting the earnings per share of the business (EPS), 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 Swap due to which it is one of the important tools used by lenders and debt holders to navigate the business during stressful times or where 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, 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. It is used in such cases to support viable businesses and avoid bankruptcy on account of failure to make interest payment commitments as well as to allow such business to survive and regain the lost ground.
Advantages
It offers certain advantages to the business. Few noteworthy are enumerated below:
- It provides businesses with the much-needed capital required for survival.
- It reduces the interest component of the business thereby enabling the business to generate sufficient free cash flow to equity and for retention purposes.
- It helps businesses to avoid default which can make their credit rating to 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 dilution of interest of equity stakeholders as more and more debt is swapped for equity.
- It results in a distress sale of equity of the business as lenders demand a huge discount to the intrinsic value of shares to compensate for the risk. This can be disadvantageous in cases where a business downturn is on account of one-off events and business is going to 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 debt is converted by lenders into the equity of the business to provide the much-needed liquidity and to reduce the interest payment component on the business which is already under financial stress. The conversion or swap usually is done at a deep discount to enable lenders to cover up for the risk that they undertake by betting on the business which is on the verge of bankruptcy.
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