Debt/Equity Swap

Updated on April 8, 2024
Article byNiti Gupta
Edited bySusmita Pathak
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Debt/Equity Swap?

Debt/Equity Swap is an arrangement relating to financial restructuring in which the debts of the company are converted into stock. Such an arrangement is sought for when the company is into financial crisis and the existing lenders are given an option to get the debt given by them converted into equity at a pre-decided swap ratio.

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Debt/equity swap is one of the means of debt restructuring using which firms exchange their debt obligations with equity or stocks. It is used by the government to exchange debt obligations from other nations by offering them a stake in a firm by private acquisition of it.

Key Takeaways

  • A debt/equity swap involves exchanging existing debt obligations for equity ownership in a company. This financial arrangement allows a company or individual to convert debt into shares or other equity instruments.
  • Financially distressed companies commonly employ debt/equity swaps as a strategic measure to alleviate their debt burdens, improve their financial health, and avoid the risk of bankruptcy.
  • In a debt/equity swap, creditors agree to convert their outstanding debt into equity securities issued by the company. This conversion results in the creditors becoming shareholders or equity holders in the company.

How Does Debt/Equity Swap Work?

Debt/equity Swap allows entities, including the government, to convert their debt obligations into equity ownership, thereby giving the lenders a stake in the firms the stocks belong to instead of paying them back.

When a company faces a serious financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more or is near to the situation of liquidation, then the company is not in a position to repay its debt. In such a situation, the company has to find ways of its financial restructuring. One of the ways for the same is an option for a debt-equity swap.

In the debt/equity swap, debt will be exchanged for equity. Thus, the company will offer the lenders to get the outstanding amount converted into the equivalent amount of equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more shares of the company. The shares are issuedShares Are IssuedShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more in lieu of the outstanding debt in accordance with the predetermined ratio. The company is saved from immediate cash flows arising due to repayment.

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Reasons for Debt/Equity Swap

Debt/equity swap is mostly used in those cases where the company is facing financial stress and is not having enough cash flows to make payments for the debt. In such situations, either the company itself may propose the debt/equity swap, or the debt holders may ask the company for the same in order to save themselves from the risk of failure of payments in the future.

Basically, a company opts for debt/equity when it is into long-term financial problems. In such a case the company knows that it will not be able to make the repayment of its outstanding debts, which will bring negative publicity for the company. In order to avoid such negative publicity, the company plans financial restructuring by way of a debt/ equity swap wherein it offers the debt holders to exchange the debt for equity so that it does not have to make repayments. Thus, a debt/equity swap helps the company in the sense that it is not required to make immediate repayments and financial stress is reduced to this extent.

Examples

The situation of debt/equity swap can be well understood by way of the following example.

Example 1

Let us say, a company ABC Ltd was facing a financial crisis, and it owes to its lender a total amount of $2,00,000. ABC Ltd offers its lender a 25% shareholding in the company in exchange for the existing amount of outstanding debt. This is a situation of debt/equity swap wherein the borrower asks its lender to exchange the existing debt for equity.

Example 2

In March 2023, China Evergrande Group, a real estate giant, revealed its plans for restructuring its debt obligations from different nations worth $22.7 billion. It offered creditors multiple options to convert their debt into equity backed by the group and its two listed companies – Evergrande New Energy Vehicle Group and Evergrande Property Services Group.

Advantages

Debt equity swap works as one of the most useful means of settling their debt. It helps not only the private forms that have lenders scattered all around, but also the government which is burdened with billions of repayment obligations. Here is a list of benefits that these options offer to different entities:

  • The company is saved from defaults in repayment of the loan and outstanding interest, which it may incur since it is facing financial stress.
  • The company is also saved from the negative image that arises when it is not able to repay its debts.
  • Since repayments are not to be done, the company is able to maintain its cash flows.
  • A debt/equity swap is a cheap alternative as compared to other methods of financing in case of financial stress. The reason is that as soon as the debt market becomes aware of the fact that companies on a larger scale are incurring financial difficulties in a country, the rate of interest will tend to increase. Thus, the company is better off choosing a debt/equity swap rather than going for more debt.

Disadvantages

Though there are multiple advantages of debt/equity swaps, it is not devoid of demerits. Listed below are some of the limitations of the process. Let us have a look:

Frequently Asked Questions (FAQs)

1. What is the risk associated with debt/equity swaps?

Debt/equity swaps carry certain risks. One risk is the potential dilution of existing shareholders’ ownership stake in the company when debt is converted into equity. Another risk is the uncertainty of future financial performance, as the company’s success after the swap will determine the value of the equity received. Additionally, tax implications and regulatory considerations may be associated with debt/equity swaps that must be carefully evaluated.

2. Are debt/equity swaps subject to regulatory considerations?

Yes, debt/equity swaps are subject to regulatory considerations. Regulatory approvals or notifications may be required to convert debt into equity, depending on the jurisdiction and specific circumstances. Regulatory bodies may assess the impact on shareholders’ interests, debt repayment obligations, financial stability, and compliance with applicable laws and regulations.

3. What is a debt-to-equity swap IAS 32?

A debt-to-equity swap under IAS 32 refers to a transaction where a company converts its debt obligations into equity instruments. IAS 32 is the International Accounting Standard that guides the presentation and classification of financial instruments, including the accounting treatment for debt-to-equity swaps. The standard outlines specific criteria that need to be met for the swap to qualify as an equity transaction for accounting purposes.

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