Debt Restructuring Meaning
Debt restructuring is a refinancing process whereby the company facing cash flow issues enters into an arrangement with lenders to renegotiate a favorable or flexible terms, thereby saving themselves from bankruptcy. The lenders may choose to lower the rate of interest for the business or increase the time limit for paying the interest and principal amount.
Debt Restructuring Methods
#1 – Debt for Equity Swap
In case of debt to equity swap, the lenders may choose to forgo the outstanding debt for a stake in the company. This is usually done in cases where the company has a large asset base, and a large balance sheet and bankruptcy will create little value for the lenders.
Thus, the lenders take the management of the company and try to run it as a going concern. The lenders take a major equity stake and thus diluting the stake of the original shareholders who may own a diminished stake in the company.
For example, the debt for equity swaps is one of the best ways to deal with sub-prime mortgages. A householder who is not able to service his debt of $ 200,000 may reach an agreement with the bank to reduce the mortgage to 75%, i.e. $ 150,000, and the bank will receive say 60% of the amount of the resale of the house greater than % 150,000.
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#2 – Bondholder Haircut
A defaulting company with outstanding bonds may negotiate with the bond investors and offer payments at a discounted price which will omit or reduce the interest payments or principal payments.
For example, Wells Fargo owed $ 267 billion to the bondholders in its Annual report of 2008, a 20% haircut may reduce its debt by $ 54 billion thereby creating an equivalent amount of equity which was good enough to recapitalize the bank.
#3 – Negotiating Repayment Terms
A company may negotiate repayment terms which may include reducing the interest rate, writing off some outstanding loans, increasing time to repayment. This is a more affordable method and can be achieved by an agreement between the lenders and the company.
Advantages
- Legal protection to the business from the lenders
- Protection of the company’s assets
- Protection of the company from closing down and it will run as a going concern
- Jobs of the employees are saved.
- Better recovery for creditors than bankruptcy
Disadvantages
- Lower recovery by lowering of interest payments and increasing schedule
- Write-offs may hit the balance sheet of the creditors.
- No assurance that the business will run smoothly and will make timely payments even after debt restructuring
Important Points about Debt restructuring
- Debt restructuring is a process to restructure the company’s obligation facing financial difficulties.
- It may include debt for equity swap, haircuts, an elongated period of non-payments, reducing interest rates.
- Although it may save the company from bankruptcy in the short term, there is no assurance that the business will run smoothly after debt restructuring.
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