Debt-for-equity swap
Also known as: Debt conversion, Balance sheet restructuring
Creditors give up debt and receive the company instead. Where the value breaks decides who ends up owning it.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat actually happens?
A company owes more than it can pay. Not temporarily — genuinely. Extending the dates would only mean more interest on a debt that was always too big.
So the debt has to shrink. The creditors will not simply write it off, and they do not have to. What they can do is exchange it for something: the company itself.
They cancel some or all of what they are owed, and in return they are issued shares. The old shareholders — who owned a company worth less than its debts — are usually left with very little or nothing, sometimes with a small stake to keep them cooperative.
Which creditors get the company depends on one number: where the value runs out. Add up what the business is worth, work down the queue paying each class in turn, and the class you are paying when the money stops is the class that ends up owning it. Everybody above is paid; everybody below gets nothing.
- 1
Valuation4–10 wks
Where enterprise value runs out is established, which decides who is in the money and who is negotiating for option value.
- 2
Negotiation6–16 wks
Which class converts, at what price, and what the existing shareholders keep.
- 3
Documentation4–8 wks
A new shareholders' agreement, a new board and a new capital structure are written at once.
- 4
Approval2–8 wks
Creditor classes vote and, where a formal procedure is used, a court sanctions the plan.
- 5
Implementation2–4 wks
Debt is cancelled, shares are issued and the lenders become the owners.
Where the value breaks — The valuation everybody is arguing about decides. This is not an input to the negotiation; it is the negotiation.
Class approval — Each class of creditors decides. How creditors are grouped decides which majorities are needed and therefore who holds a veto.
Sanction — The court, where one is used decides. The test is procedural fairness and whether dissenters are worse off than in the alternative.
Who is on the deal
| Who | Side | What they are actually for |
|---|---|---|
| The senior creditors | Buy side | Are usually the class at the value break, and therefore usually the ones who end up owning the company. |
| The junior creditors | Sell side | Are frequently below the break and negotiating for option value rather than for recovery. |
| The existing shareholders | Sell side | Are usually left with very little, and occasionally with a small stake to secure their cooperation. |
| Management | Neither | Is being asked to run the company for its new owners, and is negotiating its own incentive package at the same time. |
| The valuation experts | Both | Produce the number the whole argument turns on, one for each side. |
- Desk
- Restructuring
- What changes hands
- Debt cancelled, shares issued
- Who ends up owning it
- Whichever class sits at the value break
- Old shareholders
- Usually left with very little
- The whole argument
- A valuation, with legal consequences
What decides whether it completes
Not how hard this is, and not a rating — there is deliberately no total. It says which of five blockers decides whether this transaction happens at all, in the same order on all 70 transaction types so they can be compared. This publication's own reading; see the notice below.
- Pricedecides it
- Financingmatters
- Approvaldecides it
- Diligencebarely applies
- Executiondecides it
What decides it here. Where the enterprise value runs out decides who ends up owning the company, so the valuation is not an input to the negotiation — it is the negotiation. Everything after it is procedure: classes, majorities and a court that tests whether dissenters are worse off than in the alternative.
3 · IntermediateHow it runs in practice
The value break
Suppose a business is worth 500. It owes 300 senior secured, 300 junior, and has shareholders. The senior debt is covered in full. The junior debt is owed 300 and there is 200 left, so it recovers two thirds — and it is the class at the break. The junior lenders become the owners; the shareholders receive nothing.
Move the valuation to 800 and the junior debt is covered too, the shareholders are back in the money, and the whole negotiation is different. Move it to 250 and even the senior lenders are impaired. Nothing about the business changed in any of these; the valuation did.
Which is why the forecast is fought over
Value is argued from a business plan, so the plan is the battleground. Creditors below the break argue for a higher valuation because it puts them in the money; creditors above argue for a lower one because it means they own more of the company. Each commissions its own expert, and both are honest and reach different answers.
What the new owners have to solve immediately
- Management. The people running the company work for new owners now, and their incentives have to be rewritten.
- Governance. A new board, drawn from creditors who never intended to own an operating business.
- The remaining capital structure, which must be sustainable or this happens again.
- Liquidity, because a company that reached this point rarely has spare cash — see rescue financing.
Consent or court
If every affected creditor agrees, this can be done by contract. They rarely all agree, so it is usually implemented through a restructuring plan or a court process, where a sufficient majority can bind the rest.
4 · AdvancedThe numbers & the documents
Why some creditors do not want the equity
Because they cannot hold it. Bank lenders frequently face capital charges that make equity in a leveraged company unattractive; some funds are mandated to hold debt only. Those holders sell into the process at a discount, and the buyers are distressed funds that specifically want to own the outcome.
This is why the creditor group at the end of a restructuring looks nothing like the one at the start, and why the identity of the holders is checked repeatedly rather than assumed.
The shareholder stub
Out-of-the-money shareholders are sometimes left a small stake despite having no legal entitlement. The reasons are practical: shareholder approval may be needed for the mechanics, litigation can be delayed for years, and a founder's continued involvement can be worth more than the stake. It is a payment for cooperation rather than a recognition of value, and it is disclosed as such.
What the new owners actually bought
A business, at an implied valuation set by the process, having converted a claim they bought at a discount. A fund that paid sixty for a claim of a hundred and receives equity valued at seventy has made money on a transaction that everybody described as a loss. Both statements are true, and it is why recovery rates measured against face value and returns measured against purchase price are different numbers that get quoted interchangeably.
Whether it works
The mechanism fixes the balance sheet and does nothing whatever to the business. A company that was over-borrowed and otherwise sound emerges viable. One whose problem was that its products no longer sell emerges with less debt and the same problem, and returns to this desk within a few years — which is common enough to have a name in the trade, and is the honest limit of what this transaction can do.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow people on the deal think about it
Now say it back
Close the page and give Debt-for-equity swap in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — name both sides and what each one is actually trying to get.
- What has to happen, in order — the three or four stages, not the whole timetable.
- Where the money comes from — cash, new shares, or borrowed; somebody has to fund it.
- What kills it — the ordinary way, not the dramatic one.
Where this transaction shows up elsewhere
- EasyAmend and extendDealThe maturity is pushed out and the terms are adjusted, without anybody writing anything off
- EasyCourt-supervised reorganisationDealA company files for protection and keeps running
- EasyStandstillDealCreditors agree not to enforce while a plan is negotiated
- MediumDistressed exchangeDealBondholders are offered less than they are owed, and the alternative is not repayment
- HardMezzanine financeDealDebt between the senior lenders and the equity
- HardRestructuringDeskWhat happens when a company cannot pay: the standstill, the valuation fight, classes and voting, new money and the…