A familiar friend: debt-to-equity swaps

Current levels of corporate debt are rising unsustainably. Will debt-to-equity swaps be the solution?

According to a recent report in the Financial Times, UK business faces a potential debt burden of up to £105bn with small and medium sized companies (which employ approximately 16m people in the UK) under most pressure given lack of easy access to liquidity. Commentators agree that levels of corporate debt are likely to be unsustainable and, as a consequence, action will be required.

The above creates obvious issues for both borrowers and lenders. Borrowers needing cash will be mindful of the restrictions that a weak balance sheet imposes on them and lenders will need to be pragmatic in amending and waiving existing facilities, which may also include security packages and require creativity and commerciality around ranking arrangements.

One potential solution might be debt-to-equity swaps. As was the case in previous financial crises, we expect to see an increasing trend for such transactions in 2020/2021 as lenders come under pressure to align themselves with (struggling) borrower clients and take steps to ease the debt burden on them.

In summary, a debt-to-equity swap is a transaction where a creditor (usually a bank or other debtholder) converts existing indebtedness – in the form of principal, accrued fees and interest - owed to it by a company into shares in the borrower. There is no prescribed ‘one size fits all’ structure for the debt-to-equity swap and, in our experience, each one will be driven by specific factors on a case by case basis and commercial issues. As a starting point however, the company and the lender will need to agree:

• How much of the debt is being swapped?
• What percentage of equity will be issued to the creditor and, crucially, the terms on which the shares will be issued and the rights attaching to the shares i.e. voting rights, rights to dividends or preferential rights and/or ranking on a sale/liquidation;

There are obvious advantages for the company: a debt to equity will materially improve the company’s balance sheet (which may enable the company to access new borrowings); it will reduce the interest and repayment burden; and it can align the lender more fully with the long-term interests of shareholders. Lenders will need to be mindful of any security being released and the usual lender protections found in facility agreements falling away (although this may not be relevant if it is a partial debt-to-equity only where some of the existing indebtedness is preserved and/or where the protections can be replicated (to a greater or lesser degree) in the shareholders’ agreement).

Establishing the tax treatment of a debt-to-equity is critical. The borrower will not want to suffer a tax charge on what may otherwise amount to a taxable release and the lender will want relief for its bad debt. This is generally achievable provided the parties are not connected at the outset and provided the borrower only issues ordinary shares.

We expect to see significantly more debt-to-equity transactions in the coming months as companies and lenders look to find creative solutions to provide additional liquidity. Watch this space!