Introduction
When companies face financial difficulties, they can use debt/equity swaps as a practice of converting debt into equity. Debt/equity swaps are particularly relevant under the IBC (Insolvency and Bankruptcy Code) paradigm in India, which often gives outcomes for shareholders and creditors in distressed sectors.
What Is a Debt/Equity Swap?
A debt/equity swap, which may also be termed a debt swap or debt equity conversion, is a form of financial restructuring in which a company converts its existing debt (loans, bonds, etc.) into equity shares of the same company. This transaction is often referred to as converting debt into equity. It is an opportunity for the company to improve its financially distressed situation and reduce debt while allowing creditors to hold an equity position. In India, debt/equity swaps have become more relevant since the lodging of a plan post-bankruptcy within the Insolvency and Bankruptcy Code, 2016. This is especially useful for companies facing distress and the desire to attain a path for recovery.
It is important for investors and stakeholders to understand debt equity swaps, especially given the corporate borrowing levels in the Indian market and the high occurrences of debt restructuring in sectors like infrastructure, steel, and real estate. Moreover, debt/equity swaps may reconfigure the financial markets for creditors and shareholders, even during distress.
Open Demat Account and Start Trading!
How Debt/Equity Swaps Work
A debt equity swap begins when a company that cannot pay its obligations seeks to negotiate with its creditors (typically banks, bondholders or financial institutions) to cancel part or all of its debt in exchange for equity shares. This reduces liabilities on the balance sheet and interest expense and better positions the company with a stronger balance sheet, with the hope of preventing bankruptcy. The creditors as owners will have the advantage of potential profits from their equity ownership if the company can turn around. Still, they have also assumed the risk associated with an equity ownership position.
In India, Debt/equity swaps are usually implemented via IBC resolution processes through the NCLT. For example, a company with ₹500 crores worth of debt may offer its creditors equity worth ₹200 crores to eliminate its obligations. The creditors have equity shares instead of interest payments to the maximum extent possible, and they are betting that the company will recover in the long term. These swaps are content-based agreements about the various terms between the parties involved, as well as company valuations and regulatory approvals to comply with SEBI rules.
Who Benefits from Debt/Equity Swaps?
Companies
Debt Reduction: Swaps lower debt levels, alleviate financial burdens, and decrease interest expenses. This can free up cash for Indian companies' operations or growth.
Bankruptcy Avoidance: Restructuring debt can help companies maintain their position, rather than liquidating.
Improved Financial Situation: A clean balance sheet often comforts new investors and increases credit ratings.
Creditors
Potential Recovery: Creditors may extract greater value through equity based on a possible recovery instead of a liquidation.
Stakeholder: As a result of swaps, banks or bondholders will be allocated a degree of control as stakeholders and can thereby influence the company's recovery.
Shareholders
Mixed Impact: Existing shareholders will be diluted as new shares are issued (even if they buy into the new shares, their total ownership percentage declines). A successful swap can provide stability and cushion the share value.
Debt Equity Swap Advantages and Disadvantages
Advantages
For Companies: Debt/equity swaps lessen financial pressure, reduce interest costs, and improve liquidity, allowing firms to focus on growth. In India, where corporate debt is often significant, this is an excellent option for struggling industries like the power and real estate sectors.
For Creditors: This allows creditors to return to equity options, and under the IBC (Insolvency and Bankruptcy Code) resolutions, creditors would get the best chance possible to recover value (versus a resolution that leads to liquidation, which will return a lesser value).
Economic Stability: Swaps foster the sustainability of jobs and economic development by reducing the risk of corporate failure, and this is a key focus point for India's growth agenda.
Disadvantages
Shareholder Dilution: Existing investors are losing some of their ownership in the company, which could negatively impact the share price or at least decrease the shareholders' control.
Borrowers risk a new type of financing called Equity Risk. Typically, creditors now have the common equity of the business, which is riskier than debt. Therefore, they are not guaranteed to receive any returns, and if the business never recovers, they essentially will have no direct recourse.
Regulatory Implications and Tax Issues: Like the challenges faced in the previous bullet, in India, the transaction could be approved by SEBI or NCLT and have tax implications, capital gains on equity, at a minimum, and maybe other challenges to structuring the deal.
Conclusion
A debt/equity swap represents a strategic weapon for Indian corporate companies suffering from financial distress, providing a means to reduce their debt and avert insolvency. For creditors, debt/equity swaps may allow them to transform their losses into something tangible through transformed equity ownership, creating new potential gains. There are sacrifices associated with debt equity conversions, as equity will necessarily dilute the other shareholders' interest, and change the risk profile of their equity returns. In India's new evolving financial ecosystem, subject to oversight by the IBC and SEBI, debt equity conversions are pivotal to various corporate turnaround strategies. Investors and businesses must assess the benefits and drawbacks of a debt/equity swap and the full implications for further due diligence regarding maximising the upside return in the dynamic Indian marketplace.