Debt-for-Equity Swap: a Worked Example

A business can be worth keeping and still unable to carry its debt. Enforcement would sell its assets into a market that knows the seller is forced, and turn a going concern into a liquidation value. Simply cutting the debt, a haircut, leaves any recovery in the business with shareholders who have put in nothing more. A swap answers both: the lenders cancel the debt the business cannot service, and in exchange own the business whose value they have just protected.

The trade is a different kind of risk, not less of it. A lender's claim moves from the front of the queue to the back: the shares rank behind every creditor, including the lenders' own remaining loan. Their value depends on the business recovering, and turning them into cash needs a buyer, a refinancing or a listing that may be years away.

Two numbers drive everything. The first is enterprise value, what the business is worth as a going concern, usually from an independent valuation and argued over because it decides who gets what. A lower value means the converted debt is worth less, so the lenders claim a larger share of the equity; a higher one leaves room for the old shareholders. The second is the debt kept, sized to what the business's cash flow can service under the lenders' own tests. The rest of the debt is converted.

The split of the equity is then negotiated. Lenders who have converted most of the claim usually take most of the shares, and the old shareholders keep a stake to retain management, avoid a contest or secure a consent the swap needs. The new equity can be ordinary shares, preference shares that rank ahead of the old ordinary, or warrants that pay out only if value recovers. The swap comes with governance: board seats, a shareholders' agreement, and terms on how and when the lenders may sell.

A chain of fitness clubs, constructed for this page like every figure in it, owes its two lenders US$64m. Memberships have fallen and EBITDA is now US$8m. An independent valuer puts the chain's enterprise value as a going concern at US$56m. Selling the clubs one by one would net about US$34m. The lenders will keep US$32m as debt, four times EBITDA, a level that belongs to this example and not to any market.

On paper the swap beats enforcement by US$19.6m. But the US$21.6m of shares is a valuation, not cash, and the last line shows how much it rests on the valuer's number: if the business is worth US$44m rather than US$56m, the lenders' recovery falls to 67%, still above enforcement in this example but by much less. The comparison a credit committee reads is the swap's range of outcomes against enforcement's, not one figure against another.

A haircut gives part of the debt away; a swap exchanges it for ownership. Had the lenders in the example simply cut the debt to US$32m, the US$24m of equity value would belong entirely to the old shareholders. The swap keeps most of it for the lenders who made it possible. A credit bid reaches a similar ownership by a different road: the lenders buy the assets through an insolvency sale and pay with their debt, rather than taking shares in the company that owes it.

For a bank, the capital treatment differs too. Under the Basel framework's standardised approach, most equity holdings carry a 250% risk weight, against 100% for most unrated corporate loans. Equity received in a debt-for-equity swap for a corporate restructuring is kept out of the 400% weight for speculative unlisted equity, and the framework says such shares should not carry a lower charge than the debt would have. Regulators in New Zealand, Australia and the UK apply the framework with their own rules and timetables; the UK's version takes effect from January 2027 and phases the higher equity weights in. A bank reads its own regulator's rules, and in most cases the shares cost more capital than the loan they replaced.

DEFINED IN ONE PARAGRAPH → · THE HAIRCUT, WORKED → · RISK-WEIGHTED ASSETS →

It decides who has to agree. Issuing shares to lenders often needs the existing shareholders' approval, under the constitution, pre-emption rights, listing rules or, where the lenders' stake would cross a control threshold, takeovers law, and those who will be diluted may refuse. Where they do, the swap may need a court process that can bind them: a UK restructuring plan, a scheme of arrangement, or in Australia a deed of company arrangement under which shares are transferred with the court's leave. Tax on the cancelled debt can also fall on the borrower, by rules that differ in each market and are checked before the deal is signed.

It also decides what kind of owner the lender becomes. A bank holding shares needs a view on who will run the business, how the lenders will vote together, and how long they can hold before they must sell. Some lenders sell their claims to funds that specialise in owning distressed businesses rather than convert. The credit paper that recommends a swap is, in effect, an investment paper, and is read as one.

PROBLEM LOANS AND WORKOUT → · SCHEME OF ARRANGEMENT →