In this latest insight, Nigel Smith, Managing Director, Deal Advisory & Turnaround Services, explains how swapping debt for equity could prevent an insolvency and help a distressed corporate achieve its growth potential.

For many businesses, failing to pay a bank loan has in the past led to enforcement proceedings that result in the sale of assets by the lender, so as to recover the outstanding debt, or even going into insolvency where a receiver or liquidator is appointed to sell the assets. 

However, the Federal Decree-Law No. (51) of 2023 on Financial Restructuring and Bankruptcy has made it clear that companies and lenders should first consider a turnaround strategy that brings the distressed company back to health and minimises the lender’s provision for bad debt.

One of the options within a turnaround strategy that is often overlooked is the debt for equity swap. Many companies are profitable and cash-generative operationally but have insufficient cash to service the entire borrowing.

It is exactly in this scenario where the debt-to-equity swap can be of use to the company and the lender. A swap in simple terms is where a lender agrees to reduce its loan and in return gets a shareholding (equity) in the company that owes it money.

Usually, this does not entirely wipe out the debt but there is naturally a reduction in the amount of cash required to service the new (lower) level of debt as both principal and interest payments are reduced.

Top of the list of benefits is gearing and improvement of other key ratios that the lenders and trade creditors often monitor. The result is that the trading possibilities of the company are enhanced post the swap. 

To deliver a swap, it may be necessary to increase the share capital of the company in distress. Often, a swap comes with the raising of new equity as a way of moving the company back to health. This, however, will have dilution impacts on existing shareholders.

It is important to make it clear that the mechanics of delivering a swap are complex and it should not be the first option when a corporate borrower cannot service its obligations.

There are numerous technicalities that must be followed for a swap to be delivered. Many of these require expert advice in tax, legal and financial areas.

This makes it critical that any business or lender that is considering taking the swap option must have advisers with the required skills and experience.

Challenges faced during a swap

The journey often begins with an agreement among existing shareholders to go for a swap — a difficult step as shareholders will be signing off to be diluted.

However, as this is usually done to prevent an insolvency, existing shareholding will most likely be aware that they have little value left in their company at the time of going for a swap.

The actual level of shares held post the swap will depend on the amount of debt that has to be converted. Even in the most extreme cases it is normal for existing shareholders to be offered at least a nominal shareholding so as to gain their support.

The level of security that the borrower had offered for the debt also matters. This is because lenders are unlikely to consider the swap option if they are fully secured since they may easily realise security to obtain recovery in the short term.

Exit planning

The lender needs to be clear how to exit (ability to sell the shares held post the swap) as lenders do not typically like to be long-term equity holders in companies that owed them money. Indeed, there are restrictions on the amount of equity that can be held by commercial banks. Some lenders will not be able to hold shares in their borrowers and, if this is the scenario, an alternate solution will need to be found. However, at Quantuma, we have been able to advise corporates where their lending group have included some lenders who could, and some lenders who could not, hold shares. As long as this is known upfront, the debt to equity swap is still worthy of consideration.

Benefits of a swap

A stronger balance sheet arising from lower financing costs and the improvement of key ratios should ordinarily create an opportunity for the lender which before the swap was facing a substantial loss to recover its money. The improved financial ratios post such a swap will also be advantageous for the corporate. Of course its borrowing costs will be lower going forward, but equally important is that the improved financial ratios will encourage support from its suppliers.

Post the swap there is increased opportunity to recover the reduced debt over time and also participate in the future growth of the company through an increase in equity value.

This also has benefits for the company, its shareholders and all stakeholders, such as employees, because the company is able to continue to trade and pay its liabilities as they fall due. 

The pitfalls of a swap

In some situations, however, the amount of debt converted to equity is often insufficient to permit the company to trade out of its difficulties. It is not unusual for lenders to convert the minimum level of debt, where a swap of a greater level of debt will bring increased cash-flow savings to the company. Unless the ‘correct’ quantum of debt is swapped for equity, the corporate will not fully benefit from the swap and this could cause the company to ‘fail’ or require a second restructure. 

From the above, it can be seen that a debt swap is a complex situation and requires specialist advice. The cost of a swap can be high mainly because of the expert advice that the parties require.

Looking forward

With the new legislation, we should expect that debt swaps will stand among the viable solutions to turning around large and medium-sized companies that are in distress. 

Further guidance

Should you require any guidance on how to achieve a successful turnaround and gain the support of your lenders, please contact: Nigel Smith, Managing Director, Deal Advisory & Turnaround Services.

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Photo of Nigel SmithNigel Smith
Managing Director
Deal Advisory & Turnaround
m: +971 58 503 2646