Debt/Equity Swap: Definition, Purpose, Example

When a company wants to restructure its debt and equity mix to better position itself for long-term success, it may consider issuing a debt/equity or equity/debt swap.

In the case of an equity-for-debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt in the same company. Bonds are usually the type of debt that is offered.

A debt/equity swap works essentially in the opposite manner: debt is exchanged for a pre-determined amount of stock. After the swap takes place, part or all of the one asset class will be phased out and everyone who participated in the swap will now participate in the new or growing asset class being phased in.

Key Takeaways

• Debt/equity swaps involve the exchange of equity for debt in order to restructure a company’s capital position.
• Doing so can improve a company’s fundamental ratios and put it on better financial footing.
• They are sometimes conducted during bankruptcies, and the swap ratio between debt and equity can vary based on individual cases to write off money owed to creditors.

Reasons for Swaps

There are many possible reasons why management may restructure a company’s finances.

One reason is that the company may need to meet certain contractual obligations, such as maintaining a target debt/equity ratio. The contractual obligations could be a result of financing requirements imposed by a lending institution, or may be self-imposed by the company as detailed in the prospectus. The company may want to keep the debt/equity ratio in a target range so they can get good terms on credit/debt if they need it, or will be able to raise cash through a share offering if needed. If the ratio is too lopsided, it may limit what they can do in the future to raise cash.

A company may swap stock for debt to avoid making coupon and face value payments on the debt in the future. Instead of having to pay out a large amount of cash for debt payments, the company offers debt holders stock instead.

In cases of bankruptcy, a debt/equity swap may be used by businesses to often offer better terms to creditors. The swap is generally done to help a struggling company continue to operate. The logic behind this is an insolvent company cannot pay its debts or improve its equity standing. However, sometimes a company may simply wish to take advantage of favorable market conditions. Covenants in the bond indenture may prevent a swap from happening without consent.

Valuing Swaps

Both equity/debt and debt/equity swaps are typically valued at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap.

For example, assume there is an investor who owns a total of $1,500 in ZXC Corp stock. ZXC has offered all shareholders the option to swap their stock for debt at a rate of 1:1, or dollar for dollar. In this example, the investor would get $1,500 worth of debt if they elected to take the swap. If the company really wanted investors to trade shares for bonds, it can sweeten the deal by offering a swap ratio of 1:1.5. Since investors would receive $2,250 (1.5 * $1,500) worth of debt, they essentially gained $750 for just switching asset classes. However, it is worth mentioning that the investor would lose all respective rights as a shareholder, such as voting rights, if they swapped their equity for debt.

Debt/Equity Swap Implications

When more stock is issued, this dilutes current shareholders. This typically has a dampening effect on share price because what the company earns is now spread out among more shareholders. 

While in theory a company could issue stock to avoid debt payments, if the company is in financial trouble, the move would likely hurt the share price even more. Not only does the swap dilute shareholders, but it shows how cash-strapped the company is. On the flip side, with less debt and now more cash on hand the company may be in a better position.

Issuing more debt means larger interest expenses. Since debt can be relatively cheap, this may be a viable option instead of diluting shareholders. A certain amount of debt is good, as it acts as internal leverage for shareholders. Too much debt is a problem though, as escalating interest payments could hurt the company if revenues start to slip. 

With there being pros and cons to issuing both debt and equity in different situations, swaps are sometimes necessary to keep the company in balance so they can hopefully achieve long-term success.

Debt/Equity Swap vs. Convertible Bond

Debt/equity swaps and convertible bonds are both mechanisms that can alter a company’s capital structure, but they serve different purposes and are executed in distinct ways.

A debt/equity swap is typically a direct restructuring process where existing debt is exchanged for equity, often used when a company is in financial distress.

Convertible bonds are a type of debt instrument that gives bondholders the option to convert their bonds into equity shares at a predetermined price after a specified period. Unlike debt/equity swaps, which are often triggered by financial necessity, convertible bonds are issued proactively by companies seeking capital with the flexibility for bondholders to become shareholders.

Convertible bonds provide investors with regular interest payments until conversion, allowing them to benefit from fixed income while still having the potential to convert to equity if the company’s stock price rises. This instrument appeals to companies looking to attract investment without diluting existing shareholders immediately.

The timing and control of equity conversion differ significantly between the two. In a debt/equity swap, conversion to equity is immediate and usually mandatory for creditors, whereas convertible bondholders have the choice to convert if it benefits them, typically waiting for favorable stock price movements.

Convertible bondholders may also decide not to convert if the stock price underperforms, thus retaining their bond with fixed income. This means that convertible bonds tend to come with a little more flexibility compared to corporate-declared debt/equity swaps.

Example of Debt/Equity Swap

A real-world example of a debt-equity swap occurred during the Great Recession with General Motors (GM) during its bankruptcy restructuring. Facing massive debt and struggling to stay afloat during the financial crisis, GM entered into a debt-equity swap with its creditors, including the United States government and the United Auto Workers (UAW) union.

In this arrangement, GM’s creditors agreed to exchange a portion of GM’s outstanding debt for equity shares in the reorganized company, effectively reducing GM’s debt burden while giving creditors a stake in the company’s future performance.

What Is a Debt/Equity Swap?

A debt/equity swap is a financial restructuring tool where a company exchanges its outstanding debt for equity shares. This type of transaction allows a company to reduce its debt burden by converting creditors into shareholders.

How Does a Debt/Equity Swap Work?

In a debt/equity swap, creditors agree to convert a portion or all of the company’s outstanding debt into equity, typically common stock. This transaction requires negotiation, as the creditor’s position shifts from being a debt holder with priority for repayment to an equity holder with potential for gains if the company recovers. The swap is usually executed based on a predetermined debt-to-equity ratio agreed upon by both parties.

Why Do Companies Use Debt/Equity Swaps?

Companies use debt/equity swaps to improve their financial health by reducing debt, enhancing cash flow, and avoiding bankruptcy. By lowering the amount owed, companies can focus on operational growth rather than servicing debt, while also potentially improving their debt-to-equity ratio.

How Does a Debt/Equity Swap Impact Shareholders?

For existing shareholders, a debt/equity swap often results in dilution, as new shares are issued to creditors. This can decrease the value of existing shares and reduce shareholders’ ownership percentage.

The Bottom Line

A debt/equity swap is a restructuring tool where a company exchanges part of its outstanding debt for equity shares, helping to reduce debt and avoid bankruptcy. This process benefits both parties, as creditors gain potential upside as shareholders, while the company strengthens its balance sheet and stabilizes its finances.