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.