Back in October 2021, the Bank of England reported on the UK's financial stability with a particular focus on the corporate sector. One of the most striking aspects of the report was its suggestion that the number of small to medium sized enterprises ("SMEs") with debt to service had more than doubled during the Covid pandemic of 2020-2021. Despite much of this debt being issued at relatively low interest rates, the Bank of England reported that many SMEs were already concerned about their future ability to fund repayments.
Fast forward 6 months, and the geopolitical and economic climate is more uncertain than ever and interest rates are rising. Those businesses shielded from the immediate impact of rate increases by fixed interest deals or hedged positions now have a potential window of opportunity to reduce their corporate debt levels before the full effect of further anticipated rate rises is felt. Companies that are highly leveraged will likely be considering paying down debt already.
Debt for equity
There are, of course, many options for restructuring corporate debt, the most appropriate of which will depend principally on the value and prospects of the company in question and the position and priorities of its creditors.
One of the options that has historically proven particularly effective for financially viable companies is the debt for equity swap, by which the company issues shares to an existing lender in exchange for the debt being extinguished.
This briefing looks at some of the issues to bear in mind when considering a debt for equity swap.
Is the company suitable?
First and foremost, a lender will want to be satisfied that the company is financially viable before considering the possibility of a debt for equity swap. The company will need to have the potential to trade profitably and generate acceptable returns for its shareholders in order for a lender to forgive its debt and align itself instead with the company's equity investors.
Does the lender have a better option?
Whether a lender is prepared to agree to a debt for equity swap will also depend on the lender's other options. Of particular relevance to the lender will be whether:
- the lender has security it could enforce;
- there is a realistic chance of recovering all or a significant portion of the debt if the lender starts debt recovery proceedings against the company;
- the lender is able to sell down the debt, bearing in mind any restrictions contained in the terms of the facility; and
- the company has sufficient assets available to satisfy the debt if it was placed into liquidation via an insolvency process initiated by the lender or the company itself.
Can the fundamental commercial terms be agreed?
If a debt for equity swap is on the table, perhaps the most important commercial considerations for both the company and the lender are:
- How much (and which) debt will be swapped for (which) equity?
- How many shares will be issued in exchange for extinguishing the debt?
- What voting and economic rights will be attached to those shares?
The company and the lender can be expected to approach these fundamental issues from very different perspectives but reaching agreement on them is key. The end result will largely depend on the strength of their respective negotiating positions, including whether the company is in financial distress and needing to do a deal. The effect of the swap on the tax position of the company and the lender will also be highly relevant to the outcome.
Which debt and which equity?
An important factor for both parties will be the nature and extent of the company's other debts, including any amounts owed to shareholders, and how these will be dealt with. The parties will need to agree how much debt the company should realistically carry forward, bearing in mind factors such as the cost of the debt, the proposed exit strategy, and the returns expected by the shareholders.
Additionally, as a condition of swapping out its debt, a lender may require any other significant creditors to do the same. Ultimately, in becoming a shareholder instead of a creditor of the company, a lender (and particularly a secured lender) will be relinquishing its priority position in favour of other creditors. Reducing the debt owed by the company to those other creditors will give the lender more chance of maximising the potential upside for itself as a shareholder in the longer term.
Finally, where the borrower company does not sit at the top of its group structure, the shares issued by the borrower will typically need to be exchanged (via any intermediate holding companies) for shares in the ultimate holding company, so that the lender sits alongside the other investors at the top of the group.
How many shares?
The number of shares to be issued by the company will largely depend on the amount of debt to be extinguished, whether the equity is to be issued at a discount to the value of the company, and (potentially) how much control the lender expects to exert over the company as a shareholder. A lender may, for example, want to ensure it has enough voting shares to block the passing of a special resolution or to pass or block an ordinary resolution.
Conversely, the existing shareholders will not want their own shareholdings to be diluted disproportionately and will look to strike a balance in terms of the value and control they relinquish on completion of the swap.
What rights will the shares carry?
The rights attaching to the shares issued to the lender will determine the influence it has over the company when it becomes a shareholder and the economic return it can expect to receive.
As an alternative to holding a large number of voting shares in the company, a lender may prefer to take a smaller number of shares carrying weighted voting rights. These weighted voting rights would increase the lender's control over all or certain key shareholder resolutions, despite its lower percentage shareholding. The lender may also want blanket veto rights to block any proposal fundamentally affecting its interests, such as the company divesting itself of all or a material part of its assets.
In terms of economic rights, the lender is likely to expect to receive both income and capital from the company, possibly on a preferred basis and, in the case of dividends, in line with an agreed dividend policy.
More broadly, the lender's future ability to transfer its shares will also be a matter for careful negotiation. The lender may additionally look to secure, for example, the ability to appoint one or more directors or observers to the board, and drag and tag rights in the event of a proposed sale of the company.
Do the existing shareholders need to be involved?
The support of the existing shareholders is crucial to implement a debt for equity swap. This is the case not least because:
- the company's memorandum and articles of association will need to be amended to reflect the creation of any new class of shares and the rights attaching to them;
- if there is a shareholders' agreement, this will similarly need to be amended to reflect the lender's rights when it becomes a shareholder. Alternatively, a new shareholders' agreement may need to be negotiated;
- where the company has already issued different classes of shares, the holders of each share class will need to consent to any variation of their class rights arising as a result of the swap;
- the existing shareholders may have pre-emption or similar rights that will need to be waived to enable the shares to be issued to the lender; and
- having the support of as many shareholders as possible will help mitigate the risk of a shareholder challenging the swap on the grounds that its interests have been unfairly prejudiced.
Debt for equity swaps are not new, but they can still have much to offer companies navigating today's increasingly uncertain geopolitical and economic waters. To discuss how our cross-jurisdictional team of advisors can help, please call or email us or your usual contact at Bedell Cristin.