Reviewed by Aug 26, 2020| Updated on
A debt/equity swap is a transaction through which debts or obligations of an individual or a company are traded for a preset amount of equity or stock. With a debt/equity swap, a borrower will be able to transform a loan into shares of stock or equity.
Debt-to-equity swaps are common transactions that enable a borrower to transform loans into shares of stock or equity. Mostly, a financial institution such as an insurer or a bank will hold the new shares after the original debt is transformed into equity shares.
Understanding Debt/Equity Swap
Often, a debt-equity swap takes place when a company is facing financial problems and is otherwise not able to repay any of its creditor(s) without going bankrupt. In case of an equity/debt swap, every specified shareholder will be given a right to trade their stock for a preset amount of debt in the same company. No cash will be paid in exchange for a debt-to-equity swap.
One of the possible reasons for the management to restructure a company's finances is that the company may have to meet certain contractual obligations, such as maintaining a target debt/equity ratio. The contractual obligations could be a financing requirement imposed by a bank. It can also 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 funds through a share offering if needed. If the ratio is too unbalanced, it may limit the possibilities of how they can raise cash in the future.
A company may exchange stock for debt to avoid making coupon and face value payments on the debt in the future. Instead of paying out a large amount of cash for debt payments, the company offers stock to debt holders.
Debt/equity swap in brief:
- A "debt-equity swap" involves translation of existing debt capital into equity.
- The focus of a debt/equity swap is not to introduce fresh capital, but to convert capital into financial and legal equity.
- A company might also choose to convert its debt to equity in order to improve its cash flow.
- Businesses opt for debt/equity swaps as part of a company's bankruptcy restructuring.