Debt/Equity Swap

A debt/equity swap is a restructuring transaction in which a company’s debt is exchanged for equity, typically by converting bonds or loans into shares. This strategy reduces debt obligations, improves the balance sheet, and can allow a distressed company to continue operating rather than liquidating.

Key points

• A debt/equity swap converts creditors’ claims into ownership stakes, altering capital structure and ownership.
• Swaps are common in restructuring and Chapter 11 bankruptcies, where creditors may be required to accept equity under a reorganization plan.
• Swap terms (the trade or conversion ratio) and valuation determine how attractive the offer is to creditors.
• The opposite transaction—an equity/debt swap—exchanges equity for debt and is used in different restructuring contexts.

How it works

1. Negotiation: Company management and creditors negotiate terms, including what portion of debt will be converted and the equity percentage offered.
2. Valuation and ratio: A swap ratio assigns equity value for each unit of debt. Favorable ratios give creditors more equity relative to the debt they surrender; unfavorable ratios give them less.
3. Authorization: Outside bankruptcy, bond indentures or covenants may require creditor consent for a swap. In bankruptcy, a court-approved reorganization plan can compel acceptance.
4. Implementation: Debt is canceled or reduced and new or existing shares are issued to creditors, changing the ownership and capital structure.

Why companies use swaps

• Reduce leverage and interest burdens without immediate cash outflow.
• Preserve operations and value that might be lost in liquidation.
• Restore debt/equity ratios to meet lender covenants or new financing needs.
• Align creditor incentives with future company performance.

Role in bankruptcy

In Chapter 11 reorganizations, existing equity is often canceled and replaced by new equity issued to creditors—effectively a debt/equity swap. This lets the business continue operating while creditors become shareholders and may recover more than they would in liquidation. In Chapter 7, the business liquidates and swaps are generally not relevant.

Benefits and risks

Benefits:
* Lowers debt service obligations and frees cash flow.
* Can avoid distress costs and preserve going-concern value.
* Gives creditors upside if the reorganized company succeeds.

Risks and trade-offs:
* Existing shareholders are diluted or wiped out.
* Creditors become owners with equity risk—value depends on future performance.
* Market perception and governance change; new shareholders may push different strategies.
* Complex legal, tax, and valuation issues can arise.

Example

Company ABC has $100 million of debt it cannot service. ABC offers its two primary creditors a combined 25% ownership stake in exchange for canceling the $100 million obligation. The creditors accept equity in lieu of payment; the company’s debt is reduced by $100 million and its ownership structure changes to reflect the new shareholders.

Comparison: debt/equity vs. equity/debt swap

• Debt/equity swap: Debt → Equity. Used to reduce liabilities and restructure a distressed balance sheet.
• Equity/debt swap: Equity → Debt. Used to raise secured financing or smooth mergers/restructurings by issuing debt in place of equity.

Considerations for stakeholders

• Creditors should evaluate recovery prospects under the swap versus alternative outcomes (e.g., liquidation).
• Existing shareholders should assess dilution and long-term implications for control and value.
• Companies must consider covenant restrictions, regulatory and tax consequences, valuation methodology, and potential stakeholder objections.

Bottom line

A debt/equity swap is a powerful restructuring tool that can reduce leverage, preserve a company as a going concern, and convert creditors into owners. It redistributes risk and potential upside and typically requires careful valuation, negotiation, and legal approval—especially in bankruptcy. Consult financial and legal advisors to assess suitability and implications for specific situations.