T.S.S Grain Millers, which was placed under receivership for defaulting on a bank loan. FILE PHOTO | NMG 
For many businesses, failing to pay a
bank loan has in the past led to enforcement proceedings that result in
the sale of assets by lender so as to recover the outstanding debt or
even going into insolvency where a receiver or liquidator is appointed
to sell the assets.
But the Insolvency Act 2015 has
made it clear that companies and lenders should first consider a
turnaround strategy that brings the distressed company back to health as
well as minimise the lender’s provision for bad debt.
One
of the options within a turnaround strategy that is often overlooked is
the debt for equity swap (“swap”). Many companies are profitable and
cash-generative operationally but have insufficient cash to service the
entire borrowing.
It is exactly in this scenario where
the debt to equity swap can be of use to the company and the lender. A
swap in simple terms is where a lender agrees to reduce his loan and in
return gets a shareholding (equity) in the company that owes it money.
Usually,
this does not entirely wipe out the debt but there is naturally a
reduction in the amount of cash required to service the new (lower)
level of debt as both principal and interest payments are reduced.
Top
on the list of benefits is gearing and improvement of other key ratios
that the lenders and trade creditors often monitor. The result is that
the trading possibilities of the company are enhanced post the swap.
To
deliver a swap, it may be necessary to increase the share capital of
the company in distress. Often, a swap comes with the raising of new
equity as a way of moving the company back to health. This, however,
will have dilution impacts on existing shareholders.
It is important to make it clear that the mechanics of
delivering a swap are complex and it should not be the first option when
a borrower cannot service his or her obligations.
There
are numerous technicalities that must be followed for a swap to be
delivered. Many of these require expert advice in tax, legal and
financial areas.
This makes it critical that any
business or lender that is considering taking the swap option must have
advisers with the required skills and experience.
Challenges faced during a swap
Often,
the journey begins with an agreement among existing shareholders to go
for a swap — a difficult step as shareholders will be signing off to be
diluted.
However, as this is usually done to prevent
an insolvency, existing shareholding will most likely be aware that they
have little value left in their company at the time of going for a
swap.
The actual level of shares held post the swap
will depend on the amount of debt that has to be converted. Even in the
most extreme cases it is normal for existing shareholders to be offered
at least a nominal shareholding so as to gain their support.
The
level of security that the borrower had offered for the debt also
matters. This is because lenders are unlikely to consider the swap
option if they are fully secured since they can easily realise security
to obtain recovery in the short term.
Exit planning
The
lender needs to be clear how to exit (ability to sell the shares held
post the swap) as lenders do not typically like to be long-term equity
holders in companies that owed them money. Indeed there are restrictions
on the amount of equity that can be held by commercial banks.
Benefits of a swap
A
strong balance sheet arising from lower financing costs and the
improvement of key ratios should ordinarily create an opportunity for
the lender, who before the swap was facing a substantial loss, to
recover its money.
Post the swap there is increased
opportunity to recover the reduced debt over time and also participate
in the future growth of the company through an increase in equity value.
This also has benefits for the company, its
shareholders and all stakeholders such as employees, because the company
is able to continue to trade and pay its liabilities as they fall due.
The pitfalls of a swap
In
some situations, however, the amount of debt converted to equity is
often insufficient to permit the company to trade out of its
difficulties.
It is not unusual for lenders to convert
the minimum level of debt, where a swap of a greater level of debt will
bring increased cash-flow savings to the company.
The cost of a swap is often high mainly because of the expert advice that the parties require.
With
the new legislation, we should expect that debt swaps will stand among
the viable solutions to turning around large and medium-sized companies
that are in distress.
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