Often a good underlying business can find themselves in financial strife. If attended to early enough, these businesses may be saved with some financial restructuring.
It helps, in such instances, if the company has secured creditors that are willing to work with them to affect a better outcome rather than throwing everything away for no real benefit.
A consensual restructure with secured and unsecured lenders is the easiest path where a lender, or group of lenders, agree to accept shares in exchange for a partial repayment of debt. This is commonly referred to as a “debt-for-equity swap”.
The advantages of a consensual restructure
The advantages of a consensual restructure with such lenders are:
- Prevents value destruction that often results from formal external administration
- Minimum disruption to business
- Lack of adverse publicity
- Profits generated post-restructure will benefit shareholders and creditors
- Relatively simple and fast to implement
- No need for external administration or Court proceedings, consequently reducing restructuring costs and time to implement.
The disadvantages of a consensual restructure
The disadvantages of a consensual restructure with lenders are:
- The agreement only binds the lenders that agree and cannot bind other creditors or other parties. However, if these lenders represent the majority of creditors and have some form of security, they may be able to exert influence on the other creditors.
- The agreement requires compliance with the approval thresholds under the:
- Finance and security documents
- Company’s constitution
- Any shareholders’ agreements, and
- Shareholder approvals required under the Corporations Act and ASX Listing Rules (if applicable).
The key issues
- Whether lenders are willing and able to take equity instead of cash as repayment of the loan debts
- Determination of the price that the shares will be issued at
- An exit strategy for these lenders by way of a liquidity event.
Shareholders rank behind creditors for repayment of capital, so the financial risk faced by shareholders is greater than that faced by creditors. It makes sense, therefore, that they would want a higher return on their equity to compensate for the additional risk when converting from debt to equity. So, the transaction may involve some form of “discount” from the value of debt to the replacement value of equity.
For companies experiencing financial difficulty, the closer the company is to projected insolvency when it undertakes the share issue, the greater the discount to the share price required by lenders/investors. Accordingly, the earlier the company moves to address solvency issues the better the outcome.
The willingness of lenders to negotiate a debt-for-equity swap will be governed by:
- The value of the company’s assets as a whole compared to the company’s liabilities as a whole
- For secured lenders, the value of the assets that they have security over, and
- For unsecured lenders, their likely return in the event of liquidation of the company.
Commonly unsecured lenders and secured lenders with security over assets, the value of which is less than the amount of the loan, are more willing to agree to a debt-for-equity swap. The reason for this is that if they do not agree, the only alternative may be external formal administration and possibly liquidation, where those lenders would receive a significantly smaller return or, often, no return at all.
- Major bank lenders are unlikely to be able to accept equity as full or partial repayment of their loan debt;
- Non-bank lenders and major shareholders who have also advanced funds to the company are more likely to consider converting some or all of their debt to equity, notwithstanding that this will be dilutive to existing equity that they may hold
- Equity conversion of non-bank and shareholder loans is often a condition imposed by major lenders before they will agree to amend their loan terms, such as deferring interest payments, or granting waivers of covenant breaches, or extensions to loan maturity dates, and
- A new lender considering refinancing an existing major bank loan may impose the same conditions as detailed above. Obtaining non-bank finance that has flexibility in taking debt for equity may enable the company to continue in business and realise a return for all.
Government bodies cannot participate in debt for equity swaps but may defer action if major creditors are shown to be assisting in a restructure.
Informal restructures, such as contemplated above, are difficult and require specific expertise. At dVT Group we have undertaken many informal restructures and would be happy to discuss scenarios with you and your clients on a confidential basis.
If you would like to discuss any of the above, please contact dVT Group on (02) 9633 3333 or by email firstname.lastname@example.org.
dVT Group is a business advisory firm that specialises in business turnaround, insolvency (both corporate and personal), business valuations and business strategy support.