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The amount of debt swapped for equity will be an outcome of negotiations, but should enable the loan workout’s objectives to be met. Factors that influence this issue include:

If there is a balance sheet deficit, it is very likely that the company’s net worth will need to be restored. In this case, the target post-restructuring net worth of the company needs to be evaluated, for example, by making financial projections for a number of future accounting periods. This will directly impact on the amount of debt that should be swapped for equity.

The appropriate level of post-restructuring gearing will vary considerably between situations and the overall objectives of the loan workout. If a sustainable restructuring perhaps involving the raising of new debt or equity funds is envisaged, the balance sheet indicators may be required to reflect industry norms. In most workout cases, however, this may not be necessary. For instance, a restructuring which anticipates the short- or medium-term disposal of a substantial part of the business should be able to sustain a higher initial gearing.

If debt servicing is a temporary problem, it may suffice to convert some of the company’s debt into low or zero coupon bonds, say with warrants, or even to simply agree an interest holiday.

As highlighted previously, a high swap ratio may be necessary to attract new debt or equity. If so, the lenders need to consider how much new debt or equity could be raised, on what basis and whether the trade-off is acceptable.

Generally, the principal objective of loan workouts is to re-establish financial stability to a group’s operations. The swap ratio is the principal determinant of financial stability in a restructuring. It directly affects how much residual debt remains on the company’s balance sheet. It is therefore important to ensure that the lenders’ natural desire to preserve as much debt as possible does not defeat the main purpose of the restructuring.

The amount of debt to be converted into equity is probably the most sensitive issue in debt for equity swap negotiations. It often takes the longest time to resolve. The conflict between the interests of the company and its shareholders on the one hand, and the lenders on the other, is the most transparent in this area. This is because the share of a company’s enlarged equity that lenders receive tends to be relatively insensitive to the swap ratio, as existing shareholders’ minimum needs must be satisfied.

As a result, a higher swap ratio tends to reduce the likely return for the lenders. On the other hand, the more of their debt that the lenders convert, the higher is the potential value accruing to the shareholders.

This problem is compounded in some jurisdictions if the lenders are automatically required to make a provision against any debt that has been converted into equity. The greater the swap ratio is, the higher the loss that the lenders have to recognise immediately.

This conflict of interest is also present in the perception of risk. The higher the swap ratio, the lower the financial risk of the company. Management needs to service a lower debt burden and, as a result, the value of the company’s shares increases. The lenders, however, are thereby relegating a higher proportion of their exposure to the company to claims behind the company’s creditors who may currently rank after them.

In reality, however, the lenders’ traditional argument in this matter is relatively weak. A properly structured swap transaction essentially crystallises the lenders’ effective equity risk position, enabling them to share in the commensurate potentially higher returns.