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.