by Debt restructuring is a process that allows a private or public company or a sovereign entity facing cash flow problems and financial distress to reduce and renegotiate its delinquent debts to improve or restore liquidity so that it can continue its operations.
Replacement of old debt by new debt when not under financial distress is called “refinancing”. Out-of-court restructurings, also known as workouts, are increasingly becoming a global reality.
Debt restructuring involves a reduction of debt and an extension of payment terms and is usually less expensive than bankruptcy. The main costs associated with debt restructuring are the time and effort spent negotiating with bankers, creditors, vendors, and tax authorities.
Creditors of corporates are generally banks and non-banking financial companies (NBFCs). The corporate debt restructuring is done by lowering the amount of payable towards the debt. Also, the interest rate is lowered. However, the repayment tenure is enhanced, which would help the company in paying the outstanding dues.
At times, a part of the company’s debt would be waived off by the creditors. But, that would be in exchange for equities of the company. Nevertheless, this kind of arrangement is more favourable for the distressed company as compared to declaring themselves to be bankrupt and undergo tedious procedures.
Methods
Debt-for-equity swap
In a debt-for-equity swap, a company’s creditors generally agree to cancel some or all of the debt in exchange for equity in the company.
Debt for equity deals often occur when large companies run into serious financial trouble, and often result in these companies being taken over by their principal creditors. This is because both the debt and the remaining assets in these companies are so large that there is no advantage for the creditors to drive the company into bankruptcy. Instead, the creditors prefer to take control of the business as a going concern. As a consequence, the original shareholders’ stake in the company is generally significantly diluted in these deals and may be entirely eliminated.
Bondholder haircuts
A debt-for-equity swap may also be called a “bondholder haircut”. Bondholder haircuts at large banks were advocated as a potential solution for the subprime mortgage crisis by prominent economists:
Economist Joseph Stiglitz testified that bank bailouts “are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this”. He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.
Economist Jeffrey Sachs has also argued in favor of such haircuts: “The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices.”
If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute dollars and the government may be able to just provide guarantees in the short term to buttress confidence in the recapitalized institution. For example, Wells Fargo owed its bondholders $267 billion, according to its 2008 annual report. A 20% haircut would reduce this debt by about $54 billion, creating an equal amount of equity in the process, thereby recapitalizing the bank significantly.
Informal Debt Repayment Agreements
Companies that are restructuring debt can ask for lenient repayment terms and even ask to be allowed to write off some portions of their debt. This can be done by reaching out to the creditors directly and negotiating new terms of repayment. This is a more affordable method than involving a third-party mediator and can be achieved if both parties involved are keen to reach a feasible agreement.
Debt Restructuring vs. Debt Refinancing
Debt restructuring is distinct from debt refinancing. The former requires debt reduction and an extension to the repayment plan. On the other hand, debt refinancing is merely the replacement of an old debt with a newer debt, usually with slightly different terms, such as a lower interest rate.
Debt Restructuring vs. Bankruptcy
Debt restructuring usually involves direct negotiations between a company and its creditors. The restructuring can be initiated by the company or, in some cases, be enforced by its creditors.
On the other hand, bankruptcy is essentially a process through which a company that is facing financial difficulty is able to defer payments to creditors through a legally enforced pause. After declaring bankruptcy, the company in question will work with its creditors and the court to come up with a repayment plan.
In case the company is not able to honor the terms of the repayment plan, it must liquidate itself in order to repay its creditors. The repayment terms are then decided by the court.
