Whenever a company faces business and profitability disturbances, it can be a challenge to attain the desired capital structure. In such situations, there may be a need for refinancing or rescheduling, since passive shareholders may become activists and conventional capital market opportunities may be restricted.
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What is Debt Restructuring?
Debt restructuring is a process by which companies or sovereign entities avoid the risk of defaulting on their existing debt or lower availability of interest rates. It is a mechanism in which a corporation or organization refinances its current loan obligations in order to achieve greater short-term stability to ensure that the total management of its debt more manageable. It requires modifying the provisions of current debt and so this mechanism is considered where the financial crisis makes it difficult to meet the current lending requirements. This restructuring objective is to negotiate on further payment schedules and requirements, in order to prevent insolvency.
How does it work?
Companies tend to restructure their debt when they’re reaching bankruptcy. They can prioritize their loans to see which are superior compared to the others so that those loans can be paid first. Creditors can also sometimes alter the debt to avoid default or bankruptcy as they know that they will receive a lower amount if the company goes bankrupt or liquidates. Generally, in the debt restructuring process, companies reduce their interest rates on the loans and extend the dates on which their liabilities are to be paid. Often, the creditors will waive a percentage of the company’s debt. But it will be in return for the company’s shares. This may also include a bond haircut where a company may agree on the write-off of a proportion of interest or capital. Consequently, this form of agreement is better than declaring bankruptcy and undertaking tedious proceedings for the troubled business.
Reasons for debt restructuring:
The frequent shifts in today’s economy may be challenging for companies; hence debt restructuring will act as a short-term and long-term solution to sustainable business profitability. Debt restructuring is done when a company goes through financial distress that is not easily resolved, so the company either has the option of restructuring its debt or file for bankruptcy. The former is obviously preferable and cost-effective as compared to the latter. The company restructures its debt obligations so it can have the flexibility and manage its debt better in the short term.
Types of debt restructuring:
- Debt for equity swap: Creditors agree to reduce the amount of outstanding debt in exchange for equity in the company. This generally happens when the company has a large number of assets and liabilities and so forcing the company into bankruptcy is less lucrative to the creditors.
- Bondholder haircuts: Companies that have outstanding bonds can negotiate with bondholders to write off a part of the outstanding interest or principal payments.
- Informal debt repayment agreements: The companies can renegotiate directly with the creditors to write off some portion of their debt or ask for lenient repayment terms.
- An individual who can’t pay a $300,000 mortgage can renegotiate with his creditors to reduce the mortgage to 50% i.e. $150000 in return for 30 % of the sale proceeds when the mortgager sells the house.
- A company owes its bondholders $2,000,000. If they negotiate with the bondholders and get a 20% haircut, their debt would be reduced by $400000.
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Companies that are on the brink of bankruptcy can restructure their debt by negotiating with creditors and bondholders. From the creditor’s perspective, it is a better option to forgo some debt as forcing the company into bankruptcy would be less profitable. As the company avoids bankruptcy and lenders typically benefit more than they would in a bankruptcy proceeding, debt restructuring can be a win-win scenario for all parties.
Author – Abha Shetty
About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.