Ever since Evergrande Group’s debt bubble burst in September this year, the company’s financial crisis has rarely been out of the headlines. On 3 December, it announced it was exploring ways to restructure its debt, including solutions to its overseas liabilities and actively promoting overseas debt restructuring. Then, the Guangdong government stepped in, announcing that it would dispatch a working group to the company. A few days after that, Evergrande’s board announced the formation of a risk management committee.
It seems clear that Evergrande’s debt crisis is beginning to come under control. Whether this was the result of the group’s own efforts to resolve its capital dilemma via asset sales, or its decision to seek a restructuring plan under government leadership is unclear. But it all comes down to quickly raising funds for Evergrande to prevent the debt-mired group from lurching a step closer to bankruptcy.
In respect of the debt restructuring options of distressed companies, this article focuses on financing means with dual characteristics of being both debt- and equity-based: debt-to-equity swap and convertible bonds.
Debt-to-equity swaps are often just a means to transfer risks, reduce the debt and interest burden of the company, relieve pressure, or lay foundations for subsequent reform. This method more or less leaves the creditors to deal with their own assets, rather than seeking direct financing, but is frequently used in debt restructuring as it is a way of directly postponing the crisis of debtors.
Policy-based debt-to-equity swap. In China, debt-to-equity swaps are closely linked with social transformation and the reform of state-owned enterprises. Debt-to-equity swaps were initially aimed at solving the long-standing debt burdens of state-owned enterprises and the problem of non-performing loans at banks. Four major financial asset management companies established by the state acquired the non-performing assets of banks, transforming the original creditor-debtor relationship between banks and enterprises into the shareholding or controlling relationship between financial asset management companies and enterprises. After the creditor’s rights were converted into equity, the original repayment of principal and interest became distribution of dividends according to shareholdings.
The four major asset management companies became the shareholders of the enterprises at a certain stage, exercising their lawful shareholders’ rights and participating in the decision-making of material affairs. But they did not participate in the day-to-day production and operating activities of the enterprises. After the enterprises began emerging from their economic struggles, the asset management companies recovered their investment through selling their sakes via listing, transfer or repurchases by the enterprises.
Since then, debt-to-equity swaps have evolved. Before China implemented the market-oriented debt-to-equity swap, there were three main types of the transaction:
- Replacement of “appropriation-to-loan swap” by “loan-to-investment swap”. Under this method, the loan was converted into equity in the enterprise through the state-owned asset management company that controlled the distressed enterprise through capital expansion. The enterprise was reformed to help the loss-making state-owned enterprise to arrange its debts.
- Swap of bank creditor’s rights to equity: social intermediary agencies accepted creditor’s rights transferred by banks and participated in corporate debt restructuring, thus converting creditor’s rights into equity.
- Inter-company debt-to-equity swap, including shareholding system reform, conversion of creditor’s rights into additional equity, triangle replacement, etc.
From the inclusion of the vice president of China Cinda Asset Management in members of the aforesaid risk management committee of Evergrande Group, to the intervention of the Guangdong provincial government, it can be inferred that Evergrande’s subsequent debt restructuring scheme is likely to involve a government-led debt-to-equity swap.
Market-oriented debt-to-equity swap. The methods of market-oriented debt-to-equity swap are mainly as follows:
- Accepting debts and converting them into equity: accept creditor’s rights first and then convert them into equity.
- Issuing shares to repay debts: the debtor issues new shares directly through the financial market, and provides security for the creditor’s rights by creating a mortgage over the shares.
- Fund: a commercial bank, an equity transfer company and a third-party asset management company jointly establish a fund that further establishes a debt-to-equity joint venture company. The joint venture company becomes a shareholder of the target company by subscribing for its additional capital, and the fund manager indirectly manages the target company by managing the joint venture company.
- A combination of equity and debt: banks and other institutions implementing a debt-to-equity swap, in order to meet the needs of companies to reduce leverage, provide services for companies to help them obtain funds when signing agreements, such as increasing entrusted loans, increasing credit, private placement, to provide comprehensive financial services for companies.
- Debt-to-preference shares: the debtor and the creditor sign an agreement to convert the creditor’s rights into preference shares of the company.
Each of the above methods has its own pros and cons. However, considering the current situation of Evergrande, if it fails to repay certain overseas debt and falls into default, causing a “debt run”, it will be more difficult for Evergrande to issue bonds again. However, fund establishment remains an option and the setting up of a relief fund can relieve its financial pressure.
Convertible bonds are securities issued by companies and traded in the secondary market. According to the terms of the debt sale, bondholders can convert their holdings into common shares of the company within a specified period in the future. The bonds include
basic elements such as nominal – or face – value, conversion price, conversion period and the coupon, or interest rate received by holders. The purpose of issuing convertible bonds is to reduce the financing cost and postpone the equity premium. Convertible corporate bonds share attributes of stock, bonds and options. After convertible bonds reach the conversion period, bondholders can decide whether to convert their bonds into shares, thus giving investors the possibility of obtaining a greater proportion of equity.
Convertible bonds avoid some of the disadvantages of debt-based and equity-based financing that, under the condition of asymmetric information, debt contracts are not very good incentives, and there is great agency cost for equity contracts. Convertible bonds can balance the interests of both the principal and the agent by way of share purchase agreement. Moreover, convertible corporate bonds can also serve as a good source of financing for companies undergoing bankruptcy reorganisation.
Zhu Xi is a partner and Feng Yuduo is an associate at DOCVIT Law Firm
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