The planned repayment of loans and outstanding debt can sometimes get upended as a result of circumstances. Consequently, a business may find itself in a situation where it cannot pay off the debts as planned. As a result of this, the defaulting business stands the risk of going into insolvency proceedings. This is risky for the business and the lenders – the business may lose the collateral in the proceedings. In contrast, the lenders may receive lesser from collateral than the repayment schedule.
Additionally, the whole proceedings are time-consuming, involving costs. Debt restructuring helps work out a solution in such scenarios – by offering the business and the lenders an option to get the best out of a tricky situation. Here is a look at how debt restructuring works.
Is debt restructuring the same as debt refinancing?
It is time to remove misconceptions about the similarity with refinancing. Refinancing is an entirely different concept and is unrelated to debt restructuring. Refinancing is the availing of a new loan to replace an existing loan, with probably lesser interest rates, which helps the borrower to handle the repayment better.
Restructuring is all about existing debts and could include an extension of the repayment, a reduction of the amount involved, a swap of the debt for equity, or an agreement on how the sale proceeds will be disbursed among lenders.
Debt refinancing is not the last resort of a borrower and offers the borrower additional time to clear the debts. Debt restructuring is the last resort and effectively signals the end of all debt options available to a borrower.
What are the various options in debt restructuring?
The goal of debt restructuring is to allow businesses and lenders to handle the debt repayment in a suitable manner to all stakeholders. Under the debt restructuring mechanism, a lender may be willing to forego part of the outstanding debt in return for a settlement. Known as a “haircut,” this involves a write-off of part of the loan amount, the principal, and the interest.
While it may appear as a losing proposition to a lender, it is effectively a sound option. The lender effectively receives an enforceable commitment for the loan amount that has not been written off. In other words, a lender who was at risk of losing a significant portion of the loan amount ends up with a better deal.
Debt restructuring is not only about ‘haircut’ but includes other options. For instance, a company may go into complete bankruptcy, and the debt restructuring will then be only a re-arrangement of loans in such a manner as to reorganize the repayment hierarchy from the bankruptcy proceedings.
Under this option, a lender who first extended the loan receives higher priority in the settlement, while the other lenders move down in priority. This debt restructuring is intended to ensure that the lien on the collateral is arranged to offer lenders proportionate settlements and in the right order of payment.
Standard debt restructuring formulas include reducing interest rates of the loan and an extension of the loan repayment tenure. This is always the first choice of businesses, as the business protects its interest fully, with the collateral remaining safe. In banks and financial institutions, the reduced interest and extended tenure effectively offer lenders a better chance of receiving the loan amount.
This contrasts sharply with the option of receiving a lesser settlement as a result of bankruptcy proceedings. Debt restructuring offers a better solution in stressed-out scenarios and is the best option for the business and the lender in terms of settlements.
Why is debt restructuring necessary or essential?
The primary goal of lenders is to protect the funds used for extending loans. The principal amount and the expected interest from the principal amount drive the lender’s operational model. Similarly, a business’s primary objective is to protect the collateral and continue to exercise control over the collateral.
Bad debts can change the situation quickly, and the continued inability to repay the loan can result in a situation where the business has to file for bankruptcy. On the conclusion of bankruptcy proceedings, the lenders receive a proportionate amount, which may not be the amount that was expected to be recovered through principal+ interest repayment.
In a very small percentage of cases, lenders receive a good deal from bankruptcy proceedings. Similarly, a business ends up losing its collateral during bankruptcy proceedings, which can jeopardize the interests, business model, and operations.
Debt restructuring offers all stakeholders a way out of a challenging situation. Lenders were willing to forego a part of the outstanding amount – the principal and interest – help the business meet the repayment requirements and permit the business to continue earning revenues. This keeps the debt repayment cycle open and eventually resulting in repayment of debts that have been reduced accordingly.
What is debt for equity swap?
In addition to the various debt restricting options discussed above, another famous debt restructuring formula is the debt for equity swap. This involves the lenders getting control over a functioning business entity or asset, in turn, for writing off either a portion of the outstanding debt or the complete outstanding amount.
This entirely depends on the value of the collateral/potential earning capacity of the collateral. This swap of debt for equity works in favor of the lender as the lender may not expect to receive a good settlement if the collateral is put up for sale as part of bankruptcy proceedings.
However, the business ends up losing the collateral. A debt for equity swap is often the last resort of the business, and a partial write off is always the first choice of business.
Similar debt restructuring formulas that are presently used
In addition to the above, other debt restructuring formulas are used to handle situations of bad debts. A business that cannot meet its obligations of repayments can seek a change in terms of repayment.
This applies to situations where the business does not expect or anticipate any positive change in its earnings ability or its ability to repay the loan. In the eventuality of such scenarios, a business may seek renegotiated terms with the lender.
Under the renegotiated terms, lenders may agree to reduce the mortgage amount by a certain percentage. In lieu of this consideration, the lender receives a commission for a particular percentage of the asset’s sale proceeds when the borrower sells it.
This works to the advantage of the borrower and the lenders as the borrower gets into a position where it is possible to attempt salvage of the asset or retrieve some value from the asset. The lender gets a firm commitment regarding the percentage or value that would be payable at a specific time. This is a better deal with clear visibility of expected payout, rather than the receivables’ uncertainty and timelines.
What is the difference between debt restructuring and bankruptcy?
Debt restructuring refers to the agreement between a borrower and lender/s about renegotiated terms of debt. This could be one of many options and is a mutual agreement, enforceable by the lender. Bankruptcy is more about a legally enforced repayment plan that is put in place under an agreement between the borrower, the lender, and the enforcing authority.
Businesses that are unable to honor the terms of the bankruptcy repayment plan will end up being liquidated, following which the enforcing authority handles the repayment. Debt restructuring and bankruptcy are different, though debt restructuring could also plan for bankruptcy repayment. A business can go into bankruptcy directly or try debt restructuring, followed by a bankruptcy plan to repay borrowers.