Debt Restructuring: A Comprehensive Guide for Financial Distress

Debt restructuring is a process wherein a company or an entity experiencing financial distress and liquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount. problems refinances its existing debt obligations in order to gain more flexibility in the short term and make their debt load more manageable overall.

Reason for Debt Restructuring

A company that is considering debt restructuring is likely experiencing financial difficulties that cannot be easily resolved. Under such circumstances, the company faces limited options – such as restructuring its debts or filing for bankruptcyBankruptcyBankruptcy is the legal status of a human or a non-human entity (a firm or a government agency) that is unable to repay its outstanding debts. Restructuring existing debts is obviously preferable and more cost-effective in the long term, as opposed to filing for bankruptcy.

How to Achieve Debt Restructuring

Companies can achieve debt restructuring by entering into direct negotiations with creditors to reorganize the terms of their debt payments. Debt restructuring is sometimes imposed upon a company by its creditors if it cannot make its scheduled debt payments. Here are some ways that it can be achieved:

1. Debt for Equity Swap

Creditors may agree to forgo a certain amount of outstanding debt in exchange for equity in the company. This usually happens in the case of companies with a large base of assets and liabilities, where forcing the company into bankruptcy would create little value for the creditors.

It is deemed beneficial to let the company continue to operate as a going concernGoing ConcernThe going concern principle assumes that any organization will continue to operate its business for the foreseeable future. The principle purports that every decision in a company is taken with the objective in mind of running the business rather than that of liquidating it. and allow the creditors to be involved in its operations. This can mean that the original shareholder base will have a significantly diluted or diminished stake in the company.

2. Bondholder Haircuts

Companies with outstanding bonds can negotiate with its bondholders to offer repayment at a “discounted” level. This can be achieved by reducing or omitting interest or principal paymentsPrincipal PaymentA principal payment is a payment toward the original amount of a loan that is owed. In other words, a principal payment is a payment made on a loan that reduces the remaining loan amount due, rather than applying to the payment of interest charged on the loan..

3. 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. 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.

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.

Related Readings

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• CollateralCollateralCollateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments.
• Debt CovenantsDebt CovenantsDebt covenants are restrictions that lenders (creditors, debt holders, investors) put on lending agreements to limit the actions of the borrower (debtor).
• Debt ScheduleDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule based on its maturity and interest rate. In financial modeling, interest expense flows
• Senior and Subordinated DebtSenior and Subordinated DebtIn order to understand senior and subordinated debt, we must first review the capital stack. Capital stack ranks the priority of different sources of financing. Senior and subordinated debt refer to their rank in a company's capital stack.  In the event of a liquidation, senior debt is paid out first