If a corporation, individual, or sovereign entity is struggling to pay their debts, one option is debt restructuring. The ability to restructure debt can prevent companies from defaulting on loans, filing for bankruptcy, or even going out of business entirely. It can also be a way to lower interest rates. Bankruptcy can be complicated and costly, so debt restructuring is often the better option when it comes to addressing a company’s financial woes. So how does debt restructuring work?
Companies struggling to manage debt can negotiate directly with creditors to reorganize the payment terms on their debt. Defaults and bankruptcy can leave creditors with significantly diminished returns on their investment and no way to recoup their loss, so they are often willing to renegotiate payment terms by lowering interest rates or extending the deadline for repayment. Direct negotiations allow for more lenient repayment terms and can cut out the additional expense of having a third-party mediator. Sometimes companies will have no choice in the matter and can be forced by their creditors to restructure their debt if they cannot make the scheduled payments on the debt.
Other Types of Debt Restructuring
Besides direct and informal negotiations, there are other possibilities when it comes to restructuring a company’s debt.
Debt for Equity Swap
At times, debt restructuring may include a debt for equity swap whereby creditors will forgive a portion of the debt in exchange for equity. Creditors generally would rather take control of a company, called a going concern, when the company has significant assets and liabilities rather than have the company go into bankruptcy where they wouldn’t get as much money. Original shareholders often end up with less stake in the company when this happens.
Another potential renegotiation could be with the company’s bondholders. In this scenario, bondholders agree to a “haircut,” whereby some portion of the outstanding interest payments are written off, or part of the principal is not repaid.
Differences between Restructuring, Refinancing, and Bankruptcy
Debt restructuring requires a reduction in the debt and an extension on the repayment schedule, whereas refinancing replaces the old debt with newer debt, often under slightly different payment terms; for instance, a lower interest rate.
Bankruptcy is a legally enforced deferment of payment to creditors issued by a court. It can only be initiated by the company in question. Once granted bankruptcy status, the company can negotiate repayment with its creditors. If the company can not meet its deferred payment obligations, it must liquidate itself to repay the creditors. At that point, the court decides on the repayment terms.
Debt restructuring can offer companies in distress a lifeline to remain in business while still meeting their debt obligations.