What is Debt Restructuring and How Does it Work?
There may arise situations when companies face a cash crunch. In such a situation, it becomes difficult for the company to repay its lenders or fulfil its outstanding dues. As a result, businesses may have to declare bankruptcy. Thankfully, the concept of debt restructuring can help companies avoid such situations and manage their debt in a more efficient manner.
This blog explores how companies use debt restructuring and what are the different methods that can be used to do so.
What is Debt Restructuring?
Debt restructuring is a process where companies or entities facing financial distress or illiquidity seek assistance from lenders to refinance their debt and re-package it. Companies can prevent themselves from filing for bankruptcy by renegotiating the terms of their debt obligations to gain flexibility in the short-term and manage their overall debt load.
What is Strategic Debt Restructuring?
With a rise in non-performing assets (NPAs), the Reserve Bank of India (RBI) has implemented a strategic debt restructuring scheme to enable banks to deal with bad loans more efficiently.
Using this scheme, banks can recover bad loans from distressed companies by converting the outstanding dues into equity, thereby taking control of these companies. A consortium of lending institutions (also known as a joint lenders forum) is involved in converting debt, including banks and other financial institutions.
What are the Types of Debt Restructuring?
The various types of debt restructuring are categorised depending on the entity at stake.
1. Corporate Debt Restructuring
Companies may enter into negotiations with its lenders to reorganise their existing debt payments. Alternatively, a company’s creditors may introduce corporate debt restructuring to the company if it cannot make the scheduled debt payments.
2. Sovereign Debt Restructuring
Sovereign debt is issued by the Government of a country in the form of securities. A sovereign debt crisis in a country refers to a situation where the country is not able to repay its debt to its creditors on time. In such a situation, the country packages its debt and refinances it to sustain its economy.
Historically, countries like Greece, Pakistan, Turkey, and many more have opted for sovereign debt restructuring. The debtors and creditors enter into negotiations to modify the terms of the sovereign debt.
3. Personal Debt Restructuring
Individuals facing insolvency might renegotiate the terms of their debt with creditors. This could include steps like seeking a reduction in the interest rate due to not being able to repay the debt. Individuals also ask creditors to increase the repayment tenure to try and repay the debt in small instalments.
Individuals experiencing mounting credit card debts may seek credit card restructuring, by which they can restructure their outstanding dues. Many credit card companies provide relief for debtors facing such situations by lowering the interest rates or reducing the amount of late payments or penalty fees.
Also Read: What Is Moratorium Period On A Loan And How Does It Impact A Borrower?
How Does Debt Restructuring Work?
Debt restructuring works by renegotiating the terms of the current debt so that it becomes easier for the distressed entity or company to repay the debt rather than defaulting. The process entails renegotiating contracts to obtain better repayment terms, which gives rise to more flexible solutions.
The following steps will guide you toward restructuring your debt:
Step 1: Get in Touch with Your Lender
Instead of waiting for the lender to contact you for missed payments, get in touch with them. Explain your situation to them and how it has become financially difficult for you to repay the debt.
Step 2: Wait for the Lender’s Response
Lenders and creditors are under no obligation to accept your proposal; they want their borrowers to repay the debt on time as per the agreed repayment schedule. Wait for the lender’s response to see what they offer.
Step 3: Analyse Your Options
Some lenders may suggest a few offers to the borrower. If your lender does the same, compare pros and cons of all the options before accepting one.
Step 4: Enter into Negotiations with the Lender
Before you accept an entirely new debt restructuring offer, try to negotiate the terms of your old loan with the lender.
Step 5: Accept the New Terms
If there is an offer you like after negotiations, accept its terms and conditions and sign the paperwork.
Debt Restructuring Methods
The different methods used by debt restructuring companies to restore liquidity are outlined below.
1. Debt For Equity Swap
Some lenders agree to forego a certain amount of the outstanding debt in exchange for a specific percentage of equity in the company. This method is usually followed where companies have a large asset base, and the company declaring bankruptcy would not bring much value to the creditors.
The stake of the original shareholders gets diluted and the creditors would hold a stake in the company, observing its operations to ensure the company becomes profitable and the creditors get their fair share.
A great example of the debt-to-equity swap is Vodafone Idea where the Government picked up a majority stake in the company in exchange to forego some of its AGR dues debt.
2. Bondholder Haircut
At the brink repayment default, a company may negotiate with its bondholders to provide flexibility vis-a-vis bond payments. The flexibility allows the company to reduce some of the outstanding interest payments or principal amounts or even omit a portion of the outstanding dues. The company may also get the flexibility to make the payments at a discounted price.
3. Renegotiating Repayment Terms
The company may renegotiate the terms of debt repayment, such as writing off a part of the outstanding loans, reducing the interest rate, or increasing the repayment tenure.
Companies may even use callable bonds to avoid situations resulting in a default of their interest payments.
A callable bond can be redeemed early by the issuer and is used in times of decreasing interest rates. As a result, the company’s existing debt can be replaced with new debt taken at a lower interest rate as a part of debt restructuring.
What are some Debt Restructuring Alternatives?
One commonly used alternative to debt restructuring is debt refinancing. Debt refinancing is a way of offering support to distressed entities.
In the case of debt refinancing, the borrower draws a fresh loan contract that has better terms than the original contract. Debt restructuring involves making changes to the existing loan contract.
Suppose a distressed entity has taken a significant loan but does not have sufficient funds to repay it. In such a scenario, the entity may get another financier to finance a fresh loan with more favourable terms like a lesser interest rate. Debt refinancing can be done when there is a significant slash in the interest rates that benefits the borrower.
However, it has significant risks, such as increasing the debt burden. Moreover, borrowers need to conduct proper due diligence before entering into debt refinancing and analysing the net present value of the cost of the second loan they are taking.
There are several other alternatives to debt restructuring, such as:
- Debt Consolidation: If you have multiple outstanding loans, you can package them into one loan and repay it.
- Debt Management Plan: You can seek the help of a non-profit credit counselling organisation instead of seeking help from your lender. The counsellor can make negotiations with the lender on your behalf.
- Loan Forbearance or Deferment: You may be able to skip some payments without being charged late fees.
- Declare Bankruptcy: If it has become financially unfeasible to afford repaying the loan, the last resort is to declare bankruptcy. In this case, the lender might enter into negotiations with the lender at the court and may liquidate assets to repay the loan as a last ditch effort.
Functions of Debt Restructuring
Debt restructuring serves a variety of functions, some of which are mentioned below.
- Supporting distressed entities by ensuring a timely and transparent mechanism.
- Reducing losses incurred by lenders and shareholders.
- Protecting and preserving entities that are facing difficulties.
- Reviving distressed entities keeping in mind creditors and stakeholders.
Benefits of Debt Restructuring
Debt restructuring is a financial tool that is beneficial for the borrowers. Small businesses that are considering an expansion can also benefit from restructuring their debt. Some of the benefits of debt restructuring are listed below:
1. Enhances Liquidity
Debt restructuring can provide immediate liquidity relief for companies struggling with mounting debt burdens. A deferment or reduction in the interest rates or instalments frees immediate cash and instantly increases liquidity that may be used to manage the company’s operations.
2. Reduced Debt Burden
Entities involved in debt restructuring may avail benefits from lenders such as reduced repayment or less interest rates, which reduces the burden of their overall debt and may provide relief from some of the outstanding dues.
3. More Efficient Financial Management
Debt restructuring may help entities in better planning and making wiser decisions by reorganising repayment schedules in line with the cash flows.
4. Protecting Assets
Entities failing to repay secured loans may end up losing the underlying assets. Debt restructuring ensures a better means for borrowers to safeguard their assets while getting flexibility on their repayment schedules.
Also Read: What is Investment Banking and Who are Investment Bankers?
Key Points to Remember about Debt Restructuring
To sum it up, here’s all you need to know about debt restructuring:
- Debt restructuring is the process of providing support to distressed entities in meeting their financial obligations through means such as altering the terms of the agreement.
- The common methods that help in achieving debt restructuring are haircuts, equity swap, reducing interest rates and extending periods of non-payment.
- Debt restructuring protects distressed companies in the short-term. However, there is no guarantee that it can save the company from bankruptcy in the longer term.
Final Word
Debt restructuring provides an effective means for a distressed entity facing financial difficulties to refinance its outstanding obligations, gain better repayment flexibility, and make repayments more manageable.
FAQs
Ans. If you restructure your debt and lenders agree to offer you better rates, lower monthly payments, or increase your loan tenure, your credit scores might not be affected.
Ans. Through debt restructuring, you can directly negotiate with the creditors for better terms to your existing loan. However, bankruptcy means a distressed entity facing financial difficulties can delay payments to lenders through a legally enforced gap. Once a company declares bankruptcy, it can work with the court and its lenders to identify a suitable repayment plan. In case the company is still not able to repay the loans, they could liquidate their assets to meet their debt obligation.
Ans. If a financially healthy company shows early signs of stickiness in replying its debt, it may opt for debt restructuring. Banks may consider providing additional funds or revising the debt repayment schedule.
Ans. Yes, debt restructuring companies can help you better manage your debt obligations. However, ensure that the company is reputable and has a credible history.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
