Debt-for-Equity Swap in Distressed PE: Case Study

When a private-equity-backed company cannot service its debt, the negotiation stops being about interest rates and starts being about ownership. A debt-for-equity swap in distressed PE converts creditor claims into shares, cutting cash interest and principal obligations while shifting some or all control from the sponsor to lenders or distressed buyers. The transaction only makes sense when the operating business is viable, enterprise value breaks somewhere inside the debt stack, and creditors judge the equity upside to be worth more than enforcement, liquidation or a forced sale. Clayton Utz noted that in 2022 and 2023 “loan for own” deals became more common in Australia, with lenders taking equity and sponsors exiting on a “keys back” basis.

Balance sheet effect of the swap

A creditor releases, compromises or converts part or all of its claim in exchange for equity in the borrower. As a result, the company sheds liabilities and debt service, while the creditor stops being a lender and becomes a shareholder with exposure to the recovery.

Investopedia describes the mechanic plainly: the company avoids cash coupon and face value payments by offering stock instead. Existing shareholders are diluted, and the transaction signals distress, but the cash position improves because debt falls away.

That balance sheet repair has limits. It does not repair unit economics, customer churn or a structurally declining end market, which is why the viability of the operating business drives most of the disputes described below.

Restructuring options before conversion

Out-of-court exchanges, prepackaged and pre-negotiated processes can all support debt-for-equity outcomes. The path depends on how many consents are needed, whether dissenting creditors can block the deal, and whether the required legal changes need court approval.

Case-study setup: viable operations, unsustainable leverage

Take a hypothetical sponsor-owned business with a senior term loan, a second-lien tranche and sponsor equity. EBITDA has fallen after a demand shock, floating-rate interest has risen, and the interest coverage covenant is breached. Refinancing markets are shut to the credit.

The business itself still wins contracts and generates positive EBITDA before debt service. That combination, healthy operations and a capital structure built for a different earnings level, is the standard fact pattern for a conversion.

Step 1: Find where value breaks

Value enterprise value on a going-concern basis, then run it down the capital structure. If enterprise value covers senior debt but stops partway through the second lien, the second lien is the fulcrum security, the claim class where value runs out and which is likely to receive the bulk of reorganised equity.

Fulcrum identification is an analytical judgement, not a legal label. Move the exit multiple by a turn and the fulcrum can shift a class up or down, which is why valuation is usually the most contested item in the negotiation.

If enterprise value sits below total debt, existing equity is out of the money. It survives only if creditors choose to leave a stub for consent, management continuity or speed.

Step 2: Map negotiating leverage

• Senior secured lenders hold collateral, enforcement rights and, in a court process, the ability to credit bid.
• Junior lenders may be economically out of the money but can obstruct through consent thresholds or intercreditor mechanics.
• The sponsor controls the board, the management relationship and the decision to fund or walk.
• Distressed buyers accumulate claims in the likely fulcrum class to sit inside the decision-making group.
• Management holds operational knowledge and, in a services business, the customer relationships that carry the value.

Step 3: Structure the conversion

The documented package rarely stops at share issuance. Expect a debt release or conversion deed, new equity issued to converting creditors, and a residual debt tranche sized to what post-swap free cash flow can service.

Converting creditors frequently take preferred equity with a liquidation preference and leave common stock for management and any surviving sponsor stub. Board composition, reserved matters and information rights are negotiated alongside the split.

New money is the pressure point. A deleveraged company with no working capital facility can fail a second time, so someone must fund the super-senior liquidity line, and that provider prices its equity participation accordingly.

Worked example: converting an unserviceable claim

Investopedia’s illustration is the cleanest version. Company ABC has 100 million dollars of debt it cannot service and offers two creditors 25 per cent ownership in exchange for writing off the entire amount. This is hypothetical, not a real transaction.

Applied to a sponsor-owned credit, the same mechanic produces a different set of consequences:

• Pre-swap: sponsor holds 100 per cent of equity, while creditors hold 100 million dollars of claims and receive no cash interest.
• Post-swap: creditors hold 25 per cent of equity plus board representation, while the sponsor is diluted to 75 per cent on paper.
• Cash effect: the interest line disappears, and free cash flow that previously funded debt service can fund capex and working capital.
• Where the numbers move against the sponsor: if enterprise value sits below the converted claim, creditors demand far more than 25 per cent, and the sponsor stub becomes nominal or nil.

For a distressed buyer, the return calculation runs off purchase price rather than face value. A claim bought at a discount that converts into equity worth more than the purchase price can generate a multiple on invested capital even where the original lender books an impairment. That gap between recovery on face and return on cost explains why claims trade at all.

Creditor incentives for taking shares

Mayer Brown frames the trade in terms both sides can price: the company gains flexibility by cutting over-indebtedness and interest and principal obligations, while creditors avoid a total loss and gain upside. Going-concern value is preserved rather than dismantled in a fire sale.

Hogan Lovells adds a structural point specific to sponsor-backed credits. Private debt funds may be more open than traditional banks to negotiated swaps because they are more culturally attuned to holding equity and have continuing relationships with sponsors. During the global financial crisis, banks leaned towards enforcement, security sale or handing back the keys.

Lenders holding the fulcrum security also gain control, which matters when the turnaround requires management change or a different capital allocation policy. For a buyer pursuing distressed debt investments, that control can be as important as the headline discount to par.

Sponsor incentives to hand over control

Fund-level maths drives the decision. If existing equity is out of the money, further injections buy an option rather than a recovery, and the incremental cheque competes with better uses of unfunded commitments.

Sponsors also weigh reputation. A negotiated handover preserves lender relationships needed for the next five deals, which can be worth more than a contested enforcement over an asset already written down.

Modelling before signing

• Pre-swap and post-swap capitalisation tables, showing dilution class by class.
• Interest expense reduction and the resulting free cash flow after capex and working capital.
• A recovery waterfall by claim class under going-concern and liquidation scenarios.
• Implied post-money equity value, sensitised to exit multiple, EBITDA recovery and turnaround timing.
• For a claims buyer, MOIC and IRR calculated on debt purchase price, not par.

The underwriting question is not how much debt can be cancelled. It is whether the post-swap equity is worth enough to justify owning a troubled company for three to five years.

Failure points in execution

Valuation fights are the most common cause of delay, because every class has an incentive to argue for the enterprise value that places the fulcrum inside its own tranche. Practitioners also flag fiduciary issues, lender liability and successor liability as live risks once a creditor moves into the owner’s seat.

Jurisdiction matters and should not be generalised. German law raises contribution liability issues where converted receivables are overvalued. UK company law brings share allotment authority, pre-emption rights, directors’ duties towards creditors in distress and insolvency challenge risk. US practice adds credit bidding and plan confirmation mechanics, with creditor recoveries shaped by principles such as absolute priority in formal bankruptcy processes.

The operational failure mode is simpler. A deleveraged balance sheet with the same management team, the same cost base and no fresh capital produces a second restructuring within eighteen months.

Market context

Clayton Utz identifies Camp Australia, GenesisCare and Accolade Wines as public examples that come to mind in the 2022 to 2023 Australian loan-for-own wave, where lenders exchanged debt for equity and sponsors exited on a keys-back basis. The available detail supports the existence of the trend, not the terms, ownership splits or outcomes of any of those transactions.

Conclusion

The transaction succeeds when four conditions hold together: the operating business is viable after deleveraging, the fulcrum analysis is right, the post-swap entity has enough liquidity to trade, and the new owners have the mandate and capability to govern. Miss any one and the swap buys time rather than value.

Get the fulcrum wrong and you convert into equity that is worth less than the enforcement recovery you gave up. That error is not reversible, because once the claim is released the creditor has no debt to fall back on.

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Sources

• Eye of the tiger: distressed workouts are nigh | Clayton Utz
• Debt for equity swaps in private equity backed companies financed by private debt funds
• Debt/Equity Swap: Definition, Purpose, Example
• Debt/Equity Swap Explained: Benefits and Impact on Bankruptcy
• Unlocking Value in Distressed Companies: Debt-for-Equity and Loan-to-Own Strategies | PE Pathways
• Debt-to-Equity Swap: Opportunities and Risks | Mayer Brown