To advance supply-side structural reform, the Central Economic Work Conference proposed "three reductions, one reduction, and one replenishment" as five major tasks. "Deleveraging," as one of these tasks, has been a focus of economic work in recent years. In 2016, the "State Council's Opinions on Actively and Steadily Reducing Corporate Leverage" (Document No. 54) clearly required marketized and legalized methods to promote the survival of the fittest, encouraging the participation of various types of implementation institutions, and orderly carrying out marketized bank debt-to-equity swaps. After the issuance of Document No. 54, the government introduced a number of supporting policies to fully promote the process of marketized debt-to-equity swaps. As of July 31, 2018, the signed amount of marketized debt-to-equity swaps reached to 17,325 million yuan, with 351.6 billion yuan in place, involving 115 high-quality enterprises.

On January 19, 2018, seven ministries jointly issued the "Notice on Specific Policy Issues in the Implementation of Marketized Bank Debt-to-Equity Swaps" (Document No. 152), proposing three major implementation pathways: debt collection for equity, equity issuance for debt repayment, and a combination of stock and debt. This article briefly analyzes these three categories based on relevant documents and case studies.

Debt-First, Equity-Second

Concept

Debt-first, equity-second, also known as debt collection for equity, refers to the implementation institution first purchasing the creditor's debt to the equity conversion enterprise and then contributing to the equity conversion enterprise with the purchased debt.

Advantages and Disadvantages

The advantages of debt-first, equity-second mainly include: (1) In the debt collection stage, debt is purchased at a discount. If the intended purchase debt is a non-performing asset, the purchase price of the debt is usually at a discount on the principal. Even if it is not classified as a non-performing asset, it is possible to negotiate with the creditor to waive all or part of the interest. (2) In the equity conversion stage, collateral increases credibility. If the purchased debt has credit enhancement measures provided by a third party, such as pledge/guarantee, and the debtor is not the equity conversion enterprise, the implementation institution can agree with the equity conversion enterprise that the debt shall not be extinguished, and the implementation institution has the right to declare the debtor/guarantor to immediately repay under specific conditions.

The disadvantage is mainly that the implementation institution needs to negotiate with the creditor to purchase the debt, especially when it involves discounted purchases, and both parties may not reach an agreement on the purchase price, significantly increasing the uncertainty of the project. Large debt-to-equity swap projects involve many transaction counterparts and steps, and the uncertainty in the debt collection stage directly affects whether the entire project can be successfully implemented.

Practical Application

Debt-first, equity-second was one of the widely used modes of policy-based debt-to-equity swaps in 1999 and has certain particularities. In 1999, to concentrate on disposing of non-performing assets and achieving the reformation and listing of the four major banks, the State Council established four AMC companies to purchase the non-performing assets of the four major banks at full price, and further promoted debt-to-equity swaps for state-owned enterprises in distress with good market prospects through AMC companies. Since the debt collection stage was nationally arranged, adopting the debt-first, equity-second mode was relatively easy.

For example, at the end of 1999, Jiangxi Pharmaceutical had a debt-to-asset ratio of 99.22% and a heavy interest burden. Jiangxi Pharmaceutical applied to convert the debt stripped to AMC companies from ICBC, ABC, and BOC into equity, totaling 106 million yuan. After implementing debt-to-equity swaps, the company's debt-to-asset ratio dropped to 57.7%, interest expenses were significantly reduced, and by investing more in new products with better market prospects, the company's profitability greatly increased.

Equity-First, Debt-Second

Concept

Equity-first, debt-second, also known as issuing equity to repay debt, refers to that  equity conversion enterprises raise special funds by issuing equity investments in order to repaying debts

Raising funds from original shareholders and new investors to repay debts is a common solution for enterprises to face liquidity problems so equity-first, debt-second is not a typical debt-to-equity swap. There is no fundamental difference between equity-first, debt-second and debt-first, equity-second, both of which can reduce enterprise leverage to a certain extent and solve debt problems. Therefore, Document No. 152 stipulates that issuing equity is also reported as a marketized debt-to-equity swap project and requires specifying the specific debt to be repaid to prevent the cost-effective funds from being misappropriated after capital increase.

Advantages and Disadvantages

The advantages of equity-first, debt-second mainly include: It does not involve a debt collection stage, narrowing the scope of participants and reducing the complexity and uncertainty of the project.

The disadvantages mainly include: (1) Time table pressure. Since debts can only be repaid after the capital increase is completed, there is certain pressure on projects with time requirements for debt reduction. (2) Risk of fund misappropriation. Since the capital increase funds are directly transferred to the enterprise account, there is a risk of funds being misappropriated by the enterprise or its actual controller, requiring an agreed-upon fund supervision mechanism.

Practical Application

Since the issuance of Document No. 54, which started the current round of marketized debt-to-equity swaps, many state-owned enterprises have promoted debt-to-equity swaps through their controlling listed companies, including China Shipbuilding Industry Corporation, China Shipbuilding Industry Company Limited, Aluminum Corporation of China Limited, etc., and their transaction schemes are basically the same.

Taking the implemented China Shipbuilding Industry Corporation as an example. The plan of China Shipbuilding Industry Corporation is divided into two steps. The first step is to increase the capital of a subsidiary of the listed company. In August 2017, eight investors, including the National Adjustment Fund, China Life, and China Cinda, increased the capital of Dachuan Heavy Industry and Wuchuan Heavy Industry, subsidiaries of China Shipbuilding Industry Corporation, with a total of about 21.868 billion yuan, holding a total of 42.99% of Dachuan Heavy Industry and 36.15% of Wuchuan Heavy Industry. The second step is for the listed company to issue shares to the eight investors to purchase the aforementioned equity obtained from the capital increase. Investors obtain shares of the listed company through private placement, and after the lock-up period, they can choose to exit the secondary market, effectively solving the exit problem of marketized debt-to-equity swaps. Especially in the current liquidity tightening, asset prices are low, and the stock market has experienced a significant correction, investors' holding costs are low, and the profit space is large. Therefore, this model is the generally accepted implementation pathway of this round of marketized debt-to-equity swaps.

Stock-Debt Combination

1. Concept

Stock-debt combination, or "capital increase + retained debt," means that through an agreed conversion rate or retention rate, part of the debt is retained while the remaining debt is converted into equity. This model is the result of negotiation between enterprises and creditors, effectively a flexible adaptation of the debt-first, equity-second approach. It is typically used when enterprises face debt issues, but creditors do not agree to convert all the debt into equity.

2. Advantages and Disadvantages

Advantages:

- Creditors still hold a portion of the debt, which, while resolving the enterprise's debt issues, also avoids the risk of significant losses due to fluctuations in the price of the equity held.

Disadvantages:

- The enterprise and creditors need to negotiate to determine the conversion rate/retention rate. If the parties cannot reach an agreement, the project may be difficult to implement.

Practical Application:

In July 2014, the Nanjing Intermediate Court accepted the bankruptcy restructuring of Changhang Oil Transportation. As of December 31, 2013, Changhang Oil Transportation's consolidated balance sheet showed total assets of 13.774 billion yuan, total liabilities of 15.777 billion yuan, and a net asset value of -2.003 billion yuan, making it the largest bankruptcy restructuring case in terms of asset-liability scale among public companies since the implementation of the new bankruptcy law. The case effectively resolved debt issues through a combination of stock and debt under government coordination. According to the repayment plan, for ordinary creditors with claims over 500,000 yuan, the portion exceeding 500,000 yuan was repaid in cash by Changhang Oil Transportation in installments at a retention rate of 12.46%. The remaining ordinary claims were offset by shares converted from capital reserves and shares transferred by shareholders at a price of 2.3 yuan per share.

Changhang Oil Transportation resolved its debt issues through a combination of stock and debt, and through asset restructuring and divestment of loss-making businesses, the company's capital structure and profitability were improved. The company returned to the A-share market in November 2018.

These three implementation pathways in practice will be further subdivided according to different types of "debt" and "equity." For example, debt can be subdivided into bank loans, finance lease borrowings, and trust loans, and bank loans can be further subdivided according to a five-level classification system. Similarly, equity can be subdivided into common stock, preferred stock, and perpetual bonds, etc. Different types of debt and equity face different regulatory policies, so the specific operational details also vary. Despite the differences in implementation pathways for different enterprises at different times, the essence of debt-to-equity swaps remains the conversion of debt financing tools into equity financing tools, thereby improving the corporate capital structure and easing financial pressure.