Converting debt into equity can be a key component of restructuring distressed real estate loans. In this economic downturn the general trend has been that lenders have not decided to bring to market the properties against which breached loans are secured. This strategic approach is juxtaposed against an estimated £120.7bn of commercial real estate loans that are due to mature by 2012 year end and large amounts of equity chasing prime UK real estate. The adage adopted by lenders to date of "extend and pretend" will come under increasing pressure if asset values do not bounce back and the debt for equity swap could be viewed as a real alternative.
What is a debt for equity swap?
A debt for equity swap involves the creditors of the company exchanging their debt for some form of equity. The form of equity provided in exchange for the debt can take different forms. The equity interest will frequently seek to achieve a priority of return in favour of the converting creditors and impose restrictions to preserve that priority.
Debt for equity swaps in real estate investment
Debt for equity structures are utilised in working out distressed real estate loans although they are more commonly associated with corporate restructuring. Eurohypo recently created a profit-sharing structure with Great Portland Estates and Istithmar World to complete the development of Marcol House in the West End and share the proceeds. More recently, it was reported that Europhypo had agreed a joint venture with Axa to build an office tower at the site of 6 Bevis Marks, EC3 from Monterverde, a Spanish developer, while Hammerson is helping Lloyds Banking Group on a series of developments.
The factual matrix for where a debt for equity swap would arise in a real estate transaction is usually where a borrower is underwater and perhaps looking to exit. An approach would be made to the lender, before enforcement, suggesting the avoidance of crystallising the lenders' losses with the opportunity to write back the loss provision. The debt for equity swap may incentivise the borrower to enter the swap with the potential benefit of a share of the future upward realisation of the asset. The creation of the equity interest in the borrower or property holding entity will attempt to mirror the terms of the facility agreement between the lender and borrower. An example of this would be the payment of interest can be linked to dividend payments with the repayment date replicating the redemption date.
The form of equity interest commonly created in a swap is preference shares. The creation of a new class of shares can be used to reflect the shareholders' agreed priorities for distributions of income and capital return. Preference shares can provide a lender with protection in respect of its shareholding in the borrower or property holding entity. This is achieved through specific rights attaching to the preference shares. For example, the inclusion of veto rights over designated corporate matters such as the variation of class rights or actions that may result in the dilution of the lender's shareholding.
Commercial challenges such as the right to appoint directors and resolving deadlock can be dealt with through the operation of a variation of class rights. Often a key concern for the majority of lenders, similar to the transfer provisions in a syndicated facility agreement, will be the ability of a lender to exit. In a debt for equity swap this may be achieved by a sale or redemption, or pre-emption of the shares by the borrower.
A debt for equity swap provides opportunities for third parties to enter into existing lending arrangements. Asset managers and investors may wish to assist in maximising the value of the underlying assets, whilst the equity in the borrower or property holding entity may be offered as consideration. The introduction of a third party can allow the borrower to exit the existing lending arrangements and salvage their reputation in the market.
Real alternative?
A lender's objectives when faced with a factual matrix such as the one described above are centrally focused on maximising returns and avoiding crystallising losses. Options available can narrowly be categorised as restructuring with the borrower, enforcement of security or entering an arrangement with a third party. The debt for equity swap option provides a lender with a hybrid solution and allows the benefit in any future uplift in the value of the asset and, potentially, super profits usually associated with "equity kickers". In addition, it may enable a third party to access prime distressed real estate with the ability to inject new equity and/or asset management skills.
Habib Ullah
Partner
Banking, Finance and Restructuring
Nabarro LLP
h.ullah@nabarro.com
Paul Donnelly
Associate
Banking, Finance and Restructuring
Nabarro LLP
p.donnelly@nabarro.com
