Debt Conversion
Transaction Structures
1.
Introduction
This Memorandum describes several of the more common types of debt conversion transaction
structures, including: i) debt for cash or financial instruments; ii) debt for equity; iii) debt for assets;
and, iv) debt offsets. The less common debt buy-back conversion structure is also discussed.
In addition, the Memorandum provides a brief overview of the processes involved in settling or
recovering on debt under creditor and debtor mandates.
2.
Debt Conversion Transaction Structures
1.
Debt for Cash or Financial Instruments
Debt-for-cash or debt-for-financial instruments transactions are the most common type of debt
conversion transaction. The major constraint is usually the financing of such conversions by the
debtor government. In a debt-for-cash transaction, the debtor government redeems the debt tendered
for a cash payment, often at a discount from face value. In a debt-for-financial instruments
transaction (which can be considered a debt-for-debt exchange), the debtor government exchanges
the debt tendered for bonds, promissory notes or some other negotiable instrument. Both types of
transaction may be completed in a single disbursement or in tranches.
If the debt conversion proceeds are in the form of financial instruments, the attractiveness of the
transaction to the investor will depend on the marketability of the instruments and on their risk and
yield. These factors will in turn depend on the specific terms of the instruments and the economic
circumstances of the debtor country. Financial instruments are more attractive to investors if they are
negotiable or if they have staggered maturities that correspond to the financing needs of the
converting entity.
Financial instruments are also more attractive if the government's performance at maturity is secured
by future receivables or guaranteed by third parties, either expressly by a financial intermediary or
through the creation of a guarantee fund.
2.
Debt for Equity
In a traditional debt-for-equity transaction, the debtor government redeems the debt in local currency,
which the investor undertakes to invest in equity in the debtor country. In other words, the investor
uses a debt conversion to finance an equity investment that it would like to undertake. The
investment may consist of building a plant or acquiring an equity interest in a local company.
A number of debtor countries have used debt conversion in the context of the privatization of state
enterprises. Some countries, such as Argentina, have structured their debt-for-equity programs so
that external debt is exchanged directly for shares in parastatals or public entities to be privatized. In
this manner, concerns regarding the potential generation of inflationary pressure through the debtfor-equity program are greatly reduced.
3.
Debt for Assets
A debt-for-assets transaction is one in which debt is exchanged for title to or a right to enjoyment of
assets belonging to the debtor. There is no limit to the types of assets that can be transferred
pursuant to this type of debt conversion. Typical transactions include debt for 1) leases, title or other
rights to the use and enjoyment of land, property and equipment; 2) actual shares in a company, as
described in Section B above; 3) exploration and exploitation concessions in the mining, timber,
tourism and oil sectors; and, 4) contracts for or title to commodities (often termed debt for exports).
A debt-for-assets transaction can be structured as a direct transaction between the debtor government
and an investor seeking to purchase an asset for its own use or immediate resale. The investor might
exchange the debt for assets it will itself use (buildings, land, materials, machinery, etc.) or assets
that are readily monetized such as commodities.1 Alternatively, a debt-for-assets transaction can be
structured as a two-tier debt conversion in which the debt is sold by the investor to a company for
cash payments or readily monetized assets such as commodities and then redeemed with the debtor
government in exchange for other assets or to offset an obligation.
The major factors to consider in structuring a debt-for-assets transaction include the choice and
valuation of the assets. Particular concerns are asset specific and most are relatively obvious. In the
case of most assets, the primary concern is valuation of the assets being transferred and the legality
of the transfer. In the case of leases or title to real property or equipment, for example, there are a
range of legal concerns as to whether the title one receives is valid and unencumbered.
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Many commodities can serve as a cash substitute. However, the entity receiving commodities
must have the expertise to resell commodities. For an entity interested in receiving cash for use in its
projects, it might be possible to accept forward contracts for commodities. The commodity contract
would then be discounted locally or in a major commodities market for a dollar or local currency
payment.
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4.
Debt Offsets
A debt offset transaction generally involves the purchase of debt at a discount and its offset against
an obligation owed to the debtor. An investor first purchases debt at a discount in the secondary
market and sells it to a reputable local commercial company for local currency or other assets whose
value exceeds the debt purchase price, but is less than the face value of the debt. The company then
offsets the debt at par or at a negotiated discount against a debt owed by the company to the
government.
Debt offset transactions can be attractive to the debtor government for a variety of reasons. Often the
internal loans against which the debt is offset are credits under which the government does not
expect to collect. This is the case, for example, where the government offsets against debts owed by
insolvent or near insolvent parastatals. Depending on the ratios used, the transaction may also enable
the debtor government to retire more debt than it is forgiving in the offset. A secondary benefit of
transactions arranged with parastatals is that the transaction effectively strengthens the financial
condition of such parastatal entities and reduces the government's liability on debt owed by these
entities. This also enhances the government's ability to privatize the parastatal.
To structure a debt offset transaction, it is necessary to have a local private or public company that:
1) has debts to local parastatals or the government; or, 2) intends to or is in the process of purchasing
assets or commodities from parastatals or the government; and, 3) has regular cash flow or assets
which can be exchanged for the debt delivered by the investor.
5.
Debt Buy-Back Conversion
Depending on circumstances, creative combinations of several different transaction structures can
sometimes make a particular transaction more appealing to one or more of the parties involved. One
example is a so-called “debt buy-back conversion”. A debt buy-back is a relatively simple two-party
transaction in which a debtor country government nominates a market intermediary to buy its debt
back from specified creditors at a discount and cancels it in exchange for a margin or success fee.
Debtor governments, however, often have difficulty funding simple buy-backs themselves, and
public funding for such operations is limited.
As a result, debtor governments have been exploring the use of transactions that are a hybrid between
a debt buy-back and a debt conversion. In such a transaction, a commercial investor offers to cancel
debt at or very close to the debt purchase price in exchange for some other benefit, such as a
privatization bid authorization, financing guarantees, or better concession terms, to be accorded by
the debtor government.
3.
Debt Recovery or Settlement Under a Mandate
DAI often works with creditors under a creditor mandate agreement on specified debts in order to
assist the creditor to sell or recover on the claims or to restructure its portfolio. Similarly, DAI will
work with debtor entities under a debtor mandate to attempt to restructure or settle specified debts at
agreed maximums. Mandate periods range from 60 days to one year.
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1.
Creditor Mandate
A creditor mandate is an exclusive mandate from a creditor entity that grants the mandatee authority
to verify eligibility and identify a purchaser of debts owed to the creditor by a specified debtor. The
mandate is for a defined period of time and establishes a minimum debt purchase price that the
creditor is willing to accept in exchange for the assignment of the debts. Should the mandatee
identify within the term of the mandate a purchaser willing to pay the debt purchase price, the
mandate commits the creditor to completing the transaction with said purchaser. Any amount
received or recovered by the mandatee from the debtor or a third party purchaser in excess of the
debt purchase price is for the account of the mandatee.
In order to facilitate its efforts to make recovery on the debt, the mandator typically agrees to
constitute the mandatee its attorney-in fact pursuant to a Power of Attorney. The Power of Attorney
authorizes the mandatee to act on behalf of the creditor to affect the collection or sale of the debt.
2.
Debtor Mandate
A debtor mandate is a mandate granted by a debtor entity or government to arrange for the settlement
of a debt owed to a particular creditor. The mandate is for a defined period of time and establishes a
maximum price that the debtor is willing to pay to settle the debt. The mandator typically agrees to
constitute the mandatee its attorney in fact pursuant to a Power of Attorney in order to permit the
mandatee to negotiate settlement of the debt per the terms described in the mandate.
A debtor mandate may be either funded or unfunded. Under a funded debtor mandate, the debtor
agrees to deposit the mandated settlement price in cash or liquid securities in an escrow account in
advance of negotiations between the creditor and the mandatee on behalf of the debtor. The
mandatee is granted authority to access the escrowed funds in order to complete the settlement. Any
difference between the mandated price in escrow and the price agreed with the creditor is for the
account of the mandatee.
Under an unfunded debtor mandate, the mandatee must first negotiate settlement of the debt under
the parameters of the mandate, and then arrange for the transfer of the settlement price from the
debtor to the creditor. In this event, the mandatee’s fee must be negotiated on a transparent basis
with either the debtor or the creditor.
For additional information, contact:
Debt Advisory International, LLC
1747 Pennsylvania Avenue, NW, Suite 450
Washington, DC 20006
Phone: (202)463-2188
Fax: (202)463-7285
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Email: dai@debtadvisory.com