Debt to equity swaps
It has recently been announced that Ukio Bankus Investment Group (UBIG), the owners of a majority stake in the Scottish Premier League (SPL) side Heart of Midlothian, are to reduce the club's debt by arranging for a debt to equity swap which will result in the debt owed to UBIG being reduced by £12m (with a saving of £600k a year on interest costs).
The proposal will result in the percentage shareholding in Hearts controlled by UBIG, and its Chairman Vladimir Romanov, increasing to just over 95% from a previous holding of just under 82%. Three questions which arise about this proposal are:
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what is a debt/equity swap?;
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what are the reasons for the debt/equity swap? and;
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what effect will this have on the club’s other shareholders?
A debt/equity swap is where a lender agrees to reduce the amount of debt due to it by agreeing to subscribe for new shares in the borrower equal to the value of the reduction of the debt. This means that there are new shares issued which increases the total number of shares in the borrower.
Usually, a debt / equity swap between a lender and borrower (acting at arms’ length) would be driven by the mutual interest of the borrower and the lender to ensure the borrower does not go into insolvency. Typically, the proposal for a debt / equity swap would arise where a borrower is struggling with interest payments on borrowings (perhaps due to cash flow problems) but the value of its assets provide an incentive for the lender to take an equity stake in the company in exchange for the reduction in the total debt due.
Another benefit of such a proposal where the debt outstrips the assets is to ensure that the directors are not guilty of wrongful trading which is where a company continues to trade in the knowledge that it will be unable to meet its debts when they fall due. Where the assets of a company are significantly less than its debts, this is a risk for the directors and a debt/equity swap can restore the company to a more secure financial footing in terms of the balance sheet and the reduction in interest costs.
However, before preparing a “Dragon’s Den” style presentation for your bank manager, it should be noted that such swaps are fairly unusual and would only tend to be considered where a lender already has a stake in the borrower, usually as part of a transaction where there has already been a mix of debt and equity funding provided by the lender.
In this case, the parties are connected by virtue of the lender, UBIG, being the majority shareholder in Hearts and the driving force would seem to be to reduce the overall debt of Hearts to a more manageable level. The public statement from the club stated that the reduction of the debt to £24.5m (from £36.5m) will increase the ability of the club to borrow funds. This is presumably aimed at the ability to borrow from third party lenders (rather than UBIG) and has been interpreted as being linked to a proposed stadium redevelopment. It is also seen as a commitment to the club in the longer term and it is unlikely that any bank acting on arms’ length terms would have seen much (if any) commercial benefit in such a scheme. The reduction in the interest payments due by the club to UBIG will always be welcome for a football club where the costs tend to be a far higher percentage of turnover than other businesses.
This is similar to the tactic adopted by Sir David Murray and Rangers (also an SPL club) in 2004 when just over £51m was wiped off their debt through a Rights Issue to all existing shareholders (which was under-written by a company controlled by Sir David Murray).
The main difference between the Rights Issue at Rangers and the proposed debt/equity swap at Hearts is that all the shareholders in Rangers were offered shares and as such had the opportunity to maintain their percentage shareholding. In the event that the existing shareholders at Rangers chose not to accept the offer of further shares then their shareholding would be diluted (with the company controlled by Sir David Murray subscribing for all such shares not taken up).
In the Hearts proposal, there will be a fresh issue of shares which will only be offered to UBIG in exchange for £12m of the existing debt being written off. This means that none of the other shareholders who currently hold approximately 18% of the club will have the opportunity to subscribe for more shares and they will see their interests diluted down to less than 5% of the club.
The proposal at Hearts requires the approval of 75% of the shareholders by way of a special resolution but as UBIG already control over 82% of the shares, such approval will effectively be “rubber stamped” at the shareholders meeting on 31 July.
Due to UBIG’s shareholding being in excess of 75%, the club is effectively within its control at the moment, so the proposal does not change the power base at Hearts. However, one difference is that UBIG will hold over 90% of the shares after the debt / equity swap which is a crucial threshold in terms of UK company law.
The Companies Act 2006 contains provisions which state that if an offer to purchase all the shares in a company is accepted by those holding over 90% of the shares and voting rights in that company then the remaining shareholders can be forced to sell their shares at the same price. Therefore, in the event that there was to be an offer for all the shares in Hearts then the acceptance of such an offer by UBIG would mean that the minority shareholders could be forced to sell - this is not the case at present as UBIG hold less than the 90% required.
However, UK company law also states that if UBIG were to accept such an offer, then the minority shareholders could force the bidder to buy their shares at the same price (with no shares being capable of transfer unless such shares are also purchased).
The use of the debt / equity swap is an unusual one between an unconnected lender and borrower but the situation at Hearts is clearly different from a transaction at arms’ length. However, in the current market where turnover is decreasing markedly in many industry sectors, there is the possibility that this sort of proposal will be seen as a genuine middle ground to lending further funds or seeking to call in loans - especially where the lender is unlikely to be able to recover fully upon insolvency.
For further information please contact: Scott Kerr