Companies with huge debts risk being taken over by their lenders, leaving shareholders with nothing.
General Motors filed for Chapter 11 bankruptcy protection on Monday, and key to the negotiations preceding the filing was the question of bondholders converting their loans into shares.
The bondholders, who lent money to GM, would normally expect to receive interest and eventual repayment of their loans. And because consumers are not buying their cars, GM was unable to meet its commitments.
The plight of bondholders
In these situations, the bondholders effectively control the business, as their rights are superior to those of the shareholders. One solution is for the bondholders to convert their loans into shares, thereby reducing the interest bill that the company has to pay.
The number of shares a bondholder might require in order to accept shares in a struggling company is always a difficult question, and a major part of the negotiations, but invariably this process means a huge dilution of the holdings of existing investors, usually leaving them with almost nothing.
In many cases, bondholders simply want to be paid what they're owed, and don't actually want to take ownership of the business. But sometimes, acquiring distressed debt cheaply can be used as a method of getting ownership of the business -- a so-called 'loan-to-own' strategy.
It happens here too
Here in Britain, many over-leveraged businesses are going through the debt restructuring process, and the solution for some of these companies will involve debt-for-equity swaps.
Before the credit markets hit problems, the standard way for private equity funds to take over businesses was to borrow huge amounts of money. And just like GM, these businesses are now having difficulties servicing those debts.
Retirement home specialist McCarthy & Stone was taken private in 2006, following a bidding war between two private equity groups. The cost was £1.1bn, but three-quarters of that was funded by borrowing, mainly from HBOS. Less that three years later, the banks own the business and the equity holdings of the investors have been wiped out.
Some of that team were also behind the buyout of house builder Crest Nicholson in 2007. It was taken off the market at £715m, much of which was funded by adding more loans to its existing debts. Earlier this year, a consortium of over 30 banks agreed to convert part of these loans into shares, giving them 90% of the business and, again, wiping out the original investors.
Wyevale Garden Centres is another example, and there are plenty around.
But for most of us, it's the companies that are still in the public domain that concern us most. Sub-prime lender Cattles (LSE: CTT) recently suspended its shares while it grapples with a similar set of problems.
Jessops (LSE: JSP), the High Street photography chain, announced last week that "the board believes that it is unlikely that any value will be attributed to shareholders". The reason: massive debts, and the probable conversion of those debts into shares that will dilute existing shareholders' investments to nothing.
Debt-burdened property company Brixton Estates (LSE: BXTN), has several possible solutions to its difficulties, including selling off some assets to improve its balance sheet. Shares have been buoyed by an expression of interest from SEGRO (LSE: SGRO), but a debt-for-equity swap is a distinct possibility.
As ever, the lesson for investors seems to be that paying attention to the company's balance sheet is of vital importance.
More from Padraig O'Hannelly:
