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Debt Conversion Financing
The following Memorandum provides a brief overview of how debt conversion transactions are
designed and implemented to leverage the investments of companies and development
organizations implementing projects in highly indebted emerging market countries.
1.
The Rationale:
The economic rationale for debt conversions to finance investment in debtor countries is based
on the ability of investors to purchase the financial obligations of a developing country from a
creditor at a discount. An investor purchases the debt and, by prior agreement with the debtor
government, cancels the debt in exchange for receiving local currency, bonds, shares in a local
company or another form of agreed payment. Depending on the country, debt conversions can
generate between 5% and 200% more local currency for the investor's project than a conventional
foreign exchange transaction.
2.
The Benefits:
All parties involved in the transaction benefit: 1) the investor obtains local currency or assets at a
favorable discount because the debt is purchased at a significant discount in the secondary market
and redeemed by the debtor country at a value higher than its purchase price; 2) the debtor
government or company retires debt at a discount in local currency and simultaneously attracts
new investment; and, 3) the creditor government or company receives immediate partial
repayment on its outstanding loans at a price equal to the market value of the debt.
3.
The Steps:
The steps involved in completing a debt conversion include: 1) evaluating the feasibility of the
transaction; 2) application for approval of the transaction to the relevant authorities in the debtor
country; 3) structuring of the transaction to minimize performance and devaluation risks; 4)
identification of specific debts eligible for conversion; 5) negotiation of the purchase of the debt;
and, 6) redemption of the debt with the debtor in exchange for the transaction proceeds.
a.
Feasibility
Whether debt conversion is feasible in a given country depends on whether: 1) the country's
external debt is available at a significant discount from face value; 2) applicable loan or
rescheduling agreements pertaining to the debt or the debtor country prohibit the assignment or
sale of the debt; and, 3) the debtor is willing to cancel the debt through a discounted payment.
b.
Authorization of the Transaction
To apply for approval, the investor will generally submit a written request to the Ministry of
Finance or Central Bank of the debtor country requesting authorization for the conversion of a
global amount of debt to fund a specified project over a specified period of time according to
agreed terms for redemption of the debt. The application normally includes a detailed
description of the investment project, proposed conversion terms and conditions, copies of the
investing company's certificate of incorporation, copies of the debtor government's authorizations
for the investment, detailed budget and cash-flow projections for the local company and a
description of the benefits to the host country that will result from the conversion transaction.
c.
Design of the Transaction Structure
The structure of the transaction will depend on: 1) the type of debt conversion proceeds that will
be paid to the investor; 2) the foreign exchange rate applied to the debt conversion; 3) the likely
debt purchase price and debt redemption rate; 4) availability of sufficient amounts of eligible
debt; 5) the expected time required to close the transaction; 6) the feasibility of protecting
proceeds from inflation and foreign exchange devaluation; 7) the debtor government's
performance and payment risk.
d.
Identification, Purchase and Redemption of Eligible Debt
Identifying debt eligible for conversion involves contacting creditors or holders of debt in the
secondary market and negotiating the purchase of the debt from them. Many debtor governments
will set limits as to the type and amount of debt that can be converted. The investor will then
purchase the debt directly from creditors or from the secondary market pursuant to debt purchase
and assignment agreements and assign the debt to the debtor government in exchange for the
agreed debt conversion proceeds.
4.
Costs
In addition to the cost of purchasing eligible debt, transaction costs normally consist of: (i) fees
paid for legal and technical assistance; (ii) financial advisory fees; and (iii) debt conversion fees
levied by the debtor government. In the aggregate, these fees should not significantly affect the
transaction gain.
5.
Risks
The primary risks for the investor in effecting debt conversions are the performance and payment
risk of the debtor government and the risk that the debt conversion proceeds will be adversely
affected by inflation and foreign exchange devaluation. Transactions can normally be structured
to adequately address these risks by purchasing and converting debt in tranches and by using
escrow agents, however, if this is not possible, the investor is best advised not to pursue the debt
conversion transaction.
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6.
Gains
Gains from debt conversion are rarely less than 50% and can on occasion exceed 100%. In other
words, as a result of its investment in the transaction, the investor receives at least 50% more in
proceeds than if it had simply invested in cash. A sample transaction is described below.
7.
Sample Transaction:
A company investing in an emerging market country decides to capitalize a local company to
produce manufactured goods for export. The investor estimates that under a normal foreign
currency exchange transaction, the project would require an investment of US $20,000,000. The
current price of the emerging market country’s debt is $0.40 per $1.00 of face value owed. The
investor spends $13,333,333 to purchase debt eligible for conversion with a face value of US
$33,333,333. The investor presents the eligible debt to the Central Bank which has authorized
the conversion of the debt into local currency at 60% of face value or the local currency
equivalent of $20,000,000.
The Central Bank pays the local currency equivalent of 60% of face value into an escrow account
with a local escrow bank in the name of the local company and a proportionate number of shares
are issued against these funds. The investor simultaneously transfers title to the debt to the
escrow bank in favor of the government. The escrow bank, after verifying the amounts and
execution of title, releases the local currency to the company and the debt is transferred to the
government.
The investing company’s cost of acquiring local currency equivalent of US $20,000,000 is
therefore $13,333,333. The investor therefore leverages its investment funds through debt
conversion by generating an approximate gain of 50% (before fees, if any) over a conventional
foreign exchange transaction.
Debt Advisory International, LLC (DAI) structures debt related transactions in emerging markets as a principal and
as an advisor. For more information contact:
DEBT ADVISORY INTERNATIONAL, LLC
1747 Pennsylvania Avenue, NW, Suite 450
Washington, D.C. 20006
Tel. : 202-463-2188
Fax : 202-463-7285
E-mail: [email protected]