Through the Back Door Into Equity: How Loan-to-Own Is Reshaping the Restructuring Market

Loan-to-own transactions are increasingly shaping the conversation around corporate restructuring. Under this model, which originated in the US, financial investors in particular acquire claims against distressed companies with the aim of taking control through pre-insolvency restructuring negotiations or formal insolvency proceedings. enomyc author Alexander Neumann explains the role this instrument plays in the German market, the benefits such transactions offer banks and investors — and, in some cases, the affected entrepreneurs — and what to watch out for.

Loan-to-own transactions are gaining traction in the German market as well. They give activist investors the opportunity to take control of a target company with a relatively small capital outlay and actively shape its restructuring. For banks, they open up new ways to reduce risk and refocus on their core business.

Two approaches to loan-to-own transactions are particularly common:

• Investors — typically activist players such as hedge funds or debt funds — acquire debt during a company crisis, often on the distressed debt market, with the goal of converting it into equity and thereby gaining control of the company.

• A second variant involves lending during advanced stages of a crisis, when companies usually have no other access to capital markets. Financing is often provided in a position subordinate to existing debt. As security, the pledging of company shares is agreed within a typically tight covenant framework; in the event of default, these shares transfer to the creditor.

In Germany, loan-to-own transactions gained momentum in the years following the financial crisis. Restructuring law (including ESUG) addresses not only the potential binding of dissenting creditors but also the way veto rights held by existing owners can slow down or block fast restructurings. As a result, investors have become increasingly active in the restructuring market following a number of early "pilot" transactions.

Mechanisms of Loan-to-Own Transactions

Loan-to-own transactions generally fall into two phases: pre-insolvency and during formal insolvency plan proceedings. Each window offers different opportunities and risks for investors as well as for banks and other creditors. What unites both phases is that applying this instrument is frequently tied to providing fresh liquidity to help finance the operational restructuring — and, in turn, the value creation — of the company.

Ahead of insolvency, activist investors typically try to acquire non-performing loans (NPLs) from banks or other creditors in sufficiently large volumes. These loans are often heavily discounted, allowing investors to buy them for a fraction of their original value.

Before Insolvency: Loan-to-Own Through the Acquisition and Swap of Loan Liabilities

At this stage, investors aim to convert the acquired debt into equity in the event of a corporate restructuring or insolvency — typically through a debt-to-equity swap, in which the investor converts its claims into company shares. This usually happens as part of an out-of-court restructuring, where the company and its creditors agree on a conversion to avoid insolvency. In return, the investor gains not only a direct stake in the company but also influence over its management.

Another common pre-insolvency option for investors is extending loans to companies that, due to the crisis, no longer have access to capital markets. As security, existing shareholders directly pledge their company shares, typically tied to covenants whose breach triggers a transfer of those shares. This approach reflects two opposing bets on the company's short-term restructuring prospects: the debtor hopes for a turnaround using funds from this "lender of last resort," followed by a later refinancing, while investors extend the loan based on the opposite assumption — viewing it as a route into equity. This approach has been particularly visible recently in the real estate sector, where companies were no longer able to service the debt on high-volume financings for, in some cases, prominent commercial properties amid rising interest rates. In the absence of conventional alternatives, activist investors have stepped in to cover the additional financing need.

Loan-to-Own in Insolvency Plan Proceedings

In the event of insolvency, investors can also pursue loan-to-own strategies during formal insolvency plan proceedings. Here too, debt-to-equity swaps play a decisive role. By controlling a sufficiently large share of claims, investors can influence the company's restructuring within the insolvency plan process. Within the framework set by ESUG and, for example, the German Bond Act (SchVG), investors frequently manage to take over a company entirely — via a debt-to-equity swap following a capital cut — even without (potentially restructuring-willing) existing shareholders.

How Is the Market Developing in Germany?

In recent years, the number of loan-to-own transactions in Germany has risen significantly, driven by several factors. Changes to insolvency law play a key role. In particular, the 2012 introduction of ESUG (the Act to Further Facilitate the Restructuring of Companies) has made it significantly easier for investors to acquire company shares through debt-to-equity swaps and actively intervene in the restructuring process. ESUG allows creditors to play a greater role in insolvency plan proceedings and meaningfully influence a company's fate. The law aims to improve companies' restructuring prospects while ensuring a balanced settlement for creditors. In this context, how the value of claims is treated when converted into equity is not the result of one single, clear-cut valuation method but is typically embedded in a broader, consensual overall concept.

A second factor favoring loan-to-own transactions is the growing activity of activist investors. The environment for this investor group in Germany has improved markedly in recent years. Activists are increasingly willing to invest in distressed companies and take an active role in their restructuring and long-term preservation through loan-to-own strategies. These investors see opportunity in crisis, using their financial resources and negotiating skill to gain control of struggling companies. In doing so, they offer existing owners at least the prospect that their company — often their life's work — can be saved from insolvency and continue operating, even under new ownership.

Finally, the retreat of traditional banks from financing distressed companies has created a gap that activist investors, among others, are now filling. Reasons for this retreat include stricter regulatory requirements and the high level of ongoing oversight such engagements demand, combined with limited capacity for intensive account management.

Advantages for Banks and Activist Investors

Selling non-performing loans to activist investors offers banks several advantages. It allows them to clean up their balance sheets and minimize the risk of further losses — a significant argument in an environment of rising regulatory capital requirements. It also allows banks to focus more on their core business rather than tying up extensive resources in restructuring and turning around troubled companies.

For activist investors, the appeal of loan-to-own transactions lies in the ability to acquire a larger stake with a comparatively small capital outlay and thereby gain control of the target company. Through their active role in the restructuring, these investors can increase the company's value and later achieve a profitable exit.

Success Factors for Loan-to-Own Transactions

Despite the many advantages for all parties involved, loan-to-own transactions are no sure thing in today's complex market environment. For many existing shareholders, the entry of an activist investor adds further strain to an already challenging situation — not least because such transactions demand a high degree of strategic expertise, hands-on restructuring experience and communicative sensitivity.

Few companies have all of these capabilities in-house. It is therefore advisable for investors to seek advice on strategies for acquiring and subsequently increasing the value of a company. This includes analyzing the financial situation, assessing restructuring options, and negotiating with creditors and other stakeholders.

Executing a loan-to-own transaction likewise requires a deep understanding of the economic environment. Experts can support the structuring of the debt-to-equity swap and ensure that all regulatory requirements are met. Ultimately, a successful restructuring also depends on the ability to convince a range of stakeholders — from creditors to management to employees — and bring them onto common ground. An experienced advisor can credibly take on a neutral, mediating role, ensure smooth communication, and significantly improve the chances of success for such transactions.