Friday, April 24, 2009

Why Doesn't Anybody Want to Take a DIP?

I promised in an earlier post to discuss why distressed companies are having such difficulty raising Debtor In Possession financings.

I discussed the issue in this comment on the Distressed Debt Investing blog.

Floyd Norris of The New York Times, in this article from yesterday's edition, discusses the recent increase in bank loans from a different perspective (although I believe that his shot at Alan Greenspan is unwarranted; Greenspan knows more about markets than Norris ever will).

I am taking this discussion further to state that the popularity of utilizing bank debt over the last several years has changed the Chapter 11 reorganization process.

The majority of the companies that are filing, or that want to file, to reorganize took advantage of the increased availability of bank debt. Sometimes loans were taken to support an equity sponsor's leveraged buyout (or to finance a dividend payment from the purchased company to the sponsor's fund). Sometimes companies used these loans to expand (and some of those expansions were ill-timed given the current economic conditions).

In the past, if companies were looking to borrow these types of funds, they issued bonds - most of which were unsecured. Because of this, in the past, there were uncollateralized assets that were available as security to support a DIP financing if the business became financially distressed.

Bank debt, on the other hand, is usually collateralized. Banks offered first lien, second lien, and even third lien debt as the market became more and more exuberant. This was possible because of the tremendous market demand for securitized products like CDOs and CLOs. The banks were able to make loans, collect fees, sell the loans, and then repeat the process. It was very attractive to the banks and the low yields in the fixed income market made the securitized products look very attractive (particularly with the ratings they were given by the ratings agencies), which fed the exuberance.

Companies were attracted by the cheap cost of these loans and were even able to negotiate for attractive terms like minimal covenants (which provide the banks with power, outside of a bankruptcy, when a company's financial ratios indicate the company is becoming distressed) and features like Payment-In-Kind toggle (where the company, at its discretion, can pay interest due by increasing the size of the loan in the amount due instead of paying in cash).

Since bank debt is typically priced at a premium over a reference rate (like LIBOR), the banks were willing to lend at initial rates that were lower than those available in the bond market (inflation risk was minimized by the floating rate, and there was lower repayment since the loans were secured by the borrowers' assets).

Now, when these companies are looking for DIP financing, they are usually at the mercy of their existing secured creditors. Other potential lenders are less interested in offering DIP financing because there are no assets to secure the DIP. Without security, and given the difficult market for exit financing (loans to the post petition company that can be used to pay off the DIP, often at a lower interest rate than the DIP), even the administrative priority status (or, often super-priority status) offered to DIP financiers is not attractive enough for lenders to actively compete in the DIP market.

Consequently, a significant number of the DIP financings currently taking place are funded by existing secured lenders and include a roll-up of some, or all, of the existing secured debt (with the end result that the administrative priority applies not only to the new funds, but to the existing "rolled-up" loans). The terms for these DIPs provide the lenders with attractive interest rates (applying to the entire DIP, not just the new money, which means the lenders receive higher interest rates on their prepetition debt) and fees for arranging the DIP. The lenders are also able to impose numerous loan covenants that can provide them with significant power in the restructuring process.

In the Dayton Superior case that I was commenting on, the DIP is a hotly contested issue. The Court provided an interim ruling in favor of Dayton Superior's motion to accept the DIP facility offered by GECC. The economic terms of this offer are significantly inferior to the DIP offer by the bondholders, but the bondholders, who are not secured, are seeking to collateralize the DIP with the same assets currently collateralizing GECC's prepetition debt (on pari passu terms). If Dayton Superior accepted this "priming" of GECC's loans, the bondholder DIP would be contested by GECC.

Section 364(d)(1)(B) of the Bankruptcy Code states the Trustee (or Debtor) must prove there is "adequate protection of the holder of the lien on the property of the estate on which such ... equal lien is proposed to be granted."

The Court is having a final hearing on the DIP motion on May 11th. At that hearing, the bondholders will have to provide sufficient evidence that there is adequate protection for GECC's prepetition debt with the bondholders' DIP facility sharing the collateral. Dayton Superior's advisers seem to have concluded this would not be the case, which may be the reason they recommended GECC's offer over the offer made by Oaktree (and now the bondholders).

If the bondholders were willing to give up their requirement for collateral, they could pursue a strategy that would put them in a position of controlling the company after it emerges from bankruptcy.

Dayton Hudson is just one example of the how changes in financing structures have changed the dynamics of the reorganization process under Chapter 11 as opposed to previous recessions.

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1 comment:

Lawrence D. Loeb said...

Just to clarify, I'm not saying that loans replaced bonds entirely; just that the proportion of loans to bonds changed sufficiently to impact the amount of available collateral.

Here is an article from 2007 describing the increased use of loans relative to bonds.

Since the last bankruptcy wave there has been another contributing factor to the lack of assets to collateralize potential DIPs: the increased internationalization of business.

Where in the past, domestic suppliers sold goods on credit to US companies, this credit was extended with the expectation that the customer would not borrow from another lender using those goods as security. The inventory was, therefore, available as collateral to a DIP lender if the customer were to file under Chapter 11.

Now that supply chains have become more internationalized, companies rely more on letters of credit to fund their purchases of goods. This has enabled companies to borrow using their inventory as collateral. Therefore those assets are not available for a postpetition lender unless there is adequate protection for the existing liens.