*The views expressed herein are those of the authors alone and are not necessarily shared by other persons at Lowenstein Sandler LLP. Each case is unique and the law is subject to interpretation.
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In a historically low interest rate environment, where can you find returns in the double digits? Surprisingly, the answer is in chapter 11 bankruptcy cases as a “DIP” (debtor in possession) lender.
DIP Loans Can Be Lucrative
DIP lending has become a big business. With sufficient diligence on the business and adequate collateral, coupled with reasoned documentation and constant monitoring of the borrower’s activities, DIP loans can be relatively safe and lucrative.
Potential chapter 11 debtors typically are starved for working capital and in need of a lifeline. They often operate at distressed levels for a period of time and seek rescue financing when equity holders are no longer willing to, or cannot, fund them. By that time, inventory levels may have been depleted, vendors may have stopped shipping, and deliveries to customers may have slowed up. Upon commencing a chapter 11 bankruptcy case, the debtor must quickly move to restore customer and vendor confidence. DIP financing is thus critical to jump-start the debtors’ business and to increase the likelihood of a successful reorganization achieved through confirmation of a plan of reorganization or a sale of the business in a competitive environment.
Traditional prebankruptcy lenders may not understand chapter 11, including the benefits (and some burdens) that come with it. Some may be uncomfortable lending to distressed customers or borrowers in bankruptcy. Those that continue to lend often do so by burdening the debtor with unreasonably short runways within which to promulgate a plan of reorganization or to consummate a sale. In other cases, prebankruptcy lenders may have ulterior motives, such as to acquire their collateral (and the debtor’s business) in exchange for the secured debt, while subjecting the debtor to precipitous case milestones and deadlines. Such requirements may be too burdensome to managers striving to preserve the business, retain employees, and maximize value.
The high cost of DIP financing is not objectionable to management when coupled with other terms that are beneficial and address the borrower’s other important needs. For example, a funding package that provides the debtor with adequate working capital (as opposed to the bare minimum or insufficient capital typically offered by preexisting lenders) to reorganize and gives the debtor more time to develop strategy and more flexibility to operate and restructure its business more than offsets the cost of the loan. In addition, a DIP lender’s ability to provide a larger-than-necessary DIP loan will inspire vendor and customer confidence, further justifying management’s pursuit of a DIP loan bearing higher costs. From the debtor’s perspective, the increased cost of borrowing from the new DIP lender is outweighed by the projected incremental value to the debtor’s business as a result of the funding and flexibility provided by the DIP lender.
A DIP lender is compensated throughout the process for its efforts. A debtor is generally required to fund the prospective DIP lender’s professional fees and costs related to the DIP lender’s diligence and documentation of the loan. In addition to seeking higher interest rates, DIP lenders often demand payment of various fees, ranging from an upfront fee for establishing the loan, an unused line of credit fee, a monitoring fee, and a prepayment fee to an exit fee upon repayment, a restructuring fee, or some other defined trigger-point fee. These fees effectively increase the cost of money to the debtor and, similarly, the return to the lender. They also ensure that the lender’s stated interest rate is not diluted by administrative costs.
The Key To Being A DIP Lender
Given that DIP loans are often sought on an expedited timeline, a DIP lender must be nimble and capable of moving quickly. The key to being a DIP lender is understanding the real liquidation value of the proposed collateral as well as the potential costs of liquidation (including administrative costs, indirect costs, and professional fees) and litigation if the borrower’s restructuring strategy is not successful. A DIP lender’s ability to ascertain whether the debtor’s management team warrants its confidence and to limit the lending to the borrower’s net liquidation value are also imperative to a successful DIP loan. A new DIP lender avoids overexposure by requiring the borrower to adhere to adequate borrowing base formulas and providing for a controlled and expedited liquation of its collateral upon the debtor’s default on its loan obligations.
DIP financing often provides for a safer and more secure lending environment than what may be available outside of bankruptcy. To begin with, a DIP lender does not advance any money until the bankruptcy court has entered an order approving the DIP loan. Therefore, the new loan, once approved, is immune from potential challenges down the road. A DIP loan typically offers shorter maturity and is secured by substantially all of the debtor’s assets. The security interests granted in and liens obtained on substantially all of the debtor’s assets may be perfected simply by the judge’s signing the DIP financing order (even though many lenders nevertheless record their security interests in accordance with applicable law). Further, the bankruptcy court’s order will typically dictate the priority of the DIP loan relative to all other obligations of the debtor–which further ensures that the DIP lender remains in the most senior position ahead of substantially all other creditors and interest holders.
Lending outside of bankruptcy, on the other hand, leaves the lender potentially exposed to defects or other shortcomings in its collateral package (whether through documentation mistakes or perfection errors), delays associated with enforcement of defaults, and frustration of remedial efforts. Unlike when lending to a chapter 11 debtor that is required to adhere to court-approved budgets and to provide ample disclosures of its business operations and assets, a typical business lender is more reliant and dependent upon the trustworthiness of management and their disclosures.
DIP lenders can also protect their loans through other means. They can insist on covenants and other protections that would not be agreeable to borrowers outside of bankruptcy. The DIP lenders often dictate the DIP lending terms, such as the need for the lender’s prior approval of a plan of reorganization or liquidation, a sale transaction and the use and application of proceeds realized from asset sales, setting milestones for achieving certain bankruptcy objectives (ranging from sale milestones to filing deadlines for a plan or a disclosure statement, or addressing important contracts or leases), prohibition against future loans with priority senior to that of the DIP lender, and requiring detailed financial reporting. A covenant breach under a DIP loan will typically trigger a default, enabling the lender to act quickly.
Chapter 11 is intended to be transparent. Close monitoring of the debtor’s operations by the DIP lender (paid for by the borrower as an additional cost of borrowing) is standard. There also are frequent (often weekly) financial reporting requirements. And all actions outside the ordinary course of the debtor’s business require approval of the bankruptcy court which, in turn, keeps the DIP lender well informed throughout the process.
DIP lenders willing to act quickly and capable of thoroughly doing diligence on the transaction (and the borrower) and closely monitoring the borrower can minimize the risk associated with DIP loans. DIP loans, creatures of chapter 11, provide a unique opportunity for higher returns that are not available to lenders outside of bankruptcy.
About the Authors
Kenneth A. Rosen is a partner and Chair Emeritus in the Bankruptcy & Restructuring Department of Lowenstein Sandler LLP. Ken has more than 35 years of experience advising on the full spectrum of restructuring solutions, including Chapter 11 reorganizations, out-of-court workouts and financial restructurings.
Wojciech F. Jung is a partner in the Bankruptcy & Restructuring Department of Lowenstein Sandler LLP. Wojciech represents businesses, unions, pension funds, buyers and creditors in all aspects of corporate restructuring and turnarounds, liquidations, debtor-creditor law, bankruptcy and commercial litigation.