Henes: The DIP Loan - The New “It” Investment
Today, loans to debtors-in-possession — i.e., DIP loans — are all the rage. A DIP loan is a loan to a company that commences a chapter 11 case, providing it with the liquidity it needs to operate and restructure while in bankruptcy. As investors are looking for ways to put money to work, they are setting their sights on the DIP loan market as a way to realize meaningful returns. For instance, Eaton Vance , Aladdin Capital and General Electric have all announced their intention to raise funds to purchase or make DIP loans to distressed companies. There is no question that many other banks, hedge funds and private equity funds are focused on understanding and potentially beginning to participate in the world of DIP financing as well.
So, what does a curious, potential DIP lender need to know?
The DIP loan process is conducted out in the open in bankruptcy court and the making of a DIP loan needs to be approved by the bankruptcy judge. As part of this process, the company’s stakeholders may object to the DIP loan in whole or focus on specifics, such as rates, fees, covenants, conditions and the like.
As a result, the DIP loan process is different and more difficult than a typical loan process.
As banks, hedge funds and private equity funds eye the DIP loan prize, there are four trends they should be aware of:
- DIP Loans are Being Made by a Company’s Existing Lenders: Today, DIP loans are being provided by existing lenders in a distressed company’s capital structure. There is little, if any, competition from outside parties. The reason for this is simple. Distressed companies are over-loaded with senior secured debt that resulted from the pre-summer of 2007 leverage loan binge. To obtain financing from outside of the capital structure, the DIP loan would need to be used to either refinance the first lien debt or “prime” the first lien lenders, which can only be done by obtaining their consent or litigating the issue of whether they are adequately protected. Neither of these options are appetizing or realistic as the leveraged loan market remains severely constrained and so called “priming” fights are difficult, if not impossible, to win. Consequently, only lenders within the capital structure effectively are able to provide financing. As a result, if investors want to get into the DIP lending game, they needs to buy prepetition loans to get a seat at the table.
- DIP Loans are Marked by High Rates, High Fees and “Roll Ups”: For distressed companies, the lack of financing options puts them between a rock and a hard place. Without competition from the outside world, it is difficult to find negotiating leverage for rates, fees and other features of DIP loans, such as roll ups (i.e., the prepetition first lien debt is “rolled up” and treated as if it were part of the DIP loan and given the same status as the DIP loan under the Bankruptcy Code). As a result, during this current financial crisis, DIP loans are expensive. The range of rates being negotiated (when the DIP lender is not the government) is between LIBOR plus 600 and LIBOR plus 1200 (with a LIBOR floor) and the fees range from 3 percent to 5 percent. Notably, many chapter 11 cases today are concluding in less than a year, thereby making the return on investment meaningful for the DIP lender. Accordingly, a DIP loan made to the right company can be incredibly lucrative; while the best a distressed company can hope for is competition arising between “warring camps” within their senior secured debt that provides the company with more than one option.
- DIP Loans Place Milestone Requirements on Debtors: In many situations, DIP loans include provisions requiring a company to either meet milestones for the sale of assets or the filing and confirmation of a plan of reorganization. These milestones force a company in a certain direction and enable DIP lenders to influence the outcome of a chapter 11 case. While this is powerful and valuable to a DIP lender, other stakeholders, as well as the bankruptcy judge, may have strong objections to these milestones. As a result, DIP lenders should weigh the importance of having milestones against the potential “noise” and disruption they can cause if the bankruptcy judge refuses to approve them.
- DIP Loans are Not Just for Lending Anymore: As the fulcrum security of many of today’s distressed companies is the senior secured debt (i.e., the first lien leveraged loans) and as the constrained credit markets can make it hard for a company to obtain exit financing, DIP loans may be used as equity investments (once again proving that debt is the new equity). To emerge from a chapter 11 case, a company needs to pay off it DIP loan or convert it into its exit facility and must pay off or otherwise satisfy the claims of senior secured lenders through negotiation or litigation. In today’s uncertain economic environment, where distressed companies are struggling to fix their balance sheets, emerging from chapter 11 with debt (or any meaningful amount of debt) may not be an option. And, thus, an opportunity for the DIP lender. The DIP lender may provide the company with the option to pay off the DIP loan at emergence from bankruptcy or convert the DIP loan into equity. This is a valuable option for the company and a phenomenal equity investment opportunity for the DIP lender.
As investors are searching for opportunities, the DIP loan market is attractive. The DIP loan provides investors with almost instant returns and options for taking control of companies. As bankruptcy and chapter 11 have become the new milieu for M&A and investment activity, the evolution of the DIP loan market will be fun to watch.
Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.