DIP Financing

How Does DIP Financing Work in Chapter 11 Restructuring?

The ability to access financing is one of the first steps to a successful restructuring, as the value deterioration of the debtor must be curbed as it is coming up with a plan of reorganization (POR).

Oftentimes, the financing represents critical relief required to continue day-to-day operations and restore supplier/vendor trust.

Liquidity constraints and the inability to access the credit markets are by far the most profound quality shared among companies in financial distress.

That being said, DIP financing is frequently regarded as one of the main reasons why a debtor might opt for Chapter 11 in-court restructuring, as the liquidity shortages of the debtor are addressed.

In fact, certain debtors decide to proceed with obtaining bankruptcy protection due to their inability to raise either debt or equity financing.

To address the reluctance of creditors to work with these high-risk borrowers, the Court offers various measures of protection to incentivize lenders to work with the debtor.

How to Negotiate the Lending Terms of DIP Financing?

DIP financing provides funding for a debtor under Chapter 11 protection to allow for the maintenance of ongoing operations while attempting to negotiate a plan of reorganization.

The foremost benefit to debtors is being able to access much-needed capital from the credit markets – which is why the request for urgent financing is one of the most common filings made during the first-day motions.

Without such measures in place, the debtor would not be able to fund its ongoing operations, such as its net working capital (NWC) requirements.

If that were the case, the valuation of the debtor would continuously decline, credit metrics would continue deteriorating, and all the claims held by creditors would wane in value each day.

What is the DIP Financing Process?

DIP financing is an imperative feature made accessible to the debtor, which enables the operations of the debtor to continue, and the liquidity shortfall to remain subdued for the time being as negotiations for the POR are underway.

DIP loans can range widely in terms of size, complexity, and lending terms – but the commonality is that these revolving credit facilities are designed to provide debtors with immediate liquidity to fund ongoing working capital requirements to sustain day-to-day operations throughout their reorganization.

^{Financing Process Steps (Source: Paragon Financial Group)}

Considering their shortfall in liquidity and vulnerability as borrowers, in which being able to meet all interest expenses and mandatory debt repayments are placed into question, most risk-averse lenders reasonably choose not to provide capital to these borrowers without court protection.

DIP Financing for Working Capital Needs

In the absence of capital, the ability of a debtor to formulate a strategy to turn itself around may not even be an option, as capital would be near impossible to obtain.

Besides the available liquidity and prevention of a free fall in value, another consideration is the impact it has on external stakeholders, most notably suppliers/vendors and customers.

Contrary to a frequent misunderstanding, this type of financing is NOT just the handing out of capital to any borrower that filed for bankruptcy in court.

The decision comes down to the Court, which will only approve the request if there is “adequate protection” to the prepetition lenders.

Unless there is a legitimate reason for the additional capital, the motion will be denied.

Additionally, Court approval can have a positive domino effect on suppliers and customers as it shows there is a valid chance for the debtor can return to a normalized state, which suggests the viability of the POR.

How Does a Priming Lien Work (Super Priority)?

To encourage prospective lenders to extend financing to a debtor, the Bankruptcy Code can offer lenders various levels of protective measures. Such protections backing the financing commitment by the Court essentially function as a bridge for debtors to receive debt capital.

Priming is defined as the process in which a claim receives priority above other claims.

Common instances of “super-priority” being granted by the Court are:

• Debtor in Possession Financing (or DIP Loans)
• Certain Professional Fees (i.e., “Carved Out” Claims)

As lenders are aware of the different protections available by the Court, financing is ordinarily secured under “super-priority” status and lien on assets already pledged to existing lenders – making the loan safer from the perspective of the lender.

Under Section 364, the approval of priming liens is subject to two main requirements:

1. The debtor-in-possession must prove that it was unable to obtain financing without offering a priming lien as an incentive
2. The debtor must then prove that the interests of the existing lenders being primed are adequately protected

What is Roll-Up DIP Financing?

DIP financing is oftentimes provided by prepetition lenders (i.e., “roll-up”), as doing so is viewed as one of the best opportunities for prepetition lenders that were unlikely to receive full recovery.

Over the past decade, a frequent occurrence has been the “roll-up” of DIP financing, in which a prepetition unsecured lender provides the DIP loan.

If permitted by the Court, a prepetition lender can be the DIP lender, causing its prepetition claim to “roll-up” into the post-petition DIP loan.

In effect, the prepetition claim becomes rolled up into the new credit facility, which holds priority (or “super-priority”) status and primes other claims.

Conversely, senior prepetition lenders likely to receive full recoveries can provide the DIP loan to maintain their leverage in the reorganization and as a defensive mechanism to avoid losing their control over the direction of the POR.

LyondellBasell DIP Financing Example

In the case of LyondellBasell in 2009, the DIP financing, despite holding administrative status, did not have to be paid back to exit Chapter 11.

Rather, the debt was creatively negotiated to become part of the exit financing (i.e., conversion into 5-year secured notes, re-negotiated term sheet terms such as the interest rate pricing).

One contributing factor was the capital markets being in “bad shape” in 2009, which basically forced the hand of the Court to approve the request – and this type of flexible exit financing has become far more prevalent since.

Despite the fact that the Court is aware that the structuring of the DIP loan was unfavorable, ensuring adequate liquidity was the priority.

DIP Loan Distressed Debt Investing Strategies

Restricted credit markets cause the pool of potential lenders to shrink – and scarcer financing leads to more leverage being held by DIP lenders (and less favorable terms).

DIP loans, which are placed at the top of the capital stack, are one of the safest investments since the DIP lender is among the first claim holders to be compensated.

Compared to equity-converted debt, DIP loans usually exhibit lower returns due to their seniority in the capital structure and the protections provided.

But the yields do tend to see an uptick in times of severe economic recession and liquidity crises when capital is paramount.

During these periods with a high volume of bankruptcy filings, the returns from DIP loans and the negotiating leverage tend to increase (and vice versa).

Still, the lending circumstances are considered to be high-risk. While the pricing will be dependent on the capital supply and the number of potential DIP lenders, the interest rates are typically on the higher end (versus normal lending to non-distressed borrowers).

DIP financing thereby comes with higher yields from the interest rate pricing and arrangement fees.

DIP Loan Acquisition Strategy

Funders of Chapter 11 reorganizations exert significant influence over the bankruptcy proceedings and outcome through their status as the provider of the DIP loan.

The DIP lender can receive 100% recovery and high yields compared to normal lending, yet the returns on DIP loans are rarely equity-like – but there are exceptions in which provisions can be put in place to increase returns.

DIP financing packages have become increasingly creative in how they are structured, with some being re-negotiated to become the exit financing in the post-emergence entity.

For example, one distressed investing strategy used by PE funds in the 2008 financial crisis was providing DIP loans as a tool for securing control of a company with negotiated terms skewed heavily in their favor, which had to be accepted as DIP providers were scarce at the time (i.e., the roll-up financing could shift into a large stake in the equity of the post-emergency company).

To increase the yield, the debt would often be exchanged for equity in the form of convertible debt as part of the lending agreement. Once converted, if a sizeable enough stake was accumulated, the DIP lender could hold a significant percentage of the equity in the newly emerged company.

By the end, the lender would be holding onto a potential controlling stake and benefit from the upside of equity – which was the rationale for providing the financing in the first place under this particular strategy.