We’ve warned for some time that this downturn is likely to see more companies entering bankruptcy wind up being liquidated rather than continuing to operate thanks to Chapter 11, which allows companies to hold creditors at bay, renegotiate debt and restructure operations, with the idea that an ongoing concern will be able to provide better recovery rates to lenders, as well as save jobs.
However, this time around, Chapter 11 may not be a viable solution for many companies in trouble. First, in the last wave of private equity deals, not only were the companies highly levered, but the debt was often “cov lite”. Normally, in risky borrowings, banks require that the borrower maintain certain levels of performance, such as keeping a minimum net worth, or having income exceed a multiple of interest expense. If a company violates those restrictions, the lenders can accelerate the debt, meaning demand immediate repayment. Of course, the company can’t cough up the money, so the creditors can force a Chapter 11 filing if the company can’t provide adequate remedies.
In other words, covenants permit lenders to intervene when a company’s condition is starting to deteriorate but has not yet gotten desperate. Weaker covenants mean that many companies are in worse shape when they enter bankruptcy.
In addition, when a company is in the Chapter 11 process, which can take many months, it still needs to keep paying its bills (employees, supplies, taxes, and those pesky lawyers). Debtor in possession financing allows companies in Chapter 11 to borrow the needed funds to keep operating.
We’ve warned that scarce DIP financing could produce considerable collateral damage, since liquidations produce considerable job losses. Yet the Treasury and Fed have made its dubious and costly toxic asset subsidy programs priority and ignored this pressing need.
And credit markets continue to function so poorly (outside those sectors on government life support) that so-called exit financing, the debt companies would raise once they left the courthouse, is also scarce and costly. In fact, some companies that have DIPs are choosing to extend them due to the dearth of exit funding.
From Reuters:
Bankrupt U.S. companies lucky enough to survive a court restructuring are hitting another roadblock created by the economic downturn — finding the money they need to put it all behind them….. But today’s weak markets are not an option now. And like the market for the debtor-in-possession financing that is used to pay for bankruptcy, the outlook is not much better, bankers and lawyers say.“Exit financing is a pretty tough game right now to be honest with you,” said Brian Trust, a partner at Mayer Brown in New York.
“I’m not saying that you are going to see exit finance markets break open. I think they are going to be subject to the same issues, concerns, constrictions and tightness of credit that we have seen in the current DIP market — although we have seen a crack in the general credit markets.”
Many companies are preparing for continued weak credit markets, renegotiating debt and planning debt-for-equity swaps and rights offerings that put more equity into the company instead of debt. They are also doing prearranged bankruptcies more often, which can help keep debt down and decrease the amount of exit financing needed….
The issues for bankruptcy financing is that, when the credit markets tightened up last year, loans to bankrupt companies — even the DIP loans that were once coveted by lenders because they are repaid first — dried up.
“Liquidity right now in terms of fresh loans to distressed companies is very low. It’s the lowest point I’ve ever seen it, which is forcing people to be creative in terms of how they structure DIP and exit financing,” said Kris Hansen, co-chair of the nationwide financial restructuring group at Stroock & Stroock & Lavan LLP in New York.
Some companies have managed to find small amounts of exit financing. U.S. restaurant chain Buffets Holdings Inc, for instance, lined up a $120 million exit loan earlier this month….
“Because of the current disruptions in the syndicated loan market, most companies will find it more challenging to raise exit financing and instead may attempt to reinstate existing debt or, if there is hard asset collateral, turn to asset backed financing instead,” said Bruce Mendelsohn, co-head of Americas Restructuring at Goldman Sachs.
“But doing a traditional syndicated term loan is going to be very difficult and it’s going to be very expensive
Some companies have tested the exit finance market and decided a better choice is to wait it out. Frontier Airlines Holdings Inc arranged a $40 million DIP earlier this month to refinance one that would have expired next month.
Marshall Huebner, co-head of Davis Polk & Wardwell’s restructuring group and Frontier’s lead counsel, said the company met lenders and discussed both an extension of its bankruptcy financing and exit financing before deciding to extend
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Is this really a bad thing? Perhaps we have too many weak companies. For example, the lack of Circuit City and Linen’s n Things makes Best Buy and Bed Bath and Beyond stronger companies. Since consumer demand is shrinking and needs to shrink, we need fewer retailers. Part of the recovery process from recession is the weeding out of the weak, poorly managed companies so that profit margins for the survivors can increase and support growth and new hiring. The job losses in retail is unfortunate but necessary as our economy needs to rebalance and become less dependent on consumer spending.