In more normal times, when a company faces the risk of bankruptcy but believes it has a viable business, it files for Chapter 11 and works out a deal with its various creditors. To keep functioning (and paying its lawyers) while the court proceedings are in motion, large companies have resorted to debtor-in-possession financing. The DIP financing is senior to all outstanding debt, and is generally a low-risk, high return money spinner (the reason it can be both is that it takes quite a bit of skill to be in the business, since hard asset lending types need to ascertain whether, if the company is forced to liquidate, whether the DIP can be repaid).
Despite its attractiveness to banks, DIP financing has gone into a hard winter, with one of its biggest providers, General Electric, withdrawing from the market. Many have argued that the dearth of DIP financing will mean that more companies will not be able to use Chapter 11 and will instead liquidate, leading to more job losses than in previous downturns.
A Reuters story points to a different method of adaptation: companies filing for bankruptcy before they are really bankrupt, with some cash left in the till, with the hopes of being able to complete a Chapter 11 restructuring. The story indicates that banks may be willing to extend limited non-DIP financing with this approach (particularly secured financing). But a Morgan Stanley report on these adaptations suggested that they were a far less than ideal solution, and by implication, many companies would not be able to resort to it.
The bankruptcy of newspaper publisher Tribune Co and potential filing by Nortel Networks Corp reflect the increasing difficulty of accessing loans in bankruptcy, which may cause companies to preemptively file for protection, Morgan Stanley said.
Tribune filed for Chapter 11 bankruptcy protection…Instead of securing a debtor-in-possession (DIP) loan, which has traditionally been made to fund a company as it reorganizes in bankruptcy, the company reached an alternative financing deal with Barclays Capital.
This includes a $50 million letter of credit and continued use of a $300 million trade receivables facility it had made with Barclays in July. It has a $225 million balance on the facility.
“Tribune’s filing is telling, and what concerns us is that constraints on DIP financing will only worsen as the cycle wears on,” Morgan Stanley analysts said on Friday in a report….
“The most telling evidence of the challenging DIP financing environment is that companies with significant cash levels are contemplating preemptive bankruptcy (Nortel is an example) as a means to continue to function in a DIP-less bankruptcy backdrop,” Morgan Stanley added….
The popularity in recent years of companies taking out loans that were secured against their assets also complicates securing a DIP loan, as the companies are left with fewer unencumbered assets to pledge against the loan, Morgan Stanley said.
“This is yet another example of the unintended consequences of the proliferation in leveraged loans and securitization over the past few years,” the bank said.
Bankruptcy proceedings may also be more contentious than previously as corporate lenders have shifted away from banks to hedge funds and other investors.
“The holders of paper heading into bankruptcy are very different in this cycle relative to history,” Morgan Stanley said.
“The involvement of hedge funds and Collateralised Loan Obligations (CLOs) shapes our expectation that the bankruptcy process will be contentious relative to the clubby democratic-type negotiations involving commercial banks’ workout groups of the past,” the bank added.
The Morgan Stanley characterization of hedge funds is way too polite. Bank creditors are pros, they understand a deal is better than no deal, and know from experience how far they can push most structures. Hedge funds are, by their incentive structure, very short-term oriented and (generally) have no interest in a fair deal, but in securing the most for themselves. Too many parties like that at the table can often result in acrimonious negotiations and a failure to come to agreement, which is usually the worst outcome.