In this series of articles (“Bank Turndowns”), we explore why borrowers are turned down by their bank for a loan, and how they can get approved by another lender. To access all the volumes in this series, go to our “Series” page here.
If you are contemplating filing for bankruptcy on behalf of your company, looking for a new loan may be the last thing on your mind. Indeed, it seems counterintuitive to think that a bank would ever want to loan money to a company in financial distress, let alone a company in bankruptcy.
However, there is a loan product specifically tailored to keep companies afloat during bankruptcy and eventually return to profitability. Welcome to the world of “debtor-in-possession financing” (or “DIP financing”).
DIP financing takes a lot of planning and is governed by the U.S. Bankruptcy Code. It involves a lot of different parties besides just the lender and borrower, such as bankruptcy attorneys, financial advisers, and even new lenders. It also requires approval along the way from the bankruptcy court. In other words, this type of financing is very complex, but we highlight 5 fundamental principles here.
#1: What is DIP financing?
“DIP” stands for “debtor-in-possession,” the legal term for a company that has filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code, but is still in “possession” of the property in question.
As such, the company still needs to operate the business during the bankruptcy proceedings. That is where DIP financing comes in. Usually in the form of a short-term bridge loan, DIP financing gives the company the liquidity it needs to pay its vendors and suppliers and otherwise continue its day-to-day operations as the bankruptcy proceeds.
#2: What are the main benefits of DIP financing?
- Cash is king: DIP financing provides fresh, immediate cash to help the company maintain a positive cash flow. The DIP typically needs cash immediately after filing for Chapter 11 bankruptcy to cover payroll and other up-front costs of stabilizing the business. Also, as a practical matter, post-bankruptcy credit extended by vendors typically insist on cash on delivery (COD) or even cash before delivery (CBD).
- Longer-term benefits: As the reorganization process unfolds and the company stabilizes, DIP financing provides the company with a steady stream of funds for ongoing working capital.
- Everyone benefits: Under the Bankruptcy Code, the DIP lender is entitled to a special high-priority lien that takes precedence over existing debt, equity, and other claims. This generally requires consent of the subordinate lienholders, which typically is given. Without DIP lending, the value of the collateral might plummet. After all, a smaller percentage of something is better than a bigger percentage of nothing.
- Restore confidence: Perhaps most important, DIP financing helps the company instill confidence in its vendors and customers that the company will be able to maintain its liquidity and remain in business. Usually, the company achieves this by issuing a press release announcing that it has received millions of dollars in DIP financing. For example, Sears issued a press release in October 2018, and PG&E issued a press release in January 2019.
#3: Who provides DIP financing?
Generally speaking, DIP lenders fall into one of two categories, either (1) an existing lender that already provided a loan to the DIP prior to the bankruptcy; or (2) an entirely new lender that had no preexisting relationship with the DIP.
In the first scenario, where the DIP loan is provided by an existing secured lender, such loan is referred to as a “defensive DIP loan” because that particular lender has a vested interest in extending further credit to protect its existing loan position.
In the second scenario, where the DIP loan is provided by a new lender, such loan is referred to as a “true third party DIP loan,” or may be referred to as an “offensive DIP loan” if the lender is making a stalking horse bid for the company’s assets.
According to Debtwire’s North America DIP Financing Report, the majority of the DIP loans in 2017 were defensive ones by preexisting lenders.
#4: What types of companies receive DIP financing?
Businesses of all types receive DIP financing. For example, in the first half of 2017, companies receiving DIP financing fell into the following industry sectors (from most to least common):
- Energy, retail, technology;
- Alternative energy, healthcare, medical;
- Education, financial services, industrial products & services, pharmaceuticals, restaurants, services, utilities; and
- Aerospace, agriculture, construction, manufacturing, media, mining, steel, transportation.
#5: What are some typical terms of a DIP loan?
DIP financing generally comes in two forms: (1) term loans; and (2) revolving credit facilities. In most instances, term loans have become far more common than revolvers.
Lenders that specialize in DIP financing are usually willing to consider all commercial property types. Sample terms include the following:
- Loan amount: This parameter is highly variable. Some lenders offer ranges such as $500,000 to $20 million. Others offer $250,000 minimum and no maximum.
- Loan-to-value ratio (LTV): Some lenders are willing to go up to 65% or even 80%.
- Interest rate: According to Debtwire’s North America DIP Financing Report, interest rates ranged widely in 2017 from 4% to 20%, but the sweet spot for the majority of the surveyed companies fell between 6% and 12%.
- Term: The terms are typically short, ranging from six months to three years, with the possibility of interest-only payments and no prepayment penalties.
- Closing time: Lenders recognize the urgency of the situation and endeavor to close within two weeks, for example.
SPOTLIGHT – CLOSED DEAL: On behalf of a swimming pool company that recently filed for Chapter 11 bankruptcy in Florida, we helped obtain $1.25 million in much-needed DIP financing in a very short period of time. The DIP was one of two tenants of a mixed-use property, and needed financing for its cash-flow needs. The initial lender offered only $836,000, and the process was taking too long. The trustee then called us to step in and speed up the process. In less than 24 hours, we were able to secure a term sheet for $1.25 million (or $414,000 more than the initial lender’s offer). We also kept the process streamlined, including by using the appraisal and the majority of the other documents that had already been submitted to the initial lender.
In short, the loan was closed quickly, the DIP received the financing it needed to stay afloat, and the trustee thanked us for making it look good in front of its client.
Although lending to a bankrupt company seems paradoxical, DIP financing actually plays a key role in helping companies get through bankruptcy and successfully come out better on the other side. Contact us today to learn more about DIP financing and how it can help your company.
Continue exploring our “Bank Turndowns” series:
To access all the volumes in this series, go to our “Series” page here.
David A. Krebs is a licensed mortgage broker offering commercial and residential loan programs beyond your regular bank. Call us at 321-239-2781, click here to submit a message, or click here to book a free consultation.