“Loan to own” is a term used in both the USA and Canada as a way to secure a position for a potential investor to ensure that its post commencement finance (“PCF”) or DIP Finance places that investor in a strong enough position to eventually take control of either the assets or the equity in the company.
In the USA “loan to own”, or “offensive” DIP lending, underwent a significant change in the late 1990s and early 2000s as new sources of funding. Distressed investment funds entered the market. There are substantial differences in the approach by commercial banks as opposed to that of distressed investment funds in the USA.
First, commercial banks will look at financing economics and the possibility of future lending opportunities. Distressed investment funds frequently focus on the opportunity to acquire the debtor’s business at a deep discount.
Second, unlike commercial banks, most distressed investment funds do not originate loans to healthy companies. Their funds rather focus on the economic advantages available by investing in distressed companies, including the high short-term fees available via DIP loans.
Third, distressed funds also seek to take advantage of various “loan-to-own” strategies that involve acquiring a dominant or, in some cases, a “fulcrum” position in the capital structure of a distressed company and converting that debt position into equity through a bankruptcy proceeding. For example, under one common approach, the fund simply buys the debt of a distressed company from its existing lenders (normally commercial banks) at a deep discount.
Four, the fund may also acquire the debtor’s equity and, with it, some amount of management control. In addition to the acquisition of discounted debt, a fund can attempt to take ownership by providing DIP finance to the company with the goal of converting the DIP finance claim into equity in the reorganized company through a reorganization plan or, more commonly, with the intention of credit-bidding the acquired debt to then acquire assets of the debtor at auction.
Then, in the USA, like in SA, commercial banks are not in the business of owning and operating their borrowers. It is therefore distressed investment funds, which more frequently employ loan-to-own post-petition financing strategies.
Lastly, in the USA DIP funders profit through fees and interest earned in the deployment of capital. As a result, commercial banks are attracted are to the DIP financing market by the high fees and interest rates and the relative likelihood of repayment typical of DIP loans.
It is also necessary to look at how a DIP financier or for that matter PCF lender, being the distressed investment fund, control the process.
First, in order to assure that it will have an opportunity to credit-bid its PCF obligations and, if applicable, its acquired pre-commencement debt, the offensive PCF lender will typically include milestones in the credit agreement requiring the BRP to undertake a sale process. By doing this the PCF lender can therefore use the PCF agreement to exert significant control over the business rescue proceedings.
Second, a PCF lender could closely examine the company’s business operations. Information obtained from both the initial diligence before the PCF facility is secured and from the reporting requirements in the PCF credit agreements will provide the lender with a head start over other potential bidders in terms of diligence.
Thirdly, although the PCF lender must contend with other potential bidders at auction, the lender should be a step ahead of those bidders.
Then, typical reporting requirements contained in the PCF loan agreement will provide the lender with access to key information regarding the debtor’s business operations. This increases the likelihood that the distressed investment fund may be selected as the “stalking horse” bidder.
Furthermore, the reorganized debtor may then be significantly de-levered because of the conversion of secured debt to equity.
This then leads one to the question as to whether there any chances of distressed investment funds being developed in SA. Because it is would appear to be clear that banks are unlikely to develop such a “products’ may be viewed differently by a specific banking group. In other words, other funders are looking at the possibilities. It is however so that, in a high profile rescue matter, the desire to maintain or strengthen the bank’s relationship with the company can be just as important as the PCF financing loan economics.
Lastly we look at the miscellaneous issues contained in DIP Finance agreements and which potential PCF lenders in South Africa may look at.
Firstly, the agreement will provide for the loan structure and amount. The structure of a DIP loan is frequently determined by the working-capital needs of the debtor and whether it will be structured as a term loan, revolving loan, or some combination of the two, the loan structure itself is likely to have little impact on the outcome of a debtor’s case. The amount of the loan and the perception of liquidity that it can provide can demonstrate an important affirmation of a debtor’s prospects of a successful reorganization.
Second, one will look at price and fees. The pricing of DIP financing agreements is largely driven by macroeconomic factors. In the aftermath of the 2008 financial crisis, commercial lending effectively halted, and the DIP financing market froze along with it. As the DIP financing market dried up, with some former participants going out of business themselves, the few remaining participants could demand extraordinary fees. Without access to reasonably priced DIP financing, many troubled companies focused on workouts and other out-of-court restructurings. As the credit crisis eased and DIP financing again became more widely available, the fees charged for post-petition financing have decreased. Nonetheless, DIP loan pricing terms continue to be favorable when compared with pre-crisis fees and interest rates.
Third, the term and maturity. Whatever the terms of the DIP loan, one of the overriding concerns of a DIP lender is always how and when the loan will be repaid. The lender’s strategy in structuring the timing elements of the loan reflect this concern. Generally, a DIP loan will have a considerably shorter term than a typical pre-petition corporate credit agreement. A DIP lender always faces the possibility that adverse events might occur that could impede the debtor’s emergence and impair the lender’s recovery. For example, many lenders found themselves in difficult positions as the economic landscape changed rapidly in 2008. In addition, most lenders have little interest in becoming embroiled in drawn-out, contentious bankruptcy proceedings.
A lender funding a restructuring therefore typically will seek to limit the period that its borrower remains in bankruptcy and impose milestones to ensure that the debtor continues to progress toward a sale or confirmation and emergence.
Debtors, on the other hand, seek to secure enough time in chapter 11 to carry out a restructuring or sale. Some commentators have expressed concern that short-term DIP loans can make it very difficult for effective reorganization.
Fourth, the security to be provided. A lender can either secure its loan with a lien on the unencumbered assets of the debtor, if any, or through a priming lien on already-encumbered assets.
Furthermore, covenants and events of default. Credit agreement covenants and events of default are lenders’ primary means to control their relationships with their borrowers. In the bankruptcy context, lenders seek to impose various covenants and events of default, among other things, to ensure that the lender receives up-to-date financial performance data. It also provides the lender with an escape route in the event that the borrower’s business falters and ensures that the debtor adheres to a restructuring or sale strategy on a timeline that is acceptable to the lender. Together, these tools can provide powerful levers for DIP lenders to exert control over the bankruptcy case. Borrowers are required to report their performance regularly with respect to financial covenants to lenders. Outside of bankruptcy, these metrics are designed as “canaries” to ensure that the lender is made aware of the borrower’s declining financial health before default becomes inevitable. Examples include debt leverage ratio covenants, fixed-charge coverage ratio covenants, maximum debt-to-equity ratio covenants, and interest-coverage ratio covenants. These metrics, which measure the health of a company in various ways, are rarely as useful in the context of a DIP financing credit agreement because, by definition, the DIP loan borrower is already in distress.
DIP financing credit agreements, therefore, frequently contain financial covenants that measure minimum performance rather than overall financial health, which can provide the lender with an early escape route-without having to wait for an actual payment default-in the event that the borrower’s business falters. Minimum EBITDA covenants are common, usually with increasing minimum levels over time.
Hans Klopper of Independent Advisory
- Perlman F.G, Baer H.P, Kevane H, Bagby I, Corbi R.J, Farnsworth S, Krause S, Kriegel M, Lucas J.W and Maman M : “Debtor-in-Possession Financing: Funding a Chapter 11 Case” American Bankruptcy Institute
- Salerno TJ, Kroop J.A and Hansen C : “The Executive Guide to Corporate Bankruptcy” – Second Edition (BeardBooks 2010)