Watch for the DIP

While there aren't too many silver linings in the economy right now, the high number of bankruptcies in 2009 and beyond may provide an opportunity for private equity managers looking to provide debtor-in-possession (DIP) financing to companies reorganising under Chapter 11.

Dozens of high-profile private equity-backed companies such as Linens 'n Things and Mervyns declared bankruptcy in 2008, and more are expected in 2009 as portfolios acquired for large sums just a few years ago by firms like Apollo Global Management, Kohlberg Kravis Roberts and Oaktree Capital Management buckle under heavy debt loads.

Both Apollo-backed Linens and Sun Capital-backed Mervyns were forced to liquidate their businesses last year after exhausting other options. In many such cases a liquidation occurs due to a lack of bankruptcy financing – known as a DIP loan – which is used to fund a company's operations, pay professionals in bankruptcy and fund its emergence from bankruptcy.

“One of the many reasons why a private equity firm would want to make a DIP loan is because these loans ordinarily come in at the top of the capital structure with a great deal of protection and seniority.”

Although most companies would prefer to restructure their debt under the protection of Chapter 11 and reorganise and re-emerge from bankruptcy in a stronger position, some of the most active DIP lenders such as GE Capital have backed off during the current recession. Some have also reduced the length of the loans being extended from the typical 12-18 month range to as short as 60 days.

Without such financing, companies may have trouble paying its employees and suppliers and funding its bankruptcy process, sending it straight to liquidation. With traditional lenders pulling back, and Moody's Rating Service recently projecting a rise in demand for DIP financing amid the current defaults, private equity firms could fill the void.

For instance, Sun Capital Partners – which has had 10 companies go bankrupt since last year – is providing DIP financing to two of its portfolio companies to keep control of them through the bankruptcy process. The firm's strategy is to buy the companies out of bankruptcy through debt and operate them in their reorganised form.

The firm provided a $12 million DIP loan to auto parts maker Fluid Routing Solutions in February, and subsequently bought three of the company's plants, purchased some of its debt to solidify its controlling position, shed an unprofitable business line and saved 900 jobs through the restructuring. It is pursuing a similar strategy with portfolio company Big 10 Tires, including providing a DIP loan of up to $3 million to allow it to operate through bankruptcy.

Meanwhile, TPG has expressed interest in joining a DIP lending group – including Apollo, Oaktree, Deutsche Bank and Bank of America –- providing about $1 billion to its portfolio company Aleris International. “A lot of people see DIPs as a way to rescue their own investments, their own portfolio companies or because they see it as a good use of capital generally,” said Michael Sage, a partner at law firm Dechert. “One of the many reasons why a private equity firm would want to make a DIP loan is because these loans ordinarily come in at the top of the capital structure with a great deal of protection and seniority. There is always some risk the company melts down, but you are contractually and by statue at the top of the heap, and you get important controls along with that.”

Extending a DIP loan may lead to certain legal obligations, particularly if the lender acquires an equity interest in the bankrupt company, including requiring certain disclosures and precautions regarding information acquired. For instance, a private equity owner of a company is advised before it makes a DIP loan that the court and the main constituents in the case have been given full disclosure about its debt and equity stake and whether it has anyone on the board of directors.

Without that other parties in the case could claim that the firm is trying to leverage the company or get an unfair advantage. “Disclosure is very important, and as long as you're following the rules of the road and the bankruptcy code requirements in making a DIP loan, then it is hard, though certainly not impossible, for anyone to complain,” Sage said. “Any insider providing DIP financing is well served to provide full and complete disclosure whether they are making a small or big DIP loan.”