Many hedge funds and private equity firms utilize DIP financing as a part of a “loan to own” investment strategy, a strategy not necessarily attractive to a pre-existing lender. In this type of investment, the hedge fund or private equity firm provides DIP financing to the debtor-in-possession in exchange for the opportunity to convert the loan to equity and management control. The terms of the DIP financing agreement will typically provide terms that facilitate the transition of reorganization value and equity to the investing hedge fund or private equity firm as a “stalking horse” bidder in a Section 363 sale. The investing fund or firm aims to profit from the quick sale of the reorganized company. A DIP lender is essentially bargaining for the option to swap debt for equity in exchange for a high interest rate, a loan fee up front, and an exit strategy whereby it can exit bankruptcy with a repaid loan and control of the debtor company. Moreover, since DIP financing –- as the senior-most obligations of the debtor company –- generally must be paid in full in cash upon a company’s emergence from bankruptcy, the debtor, because it does not need to raise the cash necessary to pay off the DIP loans to exit bankruptcy, also benefits.

III.     Considerations for Creditors Dealing With Institutional DIP Lenders
Creditors, and particularly secured creditors of a debtor-in-possession that has received DIP financing, should be aware of the likely implications that the DIP loan and the associated DIP loan agreement will have on their rights in the bankruptcy. As noted above, debt-equity swaps and prescribed milestones allow the DIP lender to exercise significant control over the debtor-in-possession and the restructuring process. Additionally, as a part of the DIP financing process, the debtor-in-possession and DIP lender may seek to enter into a Plan Support Agreement, by which the DIP lender promises to support the eventual plan of reorganization in exchange for certain bargained-for provisions.  Accordingly, a creditor facing the prospect of DIP financing must be attentive to the process to ensure that the control exercised by the DIP lender does not prejudice its rights in the bankruptcy, and may want to consider whether it might be advantageous for it to agree up front to support a Plan in order to secure for itself favorable treatment.

For an equipment lessor, specifically, the relevant considerations for DIP lending pertain to the treatment of their leases with the debtor. During the course of the bankruptcy, a lease will either be assumed and assigned to a third party buyer or rejected, the latter resulting in the return of the leased equipment. If assumed (and subsequently assigned to a third-party purchaser) lease arrears will be cured, the new purchaser’s financials will be vetted, and the lease terms will continue with a new, viable lessee. Therefore, DIP financing is almost always an advantageous proposition to an equipment lessor whose lease will be assumed, since it makes it more likely that the lease will continue as opposed to having been rejected by the debtor-in-possession with the leased equipment (which almost certainly has significantly depreciated) returned. Of course, absent assumption, the equipment lender will have an unsecured claim to assert for “rejection” damages, but typically that is a speculative and dubious benefit.

In sum, DIP financing is not limited to only those lenders with whom a debtor-in-possession has a pre-petition relationship: Existing substantial secured creditors should at least consider DIP lending to protect and even enhance their pre-petition positions. Institutional lenders, including ever increasingly hedge funds and private equity companies, are heavily involved in the DIP financing business. Outside DIP lenders find the process attractive, profitable and relatively low risk, frequently being able to exercise a significant amount of control over the debtor-in-possession and the restructuring process. Both secured and unsecured creditors, however, must remain informed, actively involved, and vigilant in order to adequately protect their often competing financial interests with the DIP lender.

See Part I of Dipping Your Toe Into Dip Lending?

Endnotes:

(1.)  See Dahiya, Sandeep; John, Kose; Puri, Manju; and Ramirez, Gabriel. Debtor-in-possession financing and bankruptcy resolution: Empirical evidence. Journal of Financial Economics, vol. 69 (2003).
(2.)  See, e.g., In re Momentive Performance Materials, Inc., (Bankr. S.D.N.Y.) (one year); In re Coldwater Creek, Inc. (Bankr. D. Del.) (four months); In re James River Coal Company, (Bankr. E.D. Va.) (nine months).
(3.)  RadLAX Gateway Hotel, LLC, et al. v. Amalgamated Bank, 132 S. Ct. 2065 (2012).