Source: The Daily Deal
 
When Tex-Mex eatery chain Avado Brands Inc. filed for Chapter 11 in September, its second trip to bankruptcy court since 2004, the company received a $67 million debtor-in-possession financing from prepetition lender DDJ Capital Management LLC. The DIP facility, intended to keep Avado afloat while it pursued a sale as quickly as possible, is priced at 18%, rising a further 250 basis points to 20.5% if Avado defaults.
 
As the economy tumbles into recession, the most vulnerable companies are understandably headed for bankruptcy. What they're finding, however, is that the liquidity squeeze may affect even DIP financing. When times were good, companies could turn to nonbank institutions such as hedge funds for loans necessary to maneuver through restructuring, both in and out of Chapter 11. That kind of flexibility allowed for competition, which helped drive prices down. Now that liquidity has dried up, that option has all but disappeared along with it.
 
When prepetition lenders do step up, they exact a steep price. In today's radically different credit environment, DIPs have become more expensive, shorter in duration and more difficult to arrange. And in many cases, lenders are pushing toward a quick sale or liquidation rather than spending time on restructuring.
 
"Many companies are dead on arrival, and therefore the DIPs are really runways to a quick sale, implementing a prepackage plan or a liquidation," says Peter Antoszyk, a partner at law firm Proskauer Rose LLP. "That will be the norm, not the exception."
 
DIP financings are loans made during bankruptcy that provide companies cash to continue operating while working on a restructuring plan that allows them to exit Chapter 11. Generally, they provide a signaling mechanism to the world, calming vendors, customers and creditors worried that they will be left holding the bag with unpaid account receivables, unfilled orders and unmet loan payments.
 
For instance, Friedman's Inc., a Savannah, Ga., jeweler that filed for bankruptcy on Jan. 14, believed its vendors had lost confidence in the business, and would decline to ship goods without a post-petition loan in place.
 
The twice-bankrupt retail jewelry chain received a $150 million DIP loan from a lender group led by Citicorp USA Inc. as it sought a buyer.
 
Cash-strapped companies in bankruptcy typically go to traditional lenders as the first preference. But when they need greater flexibility or to buy more time, hedge funds looked more attractive despite a generally more expensive price, says Lorie Fife, a restructuring partner at Weil, Gotshal & Manges LLP. For hedge funds, DIPs are both a lucrative and safe bet. Under a court-supervised administration of the bankruptcy, DIP providers have a range of protections such as a first lien on collateral and remedies that are easier to exercise if the company does go into default, Fife adds.
 
For some companies in Chapter 11, however, having greater flexibility is no longer the issue. Wellman Inc., a Fort Mill, S.C., supplier of engineering and packaging resins, filed for Chapter 11 on Feb. 22. It had been seeking a buyer since November but was crippled by its debt, which includes $125 million on its senior revolver, $185 million from a first-lien term loan, and $265 million in second-lien debt. The company also has $400 million in unsecured industrial development revenue bonds issued by the state of Mississippi, according to filings.
 
Wellman had a choice between two DIP financing sources: prepetition lender Deutsche Bank Trust Co. Americas and Ableco Finance LLC, an opportunistic specialty finance company. In the end, it tapped Deutsche Bank for a $225 million DIP loan to fund its bankruptcy case because its pricing was more attractive and there was less uncertainty regarding the size of its borrowing base. The DIP will also help Wellman finance its operations as it continues to search for a buyer.
 
A company in Chapter 11 can choose to receive a "defensive" DIP financing from its prepetition lender intended to protect the creditor's prebankruptcy positions. Or it may borrow from someone different, making it an "offensive" DIP.
 
What's notable about the bankruptcies filed so far this year is that with perhaps one major exception — the $1 billion DIP facility for Montreal printing giant Quebecor World Inc. — most of the DIPs have been defensive, a trend sources say will continue.
 
Prepetition and post-petition new lenders often have different motivations, beyond getting a return on the capital, says Proskauer's Antoszyk. A defensive DIP is usually designed to get paid out eventually. However, as prepetition lenders now become effectively the DIP lenders of last resort, companies may have limited options and may be pushed toward a sale.
 
One reason: a company's inability to put up collateral. Having indulged in easy credit over the past few years, many troubled companies come to the table with few or no unencumbered assets left.
 
"There are no available assets anymore," says Peter Fitzsimmons, co-president of restructuring firm AlixPartners LLC. "There's a lack of available collateral to support a DIP."
 
In circumstances where a company can prove that it cannot obtain financing otherwise, a bankruptcy court may allow the company to grant a new DIP lender a lien that has priority over prepetition lenders, a practice known as priming. In reality, sources say, priming existing lenders has proved difficult and thus is rarely used.
 
When there's so little collateral in a debtor's books, a new DIP lender in effect has to buy the secured credit from prepetition creditors to obtain the first lien. In other words, a new lender must pay off the prepetition lender to avoid priming, but to do that, the financing amount must be even greater than if a company had sufficient collateral, Fife says.
 
In cases where hedge funds have provided the DIP, these were usually insiders seeking a sale of the company. Harbinger Capital Partners Master Fund I Ltd. provided a $17.2 million junior DIP to Friedman's after the jewelry chain went into bankruptcy in January. The hedge fund, a 70% shareholder and second-lien lender, bid for the company at a March 6 auction, and pushed for an expedited sale.
 
Likewise, Wornick Co., a Cincinnati-based military rations supplier that filed for Chapter 11 on Feb. 14, had received a $35 million DIP loan from prepetition lender DDJ Capital, a Waltham, Mass., hedge fund. Under a prenegotiated plan with creditors, Wornick, which has suffered from operational losses and poor performance, will sell itself to a unit of DDJ Capital Management for about $90 million. The DIP carries an interest rate of LIBOR plus 765 basis points, rising a further 200 basis points in the event of a default.
 
Changes in the bankruptcy law in 2005 resulted in shorter DIPs, but this trend has accelerated in recent months. This can hamper a company's ability to rehabilitate itself or have a dampening effect on valuation.
 
Says Fitzsimmons, "If you have a very tight deadline, maybe the buyer may not be able to do as much due diligence and consequently may not offer a high a price." Lloyd Sprung, managing director and head of capital markets at Miller Buckfire & Co. LLC, agrees. A shorter DIP "potentially limits companies' ability to pursue a more broad-based sales process and-or standalone restructuring alternatives."
 
Lillian Vernon Corp., a long-struggling direct-mail and online retailer based in Virginia Beach, Va., tapped senior lender Wachovia Bank NA for an $8.5 million DIP revolver. Wachovia, Sun Capital Partners IV LP and Bank of Montreal are owed roughly $15.58 million in prepetition secured debt.The latter two lenders are participants in a $10 million revolver that is subordinate to the debt owed to Wachovia. The DIP loan, intended to fund the company's operations prior to a sale, matures on May 31 or the confirmation date of a reorganization or liquidation plan.
 
Earlier this month, the online retailer's lawyers sought to install rival Creative Catalog Holding Corp. as the lead bidder for its assets. Its $9.25 million offer was less than the total amount of debt owed.
 
Clearly, lenders now demand a higher return, regardless of whether the financing is defensive or offensive. Debt has become more expensive and in many cases is accompanied by LIBOR floors and an original-issue discount — the difference between the stated redemption price at maturity and the issue price — if a syndication is planned. While each case may be very different, asset-based loans have been LIBOR plus 250 to 300 basis points, with up-front fees in the 1% to 2% range. But for cash flow term loans, the pricing has been LIBOR plus 500 to 600 basis points, with 2% fees and 2% original issue discount, says Sprung.
 
Understandably, expensive DIPs and transaction fees don't sit well with management or creditors. "Every bit hurts," says Brad Erens, a partner at Jones Day and head of business restructuring and reorganization. "The more you pay for DIP financing, the less you can pay your other creditors."
 
In perhaps the most glaring examples, DIP loans for both Fedders North America Inc. and Avado were priced at unusually lofty levels. The Effingham, Ill., air-conditioner maker filed for bankruptcy in August 2007 armed with a $79 million DIP loan — consisting of a $33 million senior secured revolver and a $46 million senior secured term loan — from prepetition lender Goldman, Sachs & Co.'s credit arm. The term loan portion is priced at a base rate plus 1,300 points. Goldman has a first-priority lien on all the company's property and assets. Fedders is selling off its assets.
 
In Avado's case, the parent of the Don Pablo's Mexican Kitchen and Hops Grillhouse & Brewery chains took on a $67 million DIP from pre-petition lender DDJ Capital, the second most expensive approved loan last year after Fedders', according to www.BankruptcyInsider.com. This was the second DIP Avado received from DDJ Capital, which became majority owner through a debt-for-equity swap agreement on a previous exit facility. Earlier, the company was cleared to sell a majority of its restaurants and its Madison, Ga., headquarters. The buyer? Rita Acquisition, an affiliate of DDJ Capital.
 
There may be limits to how expensive a DIP can be, however. Bankrupt eatery chain Buffets Inc. appeased creditor demands by slashing its DIP financing by $100 million after some of its creditors objected to the terms senior lender Credit Suisse Group provided.
 
Unable to handle the debt it assumed to acquire Ryan's Restaurant Group, Buffets sought Chapter 11 protection on Jan. 22 after missing payments on $321 million in 12.5% notes. The original $385 million DIP included an $85 million tranche with Credit Suisse, which was to get first-lien priority, while the $300 million rolled over from its lender's prepetition loan was getting a second-lien position.
 
The 12-month DIP was priced at LIBOR plus 725 basis points, with LIBOR between 4% and 5%, for a total cost of between 11.25% and 12.25%, according to filings.
 
Concerned about the loan pricing, an unofficial panel of bondholders noted that it was priced 400 basis points above the prepetition lenders' rates on the revolver and 425 basis points above the prepetition term loan. Creditor Levine Leichtman Capital Partners Deep Value Fund I LP said in documents filed that the DIP's "exorbitant price" and its demand of converting $300 million into administrative claims (through the DIP) gave lenders "absolute veto power" under any plan and skewed the reorganization process.
 
Levine, which is owed about $38.25 million in unsecured debt, had argued that the DIP unnecessarily strong-arms Buffets into an unfavorable auction unless the company's lenders agree to refinance their debt.
 
Notably, a LIBOR floor is increasingly applied in DIP financings, along with origination issue discounts. OIDs, considered a form of interest, help guarantee a richer return on a debt instrument. They're increasingly popping up to entice investors to DIP financing syndications by matching other debt instruments trading below par and to compensate for the risk that the debt will trade lower in the secondary market. Quebecor's DIP, led by Credit Suisse and Morgan Stanley Senior Funding Inc., was priced at LIBOR plus 500, had a LIBOR floor of 325 and an origination discount of 98%, though it did receive a longer term of maturity of 18 months. Quebecor filed for bankruptcy protection on Jan. 21 with $1 billion DIP financing, the largest yet this year.
 
Moreover, DIP terms are becoming more restrictive. Besides the normal set of covenants, DIP creditors are asking and getting other demands.
 
A victim of the housing slump, homebuilder Tousa Inc. filed a bankruptcy petition on Jan. 29 and received up to $150 million in DIP financing from Citigroup Global Markets Inc. It has a term sheet that requires the Hollywood, Fla., company to meet certain tight deadlines, including filing a plan acceptable to its senior noteholders by March 29. The company operates primarily in Florida, the mid-Atlantic, Texas and the West Coast.
 
Ultimately, companies will reap the consequences of the covenant-lite era by entering bankruptcy saddled with more debt than ever and beset by problems that are much further along than they would be otherwise. Covenants serve as warning posts for a company's performance that traditionally allow lenders to gain more leverage. With covenants, creditors can exact greater oversight on the company and apply levers so that a company can take appropriate measures before a bankruptcy becomes inevitable.
 
The disappearing covenants of recent days have eliminated many of these warning posts for a troubled company. So alarm bells may not go off until a company has accumulated significant liquidity problems, is unable to refinance and defaults on a payment. When its debtor's troubles appear beyond easy remedies, a lender may have to push for a sale or prepackaged plan rather than wait for the company to restructure and exit bankruptcy.
 
"In any environment, there's never an easy Chapter 11," says Fitzsimmons. Nowadays, it's just a bit tougher.