Americas staff writer
Hedge funds and private equity don't belong at Chapter 11
New York and Delaware courtrooms are usually reserved for
companies facing their last rights, banks wanting favourable
fallout from a bad loan and judges mulling over documentation.
Funds focus on short-term investments, not the long-term
relationships banks build by joining companies in Chapter 11,
providing exit financing and future loans.
But fund managers are there right now, in front of judges
during interim bankruptcy hearings as debtor-in-possession
(Dip) lenders. For the first time they want to improve their
investor positions by financing companies through Chapter 11
with Dip loans.
And the different motives of the funds are fundamentally
changing Dip negotiations. They are arguing over control
clauses rather than loan tenure, focusing on preferred lien
facility positions rather than interest rates.
"Hedge funds and private equity funds change the dynamic.
The new guys have different agendas and timelines," says Paul
Zumbro at Cravath Swaine & Moore.
Coming to the market
The 1978 US Bankruptcy Code created a market for banks to
bid on Dip contracts by eliminating a law that required
companies to have a trust in case of bankruptcy. The Dip loan
finances the company's actions during Chapter 11 and has a
short maturity date, usually less than two years after a
company emerges from bankruptcy. The Dip lender risks the
company liquidating after Chapter 11 and receiving limited
payment on a preferred-creditor basis.
just now seeing the effects of the Bankruptcy Code
changes. Companies used to be able to extend Chapter 11
Paul Zumbro, Cravath Swaine & Moore
Until 2009 judges had a knack for cramming-down creditors to
keep a company solvent, so the Dip risk was minimal. Since
credit became harder to get, companies are entering bankruptcy
court over-levered without hope of remaining solvent after
Chapter 11. Usual providers such as General Electric Capital
and JP Morgan are too risk adverse to provide Dip loans; so
funds are stepping into their place.
"Banks used to be able to syndicate the loans out in order
to spread the risk to smaller institutions or other funds,"
says Mark Thompson of Simpson Thacher & Bartlett. "But the
traditional banks are more constrained than ever. Without the
syndication they are unwilling to take the entire Dip on their
When it's all about control
Funds are erasing the standard model for Dip loans when
banks don't aren't involved. Their first replacement strategy
is loan-to-own. A loan-to-own method provides Dip financing in
exchange for ownership or a larger stake in the company after
emerging from Chapter 11. Either clauses in the contract will
trigger equity kickers that replace the Dip debt for preferred
equity during Chapter 11 or the equity will be exchanged after
Chapter 11 to avoid defaulting on the Dip loan.
Pre-packaged bankruptcies with these clauses have become
popular and lawyers cite funds' involvement as one reason.
Standard & Poors reports six companies filed pre-packaged
bankruptcies worth $16.5 billion in the first three months of
2009. In all of 2008 only four companies, worth $1 billion,
As part of a pre-packaged plan, Dip contracts negotiated
with funds include a schedule that forces the company to hit
benchmarks for filing for Chapter 11 and confirming a
restructuring plan with creditors. If the company is facing
liquidation, more timing clauses include bidding procedures for
assets, approval by creditors and an auction date. If a company
fails to hit these benchmarks the equity kickers trigger and
the fund controls the company.
"These triggers and features are designed to put the fund in
the driver's seat," says Shmuel Vasser at Dechert. "The fund
either knows or hopes the debtor will default on the loan and
the fund will get control."
|Tarp forces Dip loans
|Starting with auto
manufacturer Chrysler, the US government is setting
the stage to force Dip loans on creditors without
With authority from the Troubled Asset Relief Programme
(Tarp), US President Barack Obama announced a plan to
reorganise Chrysler's creditor base and provide a $4.5
billion Dip loan. The plan, which ignores the rights of
non-Tarp creditors, has raised questions from banks that
fear Obama could do the same in other companies and
"We're in unchartered waters here," says one New York
bankruptcy partner. "The bankruptcy court has given up on
Dip approval rights for creditors and approved this move
because of the government support. There's nothing in the
Bankruptcy Code that says it can't do this; it's scary
If the government starts Dip lending to other industries,
case law will leave creditors powerless to object to
reorganisation plans that force them down the lien
Creditors are worried the government will provide
assistance to General Motors next. The failing auto
company has already taken more than $15 billion in
government funding to stay afloat and comes under the
Tarp authority. After General Motors, the government
might reach into other infrastructure industries that
threaten job losses.
"Where is it going to end?" asks one former Federal
Deposit Insurance Corporation counsel. "The airline or
steel industries could be asking for help next. What will
happen when he politicises their Dip financing?"
The high-pressure timetable results from Bankruptcy Code
amendments made in 2005. Regulators agreed to shorten the time
a company has to file a restructuring plan to 18 months after
entering Chapter 11. Since then, judges have been more willing
to approve Dip loans with shorter timeframes and benchmarks
throughout the process.
"We're just now seeing the actual effects of those changes,"
says Zumbro. "Companies used to be able to extend Chapter 11
If the loan agreement doesn't have equity kickers, it will
probably have a debt-for-equity exchange requirement at the end
of Chapter 11. After a company emerges it traditionally had
exit financing from the Dip bank to pay the loan at a longer
maturity date in exchange for another bank fee.
Funds don't want that; they want control. The
debt-for-equity swap replaces exit financing and gives control
to the hedge funds or private equity. "Banks aren't set up to
own a company, they are in it to make money through fees," says
Shannon Lowry Nagle of O'Melveny & Myers. "Hedge funds want
to get in and micromanage a little more."
Moving and rolling-up structures
As a second replacement strategy, funds are using roll-ups
to move up the loan structure of the company. In exchange for a
fund in a lower lien facility providing a Dip loan, a company
will roll-up all or a portion of a fund's bonds to the top lien
facility or even above all other creditors. Often, a company
will pay the lower lien off using a portion of the Dip
financing. The swap moves the fund up the structure because Dip
loans are in the highest lien facility.
Funds often agree to roll-ups instead of loan-to-own when
the size of the Dip loan is too much for them to sponsor alone.
Instead multiple funds agree to a club structure and move up
together. Lyondell Chemical's $8 billion roll-up Dip loan this
year, with 14 hedge funds and UBS, is the largest Dip loan ever
approved. A $6.5 billion section of the loan includes $3.25
billion in new money and a $3.25 billion roll-up of a portion
of Lyondell's existing pre-petition debt to the hedge
"Although it might not be ideal, they're going to team up
because they don't want an outside fund or bank coming into the
first lien facility above them," says a New York partner that
worked on the deal. "It's a position-saving resort."
Sometimes individual funds agree to roll-ups when they don't
want the responsibility of owning a company after bankruptcy
(either because it doesn't fit in their portfolio or they don't
like the risk that comes with the company). A fund will act
alone to provide Dip financing to smaller companies if it's in
the second lien facility and wants to move above competing
funds. Traditionally, an independent roll-up Dip financing by a
bank would result in a cash swap.
company it very often comes down to put up or shut
Dan Guyder, Allen & Overy
"Sometimes a fund wants more than just fees and would rather
have 10% to 15% control of a company," says Nagle.
The more aggressive roll-up funds are facing objections in
court because creditors' committees in the first lien facility
are not thrilled with another investor moving above or level to
them. One New York lawyer says he's working on an objection to
a large Dip loan that swaps $1.50 with every $1 financing. But,
to convince bankruptcy judges, objectors will have to come to
the table requesting more than a rejection of a Dip loan. They
need a deal of their own.
"The leverage is often in favour of the Dip lender on
onerous terms," says Dan Guyder at Allen & Overy. "The
Bankruptcy Court will sometimes push back, but if that's the
only financing a company can find it's hard to argue. It very
often comes down to put up or shut up."
Pershing Square Capital put up a better offer than Farallon
Capital Management in General Growth's bankruptcy hearings.
After Farallon brought a $400 million proposed roll-up that
raised it to senior-lien facility status, Pershing Square
objected in New York Bankruptcy Court and provided $209 million
in cash collateral itself. Judge Allan Gropper did not rule on
the objection, but the alternative did send General Growth back
to negotiations with Farallon about a second, more favourable
Dip loan. Farallon finally agreed to a $400 million loan that
moved them to the corporate level (on the second lien
facility), behind Pershing Square.
"They went with what we called the 'highest best price,'"
says one New York partner that worked on the deal. "At the end
of the day the court didn't determine the better transaction,
but it did make General Growth go back and look at all of its
options before deciding."
Dipping for profit
in it to make money through fees. Hedge funds want to
micromanage a little more
Shannon Lowry Nagle, OMelveny & Myers
Some more aggressive funds are using Dip loans as profit
vehicles out of liquidation, the way banks typically did. Last
month Eaton Vance announced a plan to invest $1 billion into
Dip loans and Aladdin Capital Holdings said it would enter the
market in February. The short-term nature of these funds makes
their strategies and loan structures with anticipated
liquidations different from those of the banks that profited
from fees and interest rates.
In May 2009 GB Merchant Partners turned a quick profit in
the Dip-loan market by financing Qimonda North America, a
leading semiconductor plant in Richmond, Virginia. Qimonda was
planning liquidation after its German parent company went
insolvent at the beginning of the year. GB, a private equity
fund, laid out a budget report with ongoing business costs and
profits from the asset fire sale. Lawyers determined a $60
million Dip loan could be repaid with interest when the
company's factory was sold less than one year after bankruptcy
The contract combines a $40 million interim loan and an
additional $20 million to ensure the company has time to sell
its factory. "It happened that the worst-case scenario was a
$60 million loan to keep the lights going as the company wound
down," says Thompson, lead attorney for Qimonda. "At first we
thought $40 million would do it, but we've never seen a selling
environment like this; they had to arrange a new amount."
Cross-border companies like Qimonda, whose parents are
guaranteeing liquidation, are most likely to be targets for
quick-profit Dip loans because funds can get a fast
The speed of the budget report and the $20 million buffer
was key to GB. "There are 10% to 15% returns on Dip loans so
funds want to get these deals done," says Thompson. "You're
weighing risk versus reward with these attractive loans. In
Qimonda, the reward was enough for GB."
In search of reliable laws
we thought $40 million would do it, but weve never
seen a selling environment like this
Mark Thompson, Simpson Thacher & Bartlett
Having succeeded in the US, funds are looking elsewhere in
the world for similar opportunities. They have found a niche in
Germany, where they can loan-to-own deals and roll-ups because
the court proceedings are similar to the US. In Germany a
company must file for insolvency in court within three weeks of
discovering that it is over-indebted or facing a liquidity
drought. The short timeframe and a lack of international Dip
creditors creates desperate Dip loans that are favourable to
"We're looking for ways to profit in countries outside of
the US," says in-house counsel at a hedge fund. "Germany is a
big target for us, but there are trustworthy bankruptcy laws
and a lack of competition among firms. Any country that
provides that, we're going to look at as an opportunity."
IFLR reported last year, there is continuous debate about
harmonising bankruptcy codes in Europe. Similar Chapter 11
proceedings to Germany have been copied in the Czech Republic
and Romania. A harmonised Chapter 11 code across Europe would
draw interest from funds, but some lawyers think a UK scheme of
restructuring would be better. The UK scheme is more open to
out-of-court reorganisations and keeps creditors active through
contractual certainty of all loans. The UK's lack of structured
Chapter 11 proceeding means no Dip loans and no loan-to-own or
The more countries in Europe that move towards US-style
bankruptcy laws, the more funds will be interested. But it will
be up to lawmakers to determine if belong funds in their