Hedge funds have taken control

Author: | Published: 1 Jun 2009
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

Kyle Siskey
Americas staff writer

Hedge funds and private equity don't belong at Chapter 11 proceedings.

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.

“We’re just now seeing the effects of the Bankruptcy Code changes. Companies used to be able to extend Chapter 11 seemingly forever”
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 balance sheet."

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, filed.

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 approval.

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 industries.

"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 territory."

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 facility structure.

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 seemingly forever."

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 funds.

"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.

“For the company it very often comes down to put up or shut up”
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

“Banks are in it to make money through fees. Hedge funds want to micromanage a little more”
Shannon Lowry Nagle, O’Melveny & 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 proceedings.

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 turnaround.

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

“At first we thought $40 million would do it, but we’ve 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 funds.

"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."

As 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 roll-up potentials.

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 restructurings.