In the first of a series of four stories, IFLR digs into the state of debtor-in-possession (DIP) financing in Latin America. DIP financing is funding for a debtor which ordinarily comes in the form of secured notes or loans. It’s designed to inject liquidity and aid in covering expenses and operations during a restructuring.
Right now, restructuring is an important topic in Brazil. Companies are losing liquidity fast and looking for recovery alternatives. Yet one of the tools available to them, debtor-in-possession (DIP) financing, isn’t a trend, despite being popular in the US. That's partly down to the slow pace of the process in Brazil.“The time between the proposal and the acceptance of DIP financing terms in the US tends to be a lot quicker. The process can be a lot longer in Brazil,” said Joy Gallup, partner at Paul Hastings. But there are other, more deep-seated reasons as to why DIP financing isn’t as popular in Brazil. And according to local counsel, that's because the first experience of DIP in the country wasn’t great, and the bad image stuck.
“We’ve had a couple of experiences with DIP financing here in Brazil and, frankly, we think there’s a lot of room to improve,” said Renato Maggio, partner at Machado Meyer Sendacz e Opice.
The first DIP transaction in Brazil was the 2010 issuance of bonds by Frigorífico Independência. “We acted as counsel to the arranger on that issuance. But it turned out that the company defaulted on its very first payment,” said Maggio.
As a result, its creditors started actions to foreclose on the collateral. The case went to a small and non-specialised court in the São Paulo countryside. That combined with the relative novelty of the law led the judge in charge to submit the collateral enforcement to court review. As a legal decision, it was just the sort of thing that makes potential lenders back away from DIP financing transactions.
“The creditors eventually initiated a negotiation with debtor. But, really, most of the people involved in this transaction perceived it to be the case that creditors could not enforce their rights,” said Maggio.
- Despite the high level of distressed corporates in Brazil, DIP financing hasn’t taken off;
- Initial experiments with DIP financing in Brazil didn’t go well, suggesting creditors cannot enforce their rights;
- Brazil’s liquidation process is also discouraging DIP financing: it can take up to 15 years;
- The market is also suppressed because banks don’t enter the DIP financing market due to regulatory disincentives;
- Counsel see incremental movements in Brazil, but the key to higher future levels of DIP financing is legal clarity.
Eventually, the creditors did enforce their rights. And Maggio is quick to point out that times have changed: “The same judgement in São Paulo or Rio in today? Well, perhaps the outcome would have been different,” he said.
“Since then, our courts have become much more familiar with these issues. We may be, perhaps, in a different situation today compared with 2010,” said Renata Oliveira, partner at Machado Meyer. But the bad image hasn’t gone, as legal clarity is still absent: “It’s difficult in Brazil for lenders to be certain, because of possible lengthy court challenges,” said Gallup.
Brazilian liquidation process
Another cause of DIP’s low level of development in Brazil is the way the country approaches liquidations more generally. Again, there’s much to be desired.
The idea of super priority relies on an obvious chain of events: if a company goes bust, the relevant investors are the first to recover their capital. That encourages confidence when lending to a corporate in distress. It also assumes, however, that liquidation proceedings work in an efficient matter. According to Maggio, that’s simply not the case in Brazil.
“We have a liquidation process that has a lot to improve. It is a proceeding that may take five, ten or 15 years. That’s one of the reasons why DIP financing mindset needs to adapt to our country,” Maggio said.
"We've had a couple of experiences with DIP financing here in Brazil and, frankly, we think there's a lot of room to improve"
That kind of lag results in an army of the corporate undead which is likely to grow in number given Brazil’s current economic woes. “Here in Brazil… companies lose liquidity and become zombie companies that keep going for a long period. That’s the reality in Brazil. This liquidity gap needs to be bridged,” said Maggio.
A third factor dampening DIP financing in Brazil is common in other LatAm countries too. “The real difficulty in Mexico and Brazil and other countries is that banks don’t enter the DIP financing market,” said Gallup.
That’s down to the serious regulatory disincentives facing banks in the DIP financing space. According to Gallup, the market is instead dominated by non–traditional lenders or bondholders because the relevant bank capital requirements are so onerous.
“If you’re a bank lending to a bankrupt borrower in Mexico and Brazil, you have to hold 100% of the loan in reserve. No banks want to take that kind of capital reserve,” said Gallup.
And if a bank’s already lent to a distressed borrower, it certainly isn’t going to double down and invest more under these conditions. “It is the general view of the banks that if they lend to a company in judicial recovery, they have to provision a dollar for every dollar loaned,” said Maggio.
That means that for now, DIP financiers in Brazil are likely either private equity or hedge funds, or strategic investors that may have interests in the company or its assets, for example equity at a higher rate of convertibility to keep the company as a going concern. But there is some, albeit slow, wider success.
“In the DIP finance space, Brazil debtors were more successful in recent years in obtaining financing. What we see now is incremental movements,” said Gallup.
Market participants are not about to give up on DIP financing in Brazil. But despite an obvious appetite for distressed financing, the future of the practice in the country rests on how the law progresses.
“We really hope that we can structure transactions to make this market take off. But we need some clarity in Brazilian law, and good court precedents,” said Maggio.
Experiments in DIP financing in Mexico and Brazil
Colombo's Brazilian extrajudicial restructuring unpicked
OAS DIP loan sets Brazil precedent