|Does debtor-in-possession financing add value?
London Business School
April 18, 2016
Does debtor-in-possession financing add value?
In this paper I analyse the role of debtor-in-possession (DIP) financing in the bankruptcy process. I examine the plans of reorganisation of a large sample of Chapter 11s and find that successful reorganisations benefited from DIP financing. The size of DIP financing is shown to have a positive impact on recovery rates. DIP financing is also associated with a larger probability of a successful reorganisation, thus favouring larger recovery rates. I also find evidence of larger management turnover in firms with DIP financing, particularly when the DIP lender has no pre-petition relation with the debtor.
Key words: Bankruptcy reorganisation and liquidation; Debtor-in-possession financing; Recovery rates; Deviations from absolute priority; Management turnover.
JEL classification: G32, G33.
Does debtor-in-possession financing add value?
In this paper I examine the importance of debtor-in-possession (DIP) financing and its contribution to the wealth of the stakeholders involved in the reorganisation of bankrupt firms. DIP financing provides lending to troubled companies in Chapter 11 and is usually a short-term lifeline in the form of working capital. The Code essentially aims to induce lenders to provide credit to the debtor and at the same time encourage the trustee or debtor-in-possession to incur expenses to maintain the collateral securing a claim.
Dhillon et al. (1996) and Chatterjee et al. (1998) analysed stock and bond price responses to the announcement of DIP financing and also the likelihood of a successful reorganisation, when a firm emerges from bankruptcy with its independence preserved. They observed that new financing in bankruptcy is a positive signal to the market and DIP firms are involved in fewer liquidations. I employ a different approach, based on the plans of reorganisation of Chapter 11 firms. I use a sample of 389 large publicly-traded US firms that filed for Chapter 11 during 1986-1997, including both those with DIP financing and those without DIP financing. I compare recovery rates for all claimants of each firm to determine if DIP financing adds value to the company. I also examine the sub-sample of DIP financing firms to assess whether relatively larger amounts of DIP financing produce higher recovery rates, following a suggestion by Adams (1995). I find that there is no significant relation between the presence of DIP financing and recovery rates. However, DIP financing has a positive impact on creditors’ recovery rates as the size of the new loan increases. This is consistent with firms with larger new loans being subject to more monitoring from lenders and so less likely to over-invest. Gilson (1990) presents evidence that bank lenders exercise significant influence over financially distressed firms’ investment and financing policies. This indicates that DIP financing should be considered as a positive signal for creditors only when the size of the loan is considerably large. This evidence contrasts with that presented by Dhillon et al. (1996) and Chatterjee et al. (1998), where the size of the new financing does not seem to be an issue.1 Gilson (1989) observed that bank lenders are frequently responsible for dismissing management in financially distressed firms. I find evidence of larger management turnover for DIP firms, contrasting with Chatterjee et al. (1998). This role is less evident when the DIP lender is also a pre-petition creditor.
Like Dhillon et al. (1996), Chatterjee et al. (1998) and Elayan & Meyer (1999), I also show that DIP financing does contribute to successful emergence from bankruptcy.2 In particular, I find that when firms did not obtain DIP financing they are more likely to be liquidated, and unsecured claimants would get lower recovery rates. In this way, since getting DIP financing improves the probability of a successful reorganisation (or decreases the probability of a liquidation), it is possible that, upon the announcement of DIP financing, the market may actually be reacting to a smaller probability of liquidation and not necessarily to higher recovery rates when compared with other bankrupt companies without DIP financing. I also run logit models to assess the likelihood of a successful emergence from Chapter 11, based on some firm characteristics and features of the bankruptcy processes.
The paper is organised as follows: The next section provides a brief description of DIP financing. Section II presents the literature review. The hypotheses are introduced in Section III. The data and methodology are presented in Section IV. Section V provides the results, including recovery rates, the impact of DIP financing in successful reorganisations and the assessment of probabilities of a successful reorganisation, management turnover, the bankruptcy venue and the determinants of DIP financing. Section VI concludes.
The market for debtor-in-possession (DIP) financing in Chapter 11 filings has experienced great development since 1984, when Chemical Bank created a separate DIP financing unit. Other banks have entered this market, namely Bankers Trust New York, Citibank and General Electric Capital Corp. They have experienced minimal losses on these loans because of their priority status.
The company filing for a Chapter 11 that needs new financing has to file a motion for authorisation, which involves a two-step process. First, there is an interim financing order authorising the borrowing of a limited amount to enable the company to operate for a few weeks. Then, the entry of a permanent (final) order will potentially grant borrowing up to the full amount of the lender’s commitment. 3
The conditions of new financing are considered in Section 364 of the Bankruptcy Code. There is a hierarchy for obtaining post-petition financing, implying that the debtor first has to seek unsecured credit before the Court will grant any kind of greater protection to a new lender (see Rochelle, 1990). Following the legal fiction that a Chapter 11 is a new legal entity, the Court can permit new financing with priority over pre-petition unsecured creditors, with super-priorities over other post-petition creditors (even post-petition priority administrative expenses and taxing authorities), and secured by liens that have priority over pre-petition liens (priming liens) where the holders of such claims are adequately protected. However, there must be assets sufficient enough to cover both the new loan and all pre-petition secured debt not expressly subordinated by the Court’s order to the debtor-in-possession lender’s lien (Fitch Research, 1991).4 See Appendix A for a detailed examination of the different types of DIP financing.