Does Debtor-In-Possession Financing Add Value?

Does debtor-in-possession financing add value?

Maria Carapeto

London Business School

July 30, 1999

Does debtor-in-possession financing add value?

Abstract

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.

I.Debtor-in-possession financing

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.

II.Literature review

Ostrow (1994) states that the decision whether to approve new financing is directly related to the likelihood that creditors would get more from the distribution under the plan of reorganisation. However, sometimes there is little time to consider that an immediate liquidation could be more profitable for the creditors, and the focus is instead on whether the debtor should be permitted an opportunity to reorganise. This implies that the total value of the firm available for distribution to the claimants may be smaller than without this new financing. Rohman & Policano (1990) say that even when the debtors are not confronted with imminent default, they may choose to file for Chapter 11 as a means to secure new financing and so preserve their flexibility to accommodate future growth. In this way, rather than the last resort, DIP financing can be viewed as a “pro-active” strategy. Perhaps surprisingly, the bankrupt companies see their terms of credit improve, both in accessibility and in cost, because there is only one post-petition creditor - the debtor-in-possession bank (Millman, 1990).

Empirical studies in this area have essentially focused on the market reaction to the announcement of DIP financing and on the bankruptcy outcome. None of these studies considered the plans of reorganisation themselves, which provide the ultimate means of comparison between firms with DIP financing and firms without DIP financing, in terms of recovery rates and deviations from absolute priority rules. Also, these studies did not try to assess probabilities of a successful reorganisation once in Chapter 11, based on characteristics of the firm and the bankruptcy process.

Datta & Iskandar-Datta (1995) examined the restructuring activities of 135 financially distressed companies that filed for Chapter 11 during 1989-1990. They found significant evidence for the fact that, during the two-year period prior to filing for bankruptcy, these firms were unable to obtain financing; however, after the filing, the infusion of new capital via fresh loans is large, which may be explained by the super-priority status conferred to post-petition debt. In this way, the authors argued that firm value might not decrease, as there is an opportunity to invest in positive NPV projects.

Dhillon et al. (1996) used a sample of 25 firms with debtor-in-possession financing and 80 firms without debtor-in-possession financing that filed for Chapter 11 during the period of January 1990 to December 1993 and showed the signalling role of this new financing. The announcement of debtor-in-possession financing is associated with positive abnormal returns on equity securities and positive (weak evidence) abnormal returns on debt securities. Also, firms that employ debtor-in-possession financing have more successfully reorganisations - higher percentage of firms emerging successfully from Chapter 11 and higher ex-post EBIDT (Earnings Before Interest, Depreciation and Taxes) as a proportion of total assets and sales.

Chatterjee et al. (1998) examined a sample of 55 publicly traded firms that filed for Chapter 11 from January 1990 to December 1995 and received approval for DIP financing. Their results support the benefits of the certification and monitoring role provided by DIP lenders, that outweigh the high priority of DIP financing. They also show some evidence of management entrenchment. DIP financing is associated with a positive stock and bond price response, which may suggest the absence of wealth transfers from pre-petition creditors to high priority DIP lenders. They found that most firms that obtained DIP financing are not in economic distress. When compared to bankrupt firms without new financing, DIP firms show a significant larger probability of successfully emerging from Chapter 11 and not being involved in posterior filings.

Elayan & Meyer (1999)[5] used a sample of 123 firms with debtor-in-possession financing and 337 firms without debtor-in-possession financing that filed for Chapter 11 over the period 1980-1995. They support the signalling role provided by DIP lenders that DIP firms face a lower probability of liquidation. DIP financing is associated with a positive stock price response, in particular if the DIP firm was subsequently liquidated or the lender was a pre-existing creditor or a bank. Larger loans (relative to total assets) and the first DIP transaction (as opposed to subsequent transactions) are also associated with a more positive market reaction. In addition, they found a shorter duration under bankruptcy proceedings for DIP firms, which may indicate lower bankruptcy costs.[6]

III.Hypotheses

Datta & Iskandar-Datta (1995) claim that with DIP financing the firm value suffers less erosion, due to an opportunity to invest in positive NPV projects. Dhillon et al. (1996) and Chatterjee et al. (1998) analysed the effect of DIP financing in the stock and bond markets and found a positive impact. This suggests that the concession of DIP financing does add value to the firm. Adams (1995) points out that it is not the concession of DIP financing per se that matters, but its size, implying that small loans should not make much of a difference. These effects should then be reflected in the payments received by the claimants upon reorganisation, which are stated in the plans of reorganisation.

Hypothesis 1: Claimants of firms with DIP financing show higher recovery rates than those of firms without DIP financing. In particular, the larger the size of DIP financing, the higher the recovery rates.

Dhillon et al. (1996), Chatterjee et al. (1998) and Elayan & Meyer (1999) show that firms with DIP financing are more likely to successfully reorganise. Schwarcz (1985) argues that obtaining new financing can act as a good signal to trade creditors and have them re-establish the terms of the trade credit with the company, thus increasing the likelihood of a successful reorganisation. These studies emphasise the positive role of DIP financing in a successful reorganisation. This is a very important issue, as far as bankruptcy is often associated with asset sales at depressed prices, in particular with piecemeal liquidations, which constitute a significant dead-weight loss (see Andrade & Kaplan, 1998). Also, the productivity of the plants of Chapter 11 firms that were converted to Chapter 7 is much lower than those that remained in Chapter 11, as documented by Maksimovic & Phillips (1998), which suggests a lower value for the former firms. The positive impact of DIP financing should however be reduced in two circumstances: a) when the new loan is secured by a lien on already encumbered assets with equal or senior priority to the existing liens (priming liens); b) when the DIP lender is a pre-existing creditor and obtains an increase in the seniority of his pre-petition debt. These situations suggest a lack of confidence of the DIP lender in a successful reorganisation of the firm. Also, when DIP financing is granted by the Court shortly after filing for bankruptcy, this should not indicate necessarily good news, as far as there was not enough time to examine the financial situation of the firm, and so its true needs. Thus, successful reorganisations should be associated with more time to obtain DIP financing upon filing for bankruptcy.

Hypothesis 2: DIP financing increases the probability of a going concern and so reduces the probability of liquidation, which involves lower recovery rates. The presence of priming liens or increased seniority of pre-petition loans, and a short time to obtain DIP financing increase the probability of liquidation.

Chatterjee et al. (1998) argue that the evidence of management turnover in firms with DIP financing is not significant. The authors compared management turnover in their sample of DIP financing firms to those of Hotchkiss’ (1995), but it is possible that in this last sample some firms actually received DIP financing. This suggests that the two samples may not be independent, thereby limiting the validity of their results. Gilson (1989) observed that bank lenders frequently initiate top management changes in financially distressed firms. Gilson (1990) adds that bank lenders wield considerable influence over investment and financing policies in financially distressed firms. Since the DIP lender is usually a bank with considerable expertise in the DIP financing market and the bankruptcy process, one should expect a larger monitoring and disciplining role in DIP firms, and eventually more management turnover. When the new financing was provided by a pre-petition creditor, this disciplining role should then be less evident, due to a previous relation with the debtor.

Hypothesis 3: Management turnover is larger in firms with DIP financing. In particular, management turnover is larger when the new financing was granted by a new lender, without a pre-petition relation with the debtor.

IV.Data and methodology

A.Data sources

The main source for the data used in this paper was the Bankruptcy DataSource. This database includes bankruptcy information for every publicly-traded company with assets in excess of $50 million[7] that are in bankruptcy proceedings, have defaulted on public debt, or have issued a distressed exchange offer. The database begins in 1986.

I compiled a list of 389 firms that went bankrupt from the 1st January 1986 to the 31st December 1997.[8] Of these firms, 212 reorganised independently, 40 were acquired in bankruptcy, 57 were liquidated in Chapter 11, 13 were converted to Chapter 7 and 4 were dismissed; the result is unknown or still pending in 63 cases. The Bankruptcy DataSource (BKRDATA - Plans of Reorganization) supplied complete plans of reorganisation, with data concerning the satisfaction of all the claims, for 172 firms that reorganised successfully, including 72 debtors that raised DIP financing during the bankruptcy process. Also, complete plans of liquidation were compiled for 21 firms, including 5 cases of DIP financing. The SEC (Securities Exchange Commission) filings (including the 8Ks, 10Ks and 10Qs) were also used to check and complement the information contained in BKRDATA.

The stock prices and the number of outstanding shares were extracted from the Center for Research in Security Prices (CRSP), Bloomberg and Datastream, upon emergence from Chapter 11. Occasionally there was no market value for the stock because the firm might have become private. In these cases (37 firms), I used the estimates provided in the plans of reorganisation (when a range of values was provided, I used the mid point). The same criteria was applied to the prices of debt securities, preferred stock, options, rights and warrants, where the sources included Bloomberg and DataStream, and ultimately the plans of reorganisation themselves. In the absence of market values or estimates for debt and preferred stock, the face value and the liquidation preference value were used instead, respectively (only 16 (2) firms in my sample had market values for debt (preferred stock)); as for options, rights and warrants, I used the Black-Scholes valuation model to price these securities (in 33 cases).[9]