INVESTMENT OPPORTUNITIES / POSSIBILITIES FOR COMPANIES TO ASSIST BUSINESSES UNDER RESCUE

“Loan to own” is a term used in both the USA and Canada as a way to secure a position for a potential investor to ensure that its post commencement finance (“PCF”) or DIP Finance places that investor in a strong enough position to eventually take control of either the assets or the equity in the company.

In the USA “loan to own”, or “offensive” DIP lending, underwent a significant change in the late 1990s and early 2000s as new sources of funding. Distressed investment funds entered the market. There are substantial differences in the approach by commercial banks as opposed to that of distressed investment funds in the USA.

First, commercial banks will look at financing economics and the possibility of future lending opportunities. Distressed investment funds frequently focus on the opportunity to acquire the debtor’s business at a deep discount.

Second, unlike commercial banks, most distressed investment funds do not originate loans to healthy companies. Their funds rather focus on the economic advantages available by investing in distressed companies, including the high short-term fees available via DIP loans.

Third, distressed funds also seek to take advantage of various “loan-to-own” strategies that involve acquiring a dominant or, in some cases, a “fulcrum” position in the capital structure of a distressed company and converting that debt position into equity through a bankruptcy proceeding. For example, under one common approach, the fund simply buys the debt of a distressed company from its existing lenders (normally commercial banks) at a deep discount.

Four, the fund may also acquire the debtor’s equity and, with it, some amount of management control. In addition to the acquisition of discounted debt, a fund can attempt to take ownership by providing DIP finance to the company with the goal of converting the DIP finance claim into equity in the reorganized company through a reorganization plan or, more commonly, with the intention of credit-bidding the acquired debt to then acquire assets of the debtor at auction.

Then, in the USA, like in SA, commercial banks are not in the business of owning and operating their borrowers. It is therefore distressed investment funds, which more frequently employ loan-to-own post-petition financing strategies.

Lastly, in the USA DIP funders profit through fees and interest earned in the deployment of capital. As a result, commercial banks are attracted are to the DIP financing market by the high fees and interest rates and the relative likelihood of repayment typical of DIP loans.

It is also necessary to look at how a DIP financier or for that matter PCF lender, being the distressed investment fund, control the process.

First, in order to assure that it will have an opportunity to credit-bid its PCF obligations and, if applicable, its acquired pre-commencement debt, the offensive PCF lender will typically include milestones in the credit agreement requiring the BRP to undertake a sale process. By doing this the PCF lender can therefore use the PCF agreement to exert significant control over the business rescue proceedings.

Second, a PCF lender could closely examine the company’s business operations. Information obtained from both the initial diligence before the PCF facility is secured and from the reporting requirements in the PCF credit agreements will provide the lender with a head start over other potential bidders in terms of diligence.

Thirdly, although the PCF lender must contend with other potential bidders at auction, the lender should be a step ahead of those bidders.

Then, typical reporting requirements contained in the PCF loan agreement will provide the lender with access to key information regarding the debtor’s business operations. This increases the likelihood that the distressed investment fund may be selected as the “stalking horse” bidder.

Furthermore, the reorganized debtor may then be significantly de-levered because of the conversion of secured debt to equity.

This then leads one to the question as to whether there any chances of distressed investment funds being developed in SA. Because it is would appear to be clear that banks are unlikely to develop such a “products’ may be viewed differently by a specific banking group. In other words, other funders are looking at the possibilities. It is however so that, in a high profile rescue matter, the desire to maintain or strengthen the bank’s relationship with the company can be just as important as the PCF financing loan economics.

Lastly we look at the miscellaneous issues contained in DIP Finance agreements and which potential PCF lenders in South Africa may look at.

Firstly, the agreement will provide for the loan structure and amount. The structure of a DIP loan is frequently determined by the working-capital needs of the debtor and whether it will be structured as a term loan, revolving loan, or some combination of the two, the loan structure itself is likely to have little impact on the outcome of a debtor’s case. The amount of the loan and the perception of liquidity that it can provide can demonstrate an important affirmation of a debtor’s prospects of a successful reorganization.

Second, one will look at price and fees. The pricing of DIP financing agreements is largely driven by macroeconomic factors. In the aftermath of the 2008 financial crisis, commercial lending effectively halted, and the DIP financing market froze along with it. As the DIP financing market dried up, with some former participants going out of business themselves, the few remaining participants could demand extraordinary fees. Without access to reasonably priced DIP financing, many troubled companies focused on workouts and other out-of-court restructurings. As the credit crisis eased and DIP financing again became more widely available, the fees charged for post-petition financing have decreased. Nonetheless, DIP loan pricing terms continue to be favorable when compared with pre-crisis fees and interest rates.

Third, the term and maturity. Whatever the terms of the DIP loan, one of the overriding concerns of a DIP lender is always how and when the loan will be repaid. The lender’s strategy in structuring the timing elements of the loan reflect this concern. Generally, a DIP loan will have a considerably shorter term than a typical pre-petition corporate credit agreement. A DIP lender always faces the possibility that adverse events might occur that could impede the debtor’s emergence and impair the lender’s recovery. For example, many lenders found themselves in difficult positions as the economic landscape changed rapidly in 2008. In addition, most lenders have little interest in becoming embroiled in drawn-out, contentious bankruptcy proceedings.

A lender funding a restructuring therefore typically will seek to limit the period that its borrower remains in bankruptcy and impose milestones to ensure that the debtor continues to progress toward a sale or confirmation and emergence.

Debtors, on the other hand, seek to secure enough time in chapter 11 to carry out a restructuring or sale. Some commentators have expressed concern that short-term DIP loans can make it very difficult for effective reorganization.

Fourth, the security to be provided. A lender can either secure its loan with a lien on the unencumbered assets of the debtor, if any, or through a priming lien on already-encumbered assets.

Furthermore, covenants and events of default. Credit agreement covenants and events of default are lenders’ primary means to control their relationships with their borrowers. In the bankruptcy context, lenders seek to impose various covenants and events of default, among other things, to ensure that the lender receives up-to-date financial performance data. It also provides the lender with an escape route in the event that the borrower’s business falters and ensures that the debtor adheres to a restructuring or sale strategy on a timeline that is acceptable to the lender. Together, these tools can provide powerful levers for DIP lenders to exert control over the bankruptcy case. Borrowers are required to report their performance regularly with respect to financial covenants to lenders. Outside of bankruptcy, these metrics are designed as “canaries” to ensure that the lender is made aware of the borrower’s declining financial health before default becomes inevitable. Examples include debt leverage ratio covenants, fixed-charge coverage ratio covenants, maximum debt-to-equity ratio covenants, and interest-coverage ratio covenants. These metrics, which measure the health of a company in various ways, are rarely as useful in the context of a DIP financing credit agreement because, by definition, the DIP loan borrower is already in distress.

DIP financing credit agreements, therefore, frequently contain financial covenants that measure minimum performance rather than overall financial health, which can provide the lender with an early escape route-without having to wait for an actual payment default-in the event that the borrower’s business falters. Minimum EBITDA covenants are common, usually with increasing minimum levels over time.

Author:

Hans Klopper of Independent Advisory

References:

  • Perlman F.G, Baer H.P, Kevane H, Bagby I, Corbi R.J, Farnsworth S, Krause S, Kriegel M, Lucas J.W and Maman M : “Debtor-in-Possession Financing: Funding a Chapter 11 Case” American Bankruptcy Institute
  • Salerno TJ, Kroop J.A and Hansen C : “The Executive Guide to Corporate Bankruptcy” – Second Edition (BeardBooks 2010)

A VIEW ON SOURCES OF POST COMMENCEMENT FINANCE IN SOUTH AFRICA

I recently concluded that banks or other financial institutions are not sources for post commencement finance (“PCF”) in business rescues as is envisaged in terms of Chapter 6 of the Companies Act 71 of 2008. It also became clear that none of the South African commercial banks have thus far developed any “products” that can be described as ideal for “distressed funding”.

I suspect that commercial banks might feel that it is simply not an area where they will find a return or where there will be sufficient volumes to justify the development of such banking products. It is also understandable that conventional governance of depositors’ and shareholders’ funds will not permit distress lending.

It is must however also be understood that where a bank is exposed as a creditor in a business rescue matter that they will evaluate the matter on its own merits been made clear that the availability of and the providing of PCF is not entirely “embargoed” by banks.

We have found that the bank, as a PCF lender, would consider granting PCF when, under circumstances where the bank can be described as a “defensive pre- commencement lender” seeking to maximize the value of its pre-commencement claim. The bank may then agree to provide PCF in an amount designed to ensure a successful reorganization and which may be conditional upon them being involved in the business rescue decision making process.

At a minimum, such PCF would be expected to cover anticipated working-capital and the expenses in the business rescue process needed for the period necessary to effect operational changes or restructure the debtor’s business. In some instances, however, the nominal amount of the PCF may significantly exceed the debtor’s working-capital needs, even with the additional costs that will be incurred because of the debtor’s filing for business rescue. The effect of such a higher nominal amount of PCF may be that that the company under BR will have the benefit of increased creditor confidence and as consequence of which suppliers may be more willing to provide products on terms more advantageous to the company than what they would have been prepared to do under regular uncertain business rescue circumstances.

Furthermore, customers may continue to utilise the company’s service with the confidence that the company will ultimately emerge from Business Rescue. It is therefore so that a relatively large PCF facility can decrease the negative operational impact of a BR filing. I suspect that South African banks have thus far provided the most PCF to date but also believe and will not be surprised if all this is “defensive” PCF financing.

It has been alleged that there is an unwritten rule or understanding amongst banks in South Africa that the one bank will not bail out a company with PCF to enable a company to repay its debts with another bank. We have practically experienced in recent dealings with a parastatal lender that the borrowers had to certify the lender that the finance being obtained by shareholders (two levels up) were not to be utilised for purposes of settling the debts of a company under business rescue.

We have also found in practice that a further major stumbling block for potential PCF financiers arises when there is a pre-commencement cession of book debts in favour of a bank as security for its overdraft of whatever is owing to the bank. There is a view that banks are in terms of its cession of book debts entitled to rely on book debts created post the commencement of business rescue proceedings as additional security. This is despite them not having provided the finance that enabled the BRP on behalf of the company to render the service or manufactured the product that enabled to BRP on behalf of the company to create the invoice. All of this post the commencement of business rescue proceedings.

Its seems untenable that the PCF financier may not, as first charge, rely on the proceeds of the post BR book debts. The law in this regard needs to unfold We are of the view that in order for PCF to succeed under such circumstances the BRP needs to enter into an agreement with the bank in order to have future debts released from the cession.

It is clear to us that distressed funding or, PCF, remains one of the most topical issues in restructuring businesses and for the business rescue process to work. There is no doubt that the ability of a company under business rescue to continue trading or carrying on with its business activities depends entirely on its ability to procure PCF in some form or another.

Internationally the motivation of distressed investment funds to get involved in PCF of debtor in possession finance under Chapter 11 in the USA (“DIP finance”) is often very different from that of commercial banks. While a commercial bank may seek to profit through fees and interest earned over the course of a long-term relationship with a borrower, the business model of distressed investment funds is entirely different.

We need to look at the various forms of PCF that are available. First, there is conventional post commencement trade credit and in terms of the Companies Act the BRP may incur credit in the ordinary course of its business. This will be treated as PCF and suppliers and trade creditors typically extend this credit on similar terms as existed before the commencement of BR proceeding if they are comfortable that the debtor has sufficient cash flow to pay them on a timely basis. Such PCF enjoys the protection of section 135 of the Act and must be repaid in the order that such debts were incurred.

Second, Secured PCF which is permitted in terms of the Companies Act and under which circumstances the BRP obtains post commencement credit secured by either a lien or pledge or any other agreed form of security over assets that are otherwise unencumbered. This may appear to be preferable and safe in theory but distressed businesses under business rescue usually do not have unencumbered assets, any equity in assets that are already encumbered, or all their assets are fully encumbered by other lenders. Security for the PCF lender is therefore a logical option to have, but usually of little practical assistance.

However. an alternative, in rare cases, is a second or reversionary form of pledge or lien over assets already encumbered. This is done in the USA under Chapter 11 procedure in terms of what is called Super Priority Secured Financing. How it is works is that, under circumstances where a debtor under Chapter 11 is unable to obtain credit in any of the traditional DIP finance ways, the Bankruptcy Court can allow the debtor to obtain financing secured by a first lien on already encumbered assets of the estate. This means that secured creditors that already have liens on the assets will be pushed down or “primed”. This must be done with Bankruptcy Court approval, and creditors whose liens are being “primed” must have the opportunity to object.

The only way the Bankruptcy Court will allow such financing is if  the debtor makes an appropriate case that it is unable to obtain credit in any other way and it must be demonstrated that the creditor whose security is eroded is “adequately protected.” This essentially means that the creditor whose lien is being primed needs to be shown that even though its lien is being pushed down, it will not be unduly harmed by this event.

Author:

Hans Klopper of Independent Advisory

References:

  • Perlman F.G, Baer H.P, Kevane H, Bagby I, Corbi R.J, Farnsworth S, Krause S, Kriegel M, Lucas J.W and Maman M : “Debtor-in-Possession Financing: Funding a Chapter 11 Case” American Bankruptcy Institute
  • Salerno TJ, Kroop J.A and Hansen C : “The Executive Guide to Corporate Bankruptcy” – Second Edition (BeardBooks 2010)