Edward M. McDonough, CIRA
Section Editor
FTI ConsultingPhoenix, AZ
edward.mcdonough@fticonsulting.com

Many times the success of a Chapter 11 reorganization depends on the debtor’s ability to maintain its liquidity and preserve or grow the business during the course of the bankruptcy. This liquidity can provide the necessary financing to allow the debtor to stabilize and grow the operation. Under Bankruptcy Code §364(d), a debtor may obtain credit or incur secured debt by a senior or equal lien in property of the estate provided “… there is adequate protection of the interest of the holder of the lien on the property of the estate in which such senior or equal lien is proposed to be granted.¹ To attain debtor in possession financing (DIP financing) and also meet the requirements of the Bankruptcy Code, the debtor needs to address and develop a business plan, cash flow projection, valuation of the property, identifying economic terms which the company can support and the appropriate lender. Securing DIP financing sends a positive message to the Company’s employees, vendors and customers that the debtor will be viable during the pendancy of the bankruptcy.

Business Plan/Cash Flow Projection
It is critical for the debtor to develop a business plan and cash flow projection. This is necessary to identify the amount of funding required, use of the loan proceeds and the eventual repayment of the loan. In addition to cash flow projections, a pro-forma balance sheet may be required if the financing is to be used for inventory or receivable purposes. The pro-forma balance sheet will track the changes in inventory and receivables over time from raw material to work-in-progress through finished goods.

This will allow the lender to measure both the value added in the inventory process as well as increases in the value of their collateral.

The cash flow projection should identify the areas where the financing will be used, (e.g., inventory, completion of con-tracts, enhancement of assets, receivable financing, etc.). Typically a DIP lender will not lend solely to finance operating short-falls or to pay off a pre-petition debt. The projection and business plan should also reflect how the lender will be repaid (e.g., payment from continuing operation, sale of assets, take out through plan process, etc.). The projection and underlying assumptions must be supported by historic trends and industry guidelines.

Valuation
The prospective lender, the debtor and the court will require a valuation of the company and/or the specific assets collateralized. A valuation can be performed on both a pre and post financing perspective to reflect the value added associated with the financing. If the DIP financing does not add value to the estate, then such financing will be suspect. The valuation becomes an important fact in the event the DIP loan primes an existing pre-petition secured lender. The question for the court in a DIP loan proceeding becomes, “Is there ‘adequate protection’ for the pre-petition secured lender as well as an equity cushion in the asset to protect all secured lenders?”

The Bankruptcy Code provides a clear basis for ascertaining a secured creditor’s interest in collateral – that is, the extent to which a secured creditor is secured: It provides that an “… allowed claim of a creditor secured by a lien on property in which the estate has an interest…is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property…such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest …’² The issue faced in a valuation of the business is whether the value is computed on a going concern basis, liquidation basis, book value method or value in use. The recent decision of the United States Supreme Court in Associates Commercial Corp. v. Rash, 520 u.s. 953 (1997), that a Court must value property in which a secured creditor claims an interest on a going-concern basis – “… the price a willing buyer in the debtor’s trade, business, or situation would pay a willing seller to obtain property of like age and condition.” ³

The court will look to the valuation to conclude if there is sufficient equity (after secured debt) in the assets to protect the se-cured lenders. Additionally, if the DIP loan is a priming lien pursuant to section 364(d) of the code, the valuation is critical to sup-porting the priming.

DIP Terms
The financial terms vary by lender, by industry and the specific risk characteristics of the debtor. Total cost of the loan can range from 10%-20% and are typically LIBOR or prime plus based loans. Many lenders will charge points, exit fees, unused line fees, monthly or quarterly monitoring fees as well as yield maintenance provisions. The debtor will be expected to pay for the costs associated with the lenders’ due diligences and documentation costs. Interest is normally paid monthly although in certain cases, interest (all or part) may accrue for a period of time. The term will generally be shorter than a typical loan. Terms can range from 6-18 months. Principle repayment may be scheduled (i.e., monthly), a function of asset sales, the complete repayment on the plan effective date, or a combination thereof. Lenders willing to take higher risks may require warrants or other equity type kickers. The draw down of the DIP line is normally subject to a detail budget and is contingent on maintaining certain performance levels (e.g., EBITDA mar-gins, loan to value ratios, minimum cash balances, etc.). The lender will generally receive a first priority lien over all of the estate’s assets. Often a DIP lender is also a pre-petition secured creditor. In such cases, it is not unusual for the lender, as part of a DIP loan, to ask for waivers from the debtor covering possible lender liability issues as well as preferences, fraudulent transfers or equitable subordination actions.

It should be noted that the terms are subject to court approval.

Lenders
There are numerous potential DIP lenders. Generally, they fall into three categories.  First, traditional bank and as-set based lenders, such as GE Capital, JP Morgan Chase, Citi Group, etc. This group of lenders may already be holding pre-peti-tion secured debt and are willing to act as DIP lenders for, among other reasons, to be in a position to protect their current debt. Also, they are familiar with the company and its management allowing them to move quickly. Generally, the financing cost with this group of lenders will be less than with other lenders. Second, lenders who special-ize in lending to high risk clients, both in and out of bankruptcy. This group will take on higher levels of risk, as such, the cost of their money is much higher than traditional bank lenders (i.e., low to mid 20% effective interest rates). Finally, a potential equity partner/strategic purchaser of the company can provide the DIP funds. Their motiva-tion, beyond earning a return on the DIP financing is to position themselves as the most likely purchaser of the company or its assets. The loan can be structured to allow them maximum flexibility in acquiring the company while increasing the cost to other potential purchasers. (For example, this DIP lender may, if they are the successful bidder, convert some of the debt into equity or allow it to be paid out over time post confirmation, while if they are not the suc-cessful bidder, requiring 100% pay off at the effective date.)

Timing
Working together, the debtors and their financial advisor should examine the need for DIP financing prior to filing. This provides the company with the time needed to complete the business plan, the projections and valuation, and negotiate with potential lenders. Starting the process early provides maximum flexibility, provides liquidity during the early stages of a filing, and should result in better DIP terms for the company. In the larger complex cases, DIP finance motions are often filed in the early days of the case.

Footnotes
1 Bankruptcy Code §364(d)(1)(B)
2 Bankruptcy Code §506(a)
3 Associates Commercial Corp v Rash, 520 u.s. 953 (1997) 959 n.2.

Mr. McDonough is a Senior Managing Director at FTI Consulting and acts as a fi-nancial advisor to creditors, debtors, equity committees for both in and out of court reor-ganizations and formal bankruptcy proceed-ings, and has served as Chapters 7 and 11 trustee. He graduated with an M.B.A. and a B.S. in Accounting from Arizona State Uni-versity. He is a CPA (Arizona), a Certified General Real Estate Appraiser in Arizona and Nevada, an Associate Member of the Appraisal Institute, a Certified Insolvency and Restructuring Advisor, an Associate Member of the Association of Certified Fraud Examiners, a member of the Ameri-can Bankruptcy Institute and an Associate Member of the American Bar Association. Mr. McDonough also is a frequent speaker at various bar seminars and ABA conferences.