What if you were a well-heeled owner of a bankrupt company but had inside information on its value and could lock in the opportunity to buy it at a low price? That would be a sweet deal! Private equity sponsors and other sophisticated insiders (“Sponsors”) have used convertible Debtor-in-Possession financing (“DIP financing”), what I call “Loan-to-Own 2.0,” to obtain such windfalls. In consideration for providing this new money to allow their bankrupt portfolio companies to continue operations, they receive the right to convert their DIP financing claims into reorganized equity at a discount. The timing element of this strategy is particularly troubling, as the conversion rights and discount are granted early in the case before an accurate evaluation of either the value or the discount is possible. Sponsors’ intimate knowledge of their portfolio companies and tight management control minimize their risk. Significant discounts and low valuations applied to the conversion rights help, too. Other stakeholders receiving greater distributions under later, more accurate valuations lose out.
One of the reasons for the recent popularity of Loan-to-Own 2.0 is the power Sponsors can wield in bankruptcy cases. Control of a bankruptcy case is generally a zero-sum game. One constituency will benefit at the expense of others. At a macro level, Sponsors have recently wrestled control from lenders. Scholars like Vincent Buccola, Jared Ellias, and Samir Parikh have identified this paradigm shift and explored its implications. My new article takes up this baton and explains how the rise of convertible DIP financing reflects this new era of Sponsor control, builds on the foundation of the previous era of lender control, and echoes equity holder strategies from the mid-20th century. I argue that this history and the related Supreme Court teachings generally preclude the issuance of convertible DIP financing.
In the prior era, controlling lenders (often hedge funds or other non-institutional lenders) would commonly advance funds or buy claims to facilitate a credit bid against the debtor’s assets. This was the first version of loan-to-own. One of the ways lenders facilitated this strategy was through strategic DIP financing that established an accelerated sale timetable and provided certain favorable bid protections to the lenders’ credit bids (examples include break-up fees and expense reimbursements). Given the lenders’ advantages, other potential bidders might be dissuaded from participating. However, the original loan-to-own version still required an auction process to be conducted. Another party could bid and force the lender to pay fair value.
Lender control also manifested as a continual shift of the baseline for DIP financing in favor of lenders. This movement was the product of at least three factors: (i) changes to debtors’ capital structures that improved lenders’ leverage vis-a-vis debtors; (ii) favorable standards for obtaining approval of DIP financing; and (iii) little risk of approved financing being overturned on appeal. The result: lender-friendly terms that granted them control over the bankruptcy case and outsized returns as consideration for providing DIP financing.
Sponsors, who are more sophisticated and better financed than usual equity holders, are well-positioned to provide DIP financing. This new era has not benefited other constituencies, as Sponsors have not surrendered the gains obtained by outside lenders. Instead, they have leveraged their control in new ways to the further disadvantage of other stakeholders. They have inside knowledge of their portfolio companies and a tight rein on the board and officers. When Sponsors ask for information or order an action, obedient management makes it happen. Outside lenders’ insight and management control typically pale in comparison. This distinction partially explains why convertible DIP financing is only now becoming popular. Sponsors’ greater control over the bankruptcy process and access to information allow them to be confident that the reorganization process will run for their benefit and that potential returns from reorganized equity will be maximized.
Sponsors are not content with credit bidding for the debtor’s assets in a bankruptcy sale. They do not want to pay a fair price. Convertible DIP financing offers a tempting alternative by capturing a windfall price for reorganized equity. As consideration for providing DIP financing, the Sponsor receives the right to convert its claim to reorganized equity when a Chapter 11 plan is confirmed. Due to the strong bargaining position of a Sponsor as a DIP lender (building on the era of lender control), the conversion is usually at a discount to the value of the reorganized equity. But conversion and the associated discounting presuppose the ability to value the reorganized debtor and evaluate the propriety of the discount. Neither task can be accomplished. DIP financing is authorized at the outset of the case before the debtor is restructured or any Chapter 11 plan is proposed. Valuing the reorganized debtor (i.e., the debtor that will emerge from Chapter 11) and assessing the propriety of any discount is impossible. Any “valuation” will be a lowball “guestimate” intended to maximize the conversion rights and augment the Sponsor’s returns.
“There is nothing new under the sun” is an aphorism often applied to bankruptcy. Even outlawed strategies are later reintroduced with a tweak or under a new name. Convertible DIP financing resembles strategies used by equity holders in the mid-20th century to manipulate the debtor’s valuation to ensure that they would receive a distribution from the bankruptcy estate at the expense of other claimants. Instead of pushing for a depressed valuation (like Loan-to-Own 2.0), equity holders proposed stratospheric valuations that would support them in retaining their equity rights and associated corporate governance control. Because allocating value is a zero-sum game, this approach diluted the rights of other higher-priority stakeholders. Recognizing the unfairness of these sham valuations, the Supreme Court established a common law rule requiring an informed valuation by the bankruptcy judge before approving a reorganization plan that would issue reorganized securities. This prerequisite was part of what was known as the “fair and equitable” standard for plan confirmation.
The distribution of securities under a Chapter 11 plan must still be “fair and equitable.” The required enterprise valuation must be based on an informed judgment considering anticipated developments in the bankruptcy case and under the Chapter 11 plan. Convertible DIP financing is granted to the DIP lender before restructuring transactions are consummated or the Chapter 11 plan and disclosure statement (with an associated valuation) are filed. This is too early for any valuation of what the debtor’s reorganized equity will be worth. An informed valuation is impossible; without it, the reorganized equity cannot be granted without violating Supreme Court precedent. The only exception is when convertible DIP financing is proposed in connection with a pre-packaged Chapter 11 plan. In those situations where the plan and disclosure statement are submitted the request for DIP financing, sufficient information exists to make an informed valuation.
Not only does the grant of equity rights as consideration for DIP financing impermissibly put the cart (the grant of securities in the reorganized debtor) before the horse (the restructuring and valuation of the reorganized debtor), but it also turns the case into a speculative exercise where parties who will control the bankruptcy case extract the upside created by the reorganization. Alternative transaction structures for DIP financing exist, and the Bankruptcy Code establishes specific carrots (including priming liens and super-priority claims) for providing DIP financing. New, more bespoke forms of DIP financing may further exacerbate the levearage imbalance between lenders and debtors. As Kenneth Ayotte and Alex Huang have recently argued, greater standardization may constrain DIP lenders’ control. There is no need for the bankruptcy system to embrace this latest evolution of DIP financing when it incentivizes gamesmanship by Sponsors and other powerful insiders.
Robert Miller is an Assistant Professor at the University of South Dakota School of Law.
This post was adapted from his “Loan-to-Own 2.0” paper, available on SSRN.