Sources of DIP Financing

As mentioned in the previous article, the financing required by companies in order to keep their operations afloat after filing bankruptcy is known as DIP financing. With regard to DIP financing, there is a standard market for lenders who offer DIP financing. There are investment bankers who specialize in helping clients obtain DIP financing.

However, the task is more complicated than helping debtors obtain regular financing. This is because the lenders know that there are very few options in which borrowers have to raise funds. As a result, they definitely have the upper hand in the negotiations. Hence, the lenders try to get the best deal that they can with the borrowers. However, these deals have to be accepted by the existing lenders as well. If they do not accept the deal, then the negotiations with the borrowers become null and void. As a result, existing lenders often use their clout to get the new borrower to give a better deal.

However, the entire process turns out to be very complicated. This is because, firstly, there are multiple parties involved. Also, secondly, there are various rounds of negotiations in which the details go back and forth several times.

There are various modes of financing which are used to secure DIP financing. The details of some of these modes have been explained in this article.

Modes of DIP Financing

There are several modes of DIP financing which are used by borrowers and lenders. The details of some of these modes have been written below:

1. Unsecured Lending: If a debtor needs trade credit during the normal course of business, they are allowed to obtain the same. The permission of the court is not required before incurring any short term debt as long as it is unsecured. This is because, in bankruptcy courts, all unsecured debt are treated as administrative claims. For suppliers and creditors, this generally means that the amount of money that they lend are at risk. Hence, they will only lend money if they are confident about the ability of the buyers to pack back the debt. Suppliers are willing to extend small amounts of credit to firms facing bankruptcy. They only provide loans for a very short duration and tend to limit their exposure to the bankrupt firm.

2. Priority Unsecured Lending: In some cases, the borrowers can enter into special contracts with lenders. Under these contracts, the lenders' claim would still remain an administrative claim. However, it would have priority over all other administrative claims. This means that in the event of a bankruptcy, this would be the first administrative claim that the firm would pay. Only after this claim has been paid will other administrative claims be settled. It is easy to see why such a provision would not be acceptable to many lenders who have already provided unsecured credit to the firm. Such kinds of trade credit arrangements are only possible after obtaining permission from the courts.

3. Secured Lending: Bankruptcy law does have an option to allow the firm to mortgage some of the assets that they have in order to obtain more credit. However, the assets can only be provided as security after the approval of the bankruptcy court has been received. This is what makes this mode of financing unviable. Typically, firms that reach the bankruptcy court have fewer assets than they have liabilities. Also, these firms do not have assets that have not already been used as collateral in other loans. Hence, the applicability of this provision is very limited. Hence, even if such an asset were available, the management would have to convince the other lenders to allow mortgaging of this asset to a new lender. This is a difficult task given the fact that every asset that is mortgaged to a new lender reduces the liquidation value of the firm.

4. Priority Secured Lending: This is a very rarely used mode of DIP financing. This is because, under this mode, the borrower provides a priority claim to the new lender. In simple words, the same asset may be mortgaged to two or more lenders. The newest lender will have a priority claim on the asset in the event of a bankruptcy. This is called “priming.”

5. Bankruptcy law only allows such things to happen with the permission of the bankruptcy court. It is the job of the court to ensure that the interests of the earlier lenders are protected as well. It is for this reason that the borrower will have to convince the court that the interests of earlier lenders will not be negatively affected. The earlier lenders also have the right to appeal against such a decision.

6. In reality, such funding is only allowed when the asset which has been mortgaged is worth significantly more than the outstanding value of the debt. For instance, if the value of the asset is $100, and the value of the loan is only $60, it can still be used to borrow $30 more dollars. Some amount i.e., $10 in this case, will have to be left as an equity cushion. In simple words, the court will only agree if the current loan has been over-collateralized, and hence by allowing such financing, the value can be unlocked without harming the interests of any existing parties.

Apart from the above-mentioned modes, there are various unconventional modes which are used in DIP financing as well.

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