Dip Financing refers to debtor in possession(DIP) financing, a form of financing that is provided to companies that filed for bankruptcy.
It provides the capital funding for the companies which are surviving in bankruptcy.
In this blog on DIP financing, you will learn about what is debtor in Possession (DIP) Financing, the procedure and the sources of DIP financing for a company.
What is Debtor in Possession (DIP) Financing?
Debtor-in-possession (DIP) financing is provided to the companies which are facing financial problems or who require bankruptcy relief. It is a unique form of financing which has a unique priority over existing debt, equity, and other claims. Plus, it allows it to raise capital to fund its operations as its bankruptcy case runs its course.
In case a company needs to proceed with DIP financing, the court must approve the financing plan consistent with the protection granted to the business. Oversight of the loan by the lender is also subject to the court’s approval and protection. If the financing is approved, the business will have the liquidity it needs to keep operating.
The guarantee that this kind of financing provides attracts many potential investors. This is because the court guarantees that their interest will remain safe even if the financer is an insider or a potential acquirer.
Procedure for Obtaining DIP Financing
When a company wants to opt for dip financing, there are a set of few standard steps forever company has to follow. So, in the very beginning a company have to:
Line Up A Lender:
It means lining up all the details and relevant information related to the loan like interest rates (which may be above market rates), fees, and repayment schedule needs to be planned. Plus the details about how the funds will be utilized, and the control plan also need to be decided.
Obtaining DIP financing is somewhat difficult. This is because the company needs to convince the court that the current position of the other creditors will not be negatively affected. Alternatively, the company can directly convince the other creditors and provide the court with written documents indicating their consent.
In case any company wants to move forward with the DIP financing they have to take approval from the court. It will only communicate with the existing creditors. Also, the court makes sure to hear both sides of the parties. And they may consider the objection raised by any creditors. And may not allow the company to go forward with dip financing.
Multiple times existing lenders are only the ones who agreed to provide financing to a company.
Because under DIP financing laws protect the right and the interest of investors better. DIP financing carries security from an investor’s point of view. The validity of the terms and conditions of the loan granted under DIP financing is unquestionable!
DIP financing has multiple challenges to move forward with. Firstly it takes a lot of time to process. As the companies under the threat of bankruptcy need to reach finances quickly. Such long delays may not be in the best interest of all the stakeholders.
The bottom line is that DIP financing is a valuable tool that needs to be used correctly. It has the potential to provide companies with the critical cash flow that they need at the right time.
Sources of DIP Financing
It is a more complicated task than helping debtors obtain regular financing. Because the lenders know that there are very few options in which borrowers have to raise funds. As a result, they always have an upper hand in the negotiations.
In the case of DIP, financing lenders try to get the best deal that they can with the borrowers. But they have to make sure that these deals are acceptable by the existing lenders. In case the deal is not acceptable to them 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.
As a result, it becomes a complicated process because of two reasons:
- Firstly there are many parties involved in the process.
- Secondly, there are multiple rounds of negotiations involved.
There are various modes of financing which are used to secure DIP financing. The details of some of these modes have been explained in the next topic.
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:
In the normal course of a business, a debtor is allowed to obtain a trade credit without any prior permission from the court. Before incurring any short term debt as long as it is unsecured.
This is because, in bankruptcy courts, all unsecured debt is 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 bankrupt firms.
Priority Unsecured Lending:
Sometimes, a special contract can be drawn between the borrower and the lender. In which the claim of lenders will always remain as the administrative claim. However, it would have priority over all other administrative claims.
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.
Another mode of DIP financing is secured lending. In case of bankruptcy laws do have an option to allow the firm to mortgage some of the assets that they have to obtain more credit. But the assets can only provide security that is also only after approval from the court. As a result, this mode of financing becomes unviable.
In most cases, firms that have reached bankruptcy are left with very few assets and have more liabilities. Plus, there are no assets left in the firm which are not 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 the 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.
Priority Secured Lending:
This is a very rarely used mode of DIP financing. This is because, under this model, 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.”
- 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.
- 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, various unconventional modes are used in DIP financing as well.
DIP-to-Exit Facility means one or more debtor-in-possession financing facilities, as outlined in the DIP Order, with Goldman Sachs Bank USA as lead arranger or manager, which shall be used to repay certain of the Debtors’ prepetition secured indebtedness and shall convert into an exit facility on the Effective Date and which shall not contravene the terms of the Secured Creditor Settlement or the Reinstated Secured Debt after giving effect to any amendments or modifications to such Reinstated Secured Debt, made according to Article IV.A.2, without the prior written consent of the First Lien Committee, such consent not to be unreasonably withheld.