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Good morning. This is Sujeet Indap, the FT’s Wall Street editor. It’s great to be here filling in for Rob and Ethan. Today, two cases from the world of bankruptcy finance. Email me: [email protected].
Let’s play bankruptcy hardball
If you have read my stories elsewhere at the FT, you know that I write often about distressed debt and corporate bankruptcy fights. And I do enjoy a clash-of-the-titans psychodrama as much as anyone.
Still, just as interesting to me is the sheer financial creativity and entrepreneurship that can bubble to the surface when a troubled business is at the unique moment when it is allowed to simultaneously reset both its valuation and capital structure (ie, its debt and equity mix). The company is a blank slate. And the promise of profitably reviving it often lures in sophisticated investors, letting the company auction itself to the highest and perhaps most clever bidder.
With bankruptcies on the rise, an increasing number of blank-slate companies should, in principle, be available to budding bankruptcy financiers.
But the scholars and practitioners who follow the field are now increasingly worried about how this platonic ideal is falling short. One paper in this area caught my eye recently, “Standardizing and Unbundling the Sub Rosa DIP Loan”, by the economist Kenneth Ayotte of UC Berkeley School of Law.
The paper describes the instance of the 2020 JCPenney bankruptcy where a majority group of existing senior lenders gave the besieged retailer $450mn in financing to help it through the reorganisation process.
This so-called “debtor in possession” (DIP) loan helped the retailer fund its stay in court by paying for operating expenses to keep stores open as well as for the various advisers helping with the court case. Importantly, DIPs typically get “super priority” status that lets them jump to the front of the line to get repaid first before any existing debtholders.
However, this particular DIP came attached with a series of terms that let that majority group dictate the terms of the JCPenney restructuring, leaving the lender group in effect seizing ownership of the company for a cheap amount while also skimming fees off the top. All told, Ayotte calculates that the loan charged an effective rate of 545 per cent.
As Ayotte points out, bankruptcy law strictly governs how intra-class creditors get treated (equally) and how inter-class allocations are made (senior creditors get paid in full before junior creditors).
But once-sleepy DIP loans are becoming the way for savvy creditors — aided by aggressive lawyers and bankers — to clinch bankruptcy case victories for themselves on the day of filing, immediately neutralising the months-long investor competition that is supposed to give companies the chance to find the best restructuring deal, instead of the first.
“In the new world of ‘bankruptcy hardball’, it is impossible to assure any secured creditor — particularly a less active one — that their seniority will be respected,” writes Ayotte.
Bankruptcy court judges are left in a tough spot, no matter what the law and academic journal articles say. Few judges want a contentious, even if important, legal fight to eat up time and expenses that could doom a company from successfully reorganising.
“[I]f we were in a perfect world, this financing package would be highly objectionable,” said David Jones, the federal bankruptcy court judge in Texas overseeing the JCPenney case, according to the Women’s Wear Daily article describing the hearing over the DIP loan approval.
“[But] I’ve been in enough of these cases. I will not let this case languish. I will not let it become bogged down in fights that fail to recognise the big picture, and what’s at stake,” judge Jones added.
Protracted fights between creditors and companies (let alone between one group of creditors and another) are time-consuming and expensive for a company that is facing liquidation. And when a group is willing and able to write a big cheque to fund a DIP loan (or later an exit financing package to close the case), that group typically gets the opportunity to extract rents. The result is the ostensibly white-knuckle, hyper-competitive world of distressed debt investing looking a lot more like an inside job.
But amid that gloom, there is a more recent happy, if rare, example of how the system can work. A few weeks ago, there was an outcry after Apollo Global Management offered Yellow Corporation, the recently bankrupt trucking company, a $142.5mn DIP loan that came with a fee as high as $32mn.
Yet, against all odds, a real life auction broke out. Multiple parties challenged the Apollo DIP with their own counter-offers. Ultimately the company selected a joint financing led by both MFN Partners, Yellow’s largest shareholder, and Citadel — who bought out Apollo’s pre-existing $500mn loan to Yellow. The pair is together offering a $142.5mn loan with just $6mn in fees. (Crucially, MFN was comfortable making its portion of the DIP on a junior basis to existing Yellow debt.)
As for the contest for the company’s assets, MFN’s bankruptcy financing to fund Yellow’s auction is already looking prescient. In July, MFN bought up 42 per cent of Yellow’s publicly traded shares for an average price of about $1 each, according to securities filings.
Yellow’s total funded debt is just under $1.5bn. Yellow is not reorganising but rather selling off its terminals, trucks and trailers. The gross proceeds collected may far exceed $2bn. Depending on how much the unsecured claims are ultimately worth, the residual equity of Yellow could be worth hundreds of millions of dollars.
Yellow’s stock has rallied to $2.50, implying that MFN’s $20mn wager is already worth $50mn within just a few weeks, without any of the edginess that often defines US bankruptcy at the moment. That is the kind of old-fashioned distressed asset wheeling-and-dealing I can get behind.
One good read
Why should being in prison stop you from making millions stealing from billionaires?
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