Early last year, when corporate defaults were headed for the stratosphere and capital was hard to come by, lenders willing to provide debtor-in-possession loans to Chapter 11 companies looked to make a killing. Some deals were churning out yields of 13 to 14 percent, up-front fees of 3 to 5 percent and exit fees of 1 to 3.5 percent — double what was common for DIP financings in 2002, the last big default cycle.
Indeed, to cash in, several firms launched hedge funds dedicated to DIP financing — the first of their kind in the market — to provide primary loans to bankrupt companies. High yields and fees weren’t the only lure. Highly collateralized DIP financing is relatively risk-free, because the loans receive priority over other claims, including bank credits and bonds. Just two of the 297 DIP loans tracked by Moody’s Investors Service from 1988 to 2008 defaulted. DIP financing also tends to be first in line for full repayment before a company exits bankruptcy.
But in the Alice in Wonderland world of DIP financing, where bad is good and vice versa, the economic recovery is wreaking havoc with deal prospects. The corporate default rate is dropping (Moody’s foresees a 4.4 percent annualized default rate later this year, versus a peak of 12.7 percent last October). Fewer sizable companies are filing for bankruptcy, and more are tapping the high-yield market for capital, amending and extending their existing loans to avoid bankruptcy. The upshot: Not only are fewer significant DIP deals getting done, but spreads have shrunk. Standard & Poor’s Loan Data Corp. calculates that the average spread over three-month LIBOR for a DIP loan in the second half of last year was 750 basis points.
“DIP funds were very compelling when the capital markets were shut and you could get above-market returns. But now the question is how they’re going to put their money to work,” says Jason Mudrick, president and chief investment officer of New York–based Mudrick Capital Management, which launched a broadly focused distressed-debt hedge fund last year.
Investor skepticism has caused trouble for some firms. Boston-based Eaton Vance Investment Managers, for example, has been laboring to raise a much-trumpeted $1 billion DIP fund. Investors say the fund may be shelved altogether, although the firm says it’s still considering it. Others have tried and failed.
The few DIP funds that have succeeded lately in fundraising — conspicuous among them, Stamford, Connecticut–based hedge fund group Aladdin Capital Holdings and Santa Monica, California–based private equity group Tennenbaum Capital Partners — have done so largely because they’re focused on the capital-starved middle market (nominally, companies with less than $1 billion in debt). Last month, Aladdin closed on a $650 million DIP fund, and in December, Tennenbaum Capital completed a $440 million fund. Last year, Sankaty Advisors — the credit affiliate of Bain Capital — launched a $400 million fund called Sankaty DIP Opportunities and, separately, a $750 million fund called Sankaty Middle Market Opportunities to invest more narrowly. GE Capital Restructuring Finance, meanwhile, has allocated $2 billion for DIPs and has bid on middle-market deals.
“A lot of public market investors won’t provide DIP financing to middle-market companies because they don’t have [regular] access to them or the ability to underwrite and manage those loans,” notes Howard Levkowitz, a Tennenbaum managing partner. But by the same token, more opportunity exists for willing lenders. Neal Nilinger, CIO of Aladdin, says, “There’s so much out there now, we think our fund will be invested within the next nine to 12 months.” Yields on middle-market DIP deals are still an attractive 10 to 11 percent.
The rebounding economy isn’t all bad for DIP funds. They’ve been scouting out opportunities in “exit” loans used to finance companies emerging from Chapter 11 or restructuring. “Right now,” says hedge fund manager Mudrick, “it’s a good time to do exit paper. Two years from now it may be a good time again for the DIP market.”
