By Robert Miller (University of South Dakota)
The rise of convertible debtor-in-possession (“DIP”) financing is symptomatic of a paradigm shift in the control of large bankruptcy cases. During the prior era of lender control, distressed investors used DIP financing to shape the trajectory of bankruptcy cases and extract monopolistic rents at the expense of other constituencies. Enter the original loan-to-own: a common strategy commenced with a DIP loan, continued with the lender serving as the stalking horse purchaser, and culminated with a purchase of the debtor’s assets.
Private equity sponsors (“Sponsors”) and other sophisticated insiders are usurping control of bankruptcy cases by issuing DIP financing. Convertible DIP financing (loan-to-own 2.0) is a byproduct. The lender control era shifted the baseline for DIP financing in favor of lenders at the expense of the estate. When Sponsors propose DIP financing, they can exceed lenders’ gains by leveraging their command over management, an influence unavailable to a third-party lender. Not only do Sponsors have access to inside information, but they can trust management to direct the bankruptcy case to best serve their interests. This combination sets the stage for Sponsors proposing convertible DIP financing. They have the deepest insight into what the debtor will be worth and the power to shape the outcome of the case to maximize the return on their conversion. This time lag between proposing DIP financing and the conversion to equity on the plan effective date would be troubling for an outsider. Not so for a Sponsor with a tight rein over management.
Convertible DIP financing provides a windfall for Sponsors. It locks up a discounted stake in reorganized equity early in the case, thereby precluding a subsequent fair and equitable allocation under a chapter 11 plan. The conversion discount is not tested by the market in the context of a plan of reorganization like exit financing; it is established at the outset of the case when the Sponsors’ leverage as the proposed DIP lender is at its zenith.
This article situates convertible DIP financing within the new era of Sponsor control and explains how its distortion of valuation violates Supreme Court precedent. Sponsors’ prowess altered the baseline for DIP financing, but loan-to-own 2.0 goes too far, both normatively and legally. The Bankruptcy Code incorporates the Supreme Court common law requirement for an informed valuation prior to the grant of reorganized equity. Convertible DIP financing is authorized at the outset of bankruptcy case, too early for an informed valuation of the debtor. Reflecting Sponsor control, the valuation used to compute the conversion is a lowball guesstimate designed to augment the Sponsor’s returns at the expense of other stakeholders. Absent an informed valuation, convertible DIP financing should not be authorized.