What it means
When a company files for protection under a process such as Chapter 11 in the United States, it often has plenty of customers but very little cash. It still has to pay staff, suppliers and utilities every week, or the business will lose its value before any plan can be agreed.
DIP financing provides that working cash. Lenders are willing to supply it because the law, with court approval, can give the new loan a very strong position.
It may rank ahead of most other unsecured claims, and in some cases it can be secured on assets that already back older loans. This priority is what makes a loan to a distressed company acceptable to a careful lender.
The financing is normally agreed with strict conditions. The lender may require a detailed budget, regular reporting, milestones for the restructuring plan and a high interest rate plus fees.
If the company misses a milestone, the lender can often stop lending and force a sale or conversion of the case. Existing lenders sometimes provide the DIP loan themselves, in an arrangement known as a roll-up where some of their older debt is converted into the new, safer loan.
Other lenders may object because it moves value to the lender that is already in the room. Courts review these terms to make sure they are fair to all creditors.
For a finance professional, the key point is that DIP financing buys time and protects going-concern value (the value of a business that keeps operating). It is expensive, but it is often cheaper than liquidating a viable business.
Other countries have comparable rescue funding, though the rules and names differ.
In practice
Real-world examples.
Example
A regional retailer enters Chapter 11 with $2,000,000 in cash and weekly costs of $1,500,000. A bank provides a $15,000,000 DIP facility, which lets the retailer keep stores open and stock shelves during the Christmas season while it negotiates with creditors.
Example
A manufacturer's existing lender offers a DIP loan of $20,000,000 and converts $30,000,000 of its older debt into the new, higher-ranking loan. A group of suppliers objects, and the court asks for evidence that the terms are the best available.
Example
An airline in restructuring uses a DIP facility to keep aircraft maintained and crews paid. The lender gets weekly cash reports and the right to stop lending if flight volumes fall below the agreed plan.
Formula
Calculation
Collateral coverage ratio = Value of collateral / DIP loan amount
Suppose a distressed retailer asks for an $8,000,000 DIP loan. Its inventory and receivables, which would secure the loan, are valued at $12,000,000 in a likely sale. Coverage = 12,000,000 / 8,000,000 = 1.5 times. The lender would be covered one and a half times over, which is a comfortable margin and helps justify the court approving the loan.Case study
Seen in the real world.
Redwood Furniture Group is an illustrative, fictional chain of 60 stores that entered a court-supervised restructuring after a sharp fall in sales. It had $3,000,000 in cash and needed about $1,000,000 a week to operate, so it faced running out of money within a month.
The chief financial officer approached five lenders and accepted an offer of a $10,000,000 DIP loan at a high interest rate with a 3% arrangement fee. The loan came with a budget, weekly reporting and a deadline for filing a restructuring plan.
With the cash secured, the illustrative company closed 20 weak stores in an orderly manner and kept 40 profitable ones open. Creditors recovered more than they would have in a rushed sale, and the DIP loan was repaid from the restructured business.
Watch out
Common mistakes.
- Assuming DIP financing is free money for the troubled company, when it comes with high costs, tight conditions and the risk of losing control if milestones are missed.
- Thinking the new loan has no effect on existing creditors, when its priority can reduce what older lenders and suppliers recover.
- Leaving it too late to arrange the facility, since lenders prefer to commit before cash runs out and the company has little bargaining power once it does.
Questions
People also ask.
Why is DIP financing safer for lenders?
It usually ranks ahead of most other debt and is approved by the court, so the lender has a stronger claim on assets than ordinary lenders to a struggling company.
Who approves DIP financing?
A court normally approves it, after notice to creditors, and may hear objections from parties who say the terms are unfair.
Does DIP financing mean the company will survive?
No, because it provides time and cash but the business still needs a workable plan, and some companies are sold or liquidated despite having the loan.
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