Fat Fees, Slim Risks

"The profit is a huge number," says Chemical Banking Corp.'s Darla D. Moore. "It's one of the top, if not the top, profit makers at the bank. It's been hugely profitable beyond anyone's expectations."

Profit centers have been something of an endangered species at the nation's banks, and huge profit centers are even rarer. Yet Chemical's restructuring and reorganization division, which Moore heads, is such an animal. It specializes in the lucrative business of lending to companies in bankruptcy to help them get back on their feet. Bankruptcy lending has enabled Chemical to rake in some of the fattest fees that bankers have seen in years. And while some experts point out that such lending is a relatively new business, with some untested legal areas, the level of risk appears to be low, and the losses, so far at least, minimal.

The biggest risk faced by bankruptcy lenders these days is competitive. With Chapter 11 filings up almost 300% from 1981 and leveraged buyouts unraveling daily, new players have been attracted to the game, most notably General Electric Capital Corp. (GECC).

PIONEER DAYS. Historically, most bankruptcy financing was provided by existing creditors of the bankrupt company, and in many cases, it still is. In 1984, though, Moore and Chemical pioneered the idea of acting as a third-party lender to bankrupt companies, technically known as "debtors-in-possession." Chemical says it has underwritten more than $4 billion in committed DIP financings, although the dollar amount of loans outstanding is much less, since banks sell chunks of the DIP loans they underwrite to other banks.

After helping establish Chemical's DIP financing unit in 1984, Moore, who is married to financier Richard E. Rainwater, left to lead Manufacturers Hanover Corp.'s DIP business in 1991. Now she works for the new Chemical-Manufacturers Hanover combination as head of the restructuring division she had left. Moore's unit gets kudos from the industry for moving quickly and efficiently, qualities that are crucial in DIP financings, since debtors usually want to move swiftly.

The attractions of DIP lending are multifarious. Bankruptcy courts usually give DIP loans "superpriority" status--in other words, first claim to the debtor's cash flow and assets, as well as priority liens over certain assets that existing creditors already have liens on. And companies can't emerge from bankruptcy without paying off the DIP lender in full. "You're senior, you're secured, and you've got to be paid off, unless you agree to go forward," says James P. Heffernan of investment firm Whitman, Heffernan Rhein & Co. "You've got the best of all worlds." Also limiting the downside is that many companies will use just a minimal portion of the committed funds, buying the loans mostly as insurance policies.

But there are questions about how that protection from the bankruptcy court would hold up if a company actually does liquidate and wind up back in court. For example, if a borrower has to liquidate, the priority status a DIP lender has counted on could face legal challenges, says Donald E. McNees, head of the financial institutions consulting practice at Towers Perrin. "What seemed like airtight legal contracts could suddenly be reinterpreted in a court of law. Even secured lenders may find they have to give their pound of flesh." Despite this warning, Moore insists that these loans are usually safe: "If you structure the financing properly and get the appropriate court orders, it can be done with great prudence."

WORTH THE CANDLE. The new entrants feel the risks are small compared to the eye-popping fees DIP lenders can earn. For starters, companies must pay a 1.5% to 4% up-front fee on the entire principal amount of the DIP loan. Then, there's the premium interest rate charged on the portion of the funds used, which can range from 1.25% to 3% over the prime rate. Another interest rate is levied on the usually large portion of the unused loan. Then there are administrative fees, something called an "agent fee," and more. Potential lenders also require debtors to pay them for preparing a bid--even if the debtor doesn't accept it.

It's no wonder, then, that the competitive pressure on Chemical has intensified. Bankers Trust Co., which began pursuing DIP lending more aggressively in 1990, has already won big deals for Southland Corp. and Pan American World Airways Inc. and is co-agent with Chemical on R. H. Macy & Co.'s DIP financing. And the ranks of smaller players, including CIT Group/Business Credit Inc. and asset-based lender Congress Financial Corp., are growing.

But aggressive, well-financed GECC is the player Chemical most worries about. "GECC is rapidly emerging as the main competitor for Chemical," says Wilbur Ross, senior managing director at Rothschild Inc. "It's out there very actively marketing itself and being fairly competitive on price and speed. In a lot of cases, it boils down to either GECC or Chemical." GECC has some special advantages as a nonbank lender. Says David N. Deutsch, a managing director at Congress Financial, a provider of DIP financing for middle-market companies: "GECC could be everyone's worst nightmare, because their cost of funding is so low, since they issue top-rated commercial paper directly. And like other commercial finance companies, they're not encumbered by commercial-bank capital requirements and other regulations."

"One of our most competitive things is that we are willing to compete on price if we need to," says Jeffrey H. Coats, managing director of GE Capital Corporate Finance Group, a division of GECC. Since it formally entered the market in 1990, it has committed from $2 billion to $3 billion. It has clashed a number of times with Chemical, most recently in competing for Zale Corp.'s $470 million DIP financing. GECC lost the bidding but walked away with $750,000 for its effort.

Despite GECC's aggressive forays into the market, Moore professes unconcern about the impact on profits. Although loan pricing is down a bit, she says, there's still a healthy premium. It's well deserved, she says: "Even though the credit analysis is relatively straightforward, the execution of these transactions is incredibly complex. Sometimes you could argue that there's not enough money in the world to pay you for getting into this fray."

Moore's competitors don't seem to think so. But they're making their efforts late in the game. As the economy recovers, bankruptcies and the DIP business should slow down in the next couple of years. "Then it becomes the plan-of-reorganization market," says Coats, for financing companies on the mend. "The interesting thing is the extension beyond DIP, such as recapitalizing a company," Moore adds. That's a less lucrative and perhaps even more competitive market. Moore will be up against Coats in that business, too.

Whatever happens, Moore seems supremely confident about maintaining Chemical's primacy. "I can do a DIP financing sleepwalking," she says. But with the business changing and rivals closing in, Moore might be well advised to keep her eyes open.

       -- Lots of fees
      Debtors pay a percent of the entire loan commitment up front, premium rates on 
      the portion of the loan they use, fees on the unused portion of the loan
       -- First in line
      Through "superpriority" status granted by the Bankruptcy Court, lenders can 
      get priority over all other creditors, including senior bank lenders
       -- Assured payback
      Unless the lender agrees to extend the loan, debtors aren't allowed to emerge 
      from bankruptcy without repaying the lender in full
       -- Modest drain on lender funds
      Bankrupt companies often use the funding to comfort trade creditors and rarely 
      draw down more than a third of the financing, if that
       -- Little competition
      Because lending to debtors is so specialized, there are few competitors, which 
      has kept the pricing very lucrative
      DATA: BW
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