As Defaults Rise, Distressed-Debt Investors Seek an Edge by Buying the DIP

  • Creditors use loans to gain control of investments gone sour
  • Debt is for the fight to retain value, not clipping coupons

As global economic turmoil pushes more companies to the brink of insolvency, competition is intensifying among distressed-debt investors to safeguard their investments by funding the businesses through bankruptcy.

In recent months, some of the world’s savviest distressed investors -- from Oaktree Capital Management LP to Silver Point Capital LP to Cerberus Capital Management LP -- have competed to provide capital to help fund companies during their bankruptcy proceedings through restructuring financing or debtor-in-possession loans, also known as DIP loans. And they’re increasingly willing to go to financial extremes to get these deals done.

Molycorp Inc. is the latest troubled company to have its creditors battling over DIP debt. Oaktree currently has the senior position in its bankruptcy proceeding with a loan paying 14 percent. But holders of the rare-earths miner’s first-lien bonds, led by JHL Capital Group LLC, are offering a new loan to replace Oaktree’s that would pay just 3 percent, people with knowledge of the matter said this week. They’re willing to accept such a cheap rate because, in return, they would gain more control of the company as it pursues an asset sale.

Investors like these loans for this precise reason. They give lenders control over the restructuring process, which can potentially improve the recovery on their existing investments. Although DIP loan volume decreased in the past few years as defaults declined, market participants anticipate a revival as industries ranging from energy to retail struggle.

“It’s not about clipping the interest on that loan,” said John Greene, a managing director at the hedge fund Halcyon Asset Management. “It’s about the fight over the collateral.”

The trend goes beyond commodities-related companies, even though the default rate in the energy sector is the highest. The rate of energy defaults was at 5.2 percent for the 12 months ended Sept. 30, compared with 1.4 percent across all industries over the same period, according to a Fitch Ratings report published on Oct. 28.

Earlier this month, American Apparel Inc.’s lenders Monarch Capital LP and Standard General LP offered a $90 million loan to fund the bankrupt retailer’s restructuring. Monarch is the largest creditor in its first-lien notes and Standard General owns the lower-ranking term loan as well as the stock.

“It would not surprise me to see an even greater number of proposed defensive DIP loans in 2016 and more cash collateral litigation especially as defaults pick up in the energy sector,” said Mark Kronfeld, a partner at the hedge fund Plymouth Lane Capital Management LLC.

Representatives for Oaktree, JHL, Silver Point, Cerberus, Monarch and Standard General declined to comment.

“The last thing these existing lenders want to see is someone else coming in with a claim on the assets that ranks ahead of them,” said Lewis Grimm, a partner at the law firm Jones Day, which helps companies with these loans.

Case in point: Bankrupt gas producer Samson Resources Co.’s senior term loan lenders Silver Point and Cerberus had to offer new money to backstop a rights offering after a group of unsecured bondholders proposed a competing DIP loan. Silver Point and Cerberus were essentially forced to respond to the offer because it would’ve put them behind the other lenders.

“A defensive DIP loan is the essence of devaluing assets,” Halcyon’s Greene said. “We are bound to see nastier and more contentious fights as value dropped so much. Some of the creditors are going to be flushed.”

That’s especially true when the value of collateral shrinks at a faster pace than many fund managers have seen before. For example, when crude lost more than half its value in July, dropping to below $50 a barrel from $107 a year earlier, Samson’s unsecured bonds, which had only been issued in July 2014, became virtually worthless.

As a result, “we are going to see significant valuation fights in the energy sector next year,” said David Karp, a distressed investing attorney at Schulte Roth & Zabel LLP.

Bankruptcy index up 22 percent this year as of September 30

Patriot Coal Corp. offers the latest example of what Karp describes. Earlier this month, a lower-ranking lender to the bankrupt company, the hedge fund Cortland Capital Markets Services LLC, complained that the sale of the coal miner’s assets to Blackhawk Mining LLC was unfair, court documents show. Cortland accused a senior-ranking creditor, hedge fund Knighthead Capital Management LLC, of dominating the transaction, “which will enrich it at the expense of other creditors.”

While Judge Keith L. Phillips eventually approved the sale after a delay, “it was surprising that the arguments managed to hold up the sale by two days,” said Ted O’Brien at Doyle Trading Consultants, an independent research firm on the coal sector.

“The disputes highlight just how complicated coal restructurings have become, as creditors throughout the capital structure fight to enhance their recoveries as asset values slide.” said O’Brien.

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