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 werent 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 Moodys 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 (Moodys 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 & Poors 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 theyre going to put their money to work, says Jason Mudrick, president and chief investment officer of New Yorkbased 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 its still considering it. Others have tried and failed.
The few DIP funds that have succeeded lately in fundraising conspicuous among them, Stamford, Connecticutbased hedge fund group Aladdin Capital Holdings and Santa Monica, Californiabased private equity group Tennenbaum Capital Partners have done so largely because theyre 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 wont provide DIP financing to middle-market companies because they dont 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, Theres 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 isnt all bad for DIP funds. Theyve been scouting out opportunities in exit loans used to finance companies emerging from Chapter 11 or restructuring. Right now, says hedge fund manager Mudrick, its a good time to do exit paper. Two years from now it may be a good time again for the DIP market.