Bankruptcy woes

Liquidations are more common in the bankruptcy world as financing for reorganisations has dried up, writes Christopher Witkowsky.

Bankruptcy has become a world rife with dangers for private equity-backed companies.

Ideally, most companies would want to restructure their debt under the protection of Chapter 11, which allows them to reorganise and re-emerge as a going concern.

Last year, several high profile bankruptcies – which previously could have stayed in the courts for a year or two and emerged from Chapter 11 reorganised and in stronger positions – went to straight liquidation, or Chapter 7. Those companies include Apollo Global Management-backed Linens ‘n Things, Sun Capital Partners-backed Mervyns and TA Associates-backed Steve and Barry’s.

There are several reasons for the liquidations, the biggest being the lack of bankruptcy financing, known as debtor-in-possession loans, or DIP. Companies use DIP loans to fund operations and pay professionals in bankruptcy. Companies also seek money to pay for their emergence from bankruptcy, known as exit financing.

Some of the most active DIP lenders, including GE Capital, have backed off from lending, or have shortened the length of the DIP loans they’re extending. In the past, DIP loans range from 12 months to 18 months, whereas these days the loans can run as short as 60 days.

Without bankruptcy financing, a company may have trouble paying its employees and suppliers and funding its bankruptcy process, which could send it straight to liquidation. 

The lack of DIP financing does present an opportunity to some private equity firms with cash on hand, who can themselves become DIP lenders, like Littlejohn & Co. and Perseus, which have extended bankruptcy financing in the past. DIP loans are considered administrative claims and are among the first to get paid back. 

Another pitfall that can affect companies in bankruptcy, especially retail companies that lease numerous storefronts, is a rule that was added when the US bankruptcy code was modified in 2005. The rule gives companies a total of 210 days from the time of the bankruptcy filing to reject or assume leases on properties. If the company doesn’t make a decision in the allotted time, the company must continue paying the leases.

Experts say the 210 days is not enough time in a major bankruptcy case like Linens ‘n Things, for example, to determine exactly what stores are profitable, what stores are losing money and need to be shuttered. On top of those decisions, motions required to be filed with the court to make all this happen can take weeks to months to complete, depending on objections from creditors.

The rule leaves little wiggle room for a portfolio company to decide how to handle its leases, yet the alternative is liquidation. These bankruptcy issues will remain high on the minds of some private equity firms this year as more and more portfolio companies find themselves with no other option but to run for the shelter of Chapter 11.