Debtor-in-possession facilities (DIPs), at least in the lower middle market, are back and that sound you hear is the celebration from the turnaround community at large, including bankruptcy and restructuring attorneys. We are entering what can only described as the initial wave of what should be increased bankruptcy filing activity for lower middle market businesses. The Paycheck Protection Program, while life saving for some, has only delayed the inevitable for many small businesses that were either over-leveraged or challenged pre-COVID-19 pandemic. The proverbial can was literally kicked down the road and time is starting to run out as the PPP funds dry up.
What’s interesting is that this next cycle portends to be very different from the last. For starters, pretty much every lender is lending. Just as importantly, all lenders are flush with capital thanks to government stimulus programs indirectly subsidizing them. What’s also new is that the DIP market is bifurcating between big and small lenders, so smaller businesses now have more financing options in a Chapter 11 bankruptcy. In contrast, in past cycles, there was very little DIP capital available at the lower end of the middle market, especially for sub-$10 million DIPs. There was not enough margin for the return or threat of a priming fight. Enter the “Little Dippers.”
In this cycle, the lower end of the middle market has many well-funded participants with the sophistication to capitalize on this market opportunity. There are multiple lenders, mostly non-banks, gearing up to play in this market in addition to a lot of resource-strapped banks and business development companies. In normal times, banks or senior creditors would show up in court and fight hard to not be primed. Well, these are not normal times and the concept of “adequate protection” has never been more nebulous. Lenders looking to prime an incumbent lender use this argument to make the point that incumbents are protected under enterprise value. The counterpoint, among several, is that enterprise value is a lot harder to ascertain in these times. This is a fluid concept in a fluid market and it is going to be put to the test.
What should be noted is that priming fights do not happen often, at least when it comes to larger DIPs. When they do, they typically are front page material, with large corporations looking to create leverage or transfer assets such as intellectual property. The lower end of the market (i.e., Main Street) has not experienced this situation yet, partially due to the small size of the need and lack of absolute dollar return, but also because banks really control this market. Traditionally, it has not been great lender etiquette to enter into a priming fight with a bank, especially a non-consensual one. Banks tend to have very, very long memories when new lenders try to muscle them out. Expect this cycle to be different and feature a lot of new entrants with few-to-no commercial bank relationships to worry about. The lower end of the market is still the “Wild West” with a wide range of firms and terms.
The alignment of interests gets skewed quickly when a non-bank tries to non-consensually prime a bank or other lender. The bank might be better off in a liquidation rather than risk a going concern sale. The investment bank, if one can be hired, is typically highly incentivized to maximize liquidity to run a sale process. In fairness, the goal of this process is to provide adequate protection to the primed creditor. Industry observers expect to see a lot more priming fights this cycle, especially in the lower end of the middle market. There are new entrants with few affiliations to banks that are less concerned with etiquette. Right now, marketing small DIP capabilities has become an arms race in the small-ticket ABL community.
The small-ticket ABL community is hungry for business, as community banks and business banking groups of larger banks took significant share during the last cycle. These same groups are still reticent to easily let go of income-producing assets. Non-bank ABL groups are waiting with the appetite, capital and capacity to swoop in and provide small DIPs. These groups are also not afraid of priming fights. Many banks out there don’t have the resources to contest each battle. Certainly, the bigger priming fights will be contested, but there will be many small battles where banks don’t contest or, frankly, lose on adequate protection. There have already been a number of such instances.
There is enough court activity to know that the sub-$10 million DIP market is here to stay. What is not known is how banks are going to handle the offensive priming DIP providers trying to gain control in court. Expect to see a lot more court room showdowns this cycle in a new part of the market that has historically experienced a dearth of lenders. That’s not the case anymore and this new crop of lenders is not afraid to be aggressive. Look for the stars to align during this next cycle and for the constellation of “Little Dippers” to outshine the “Big Dippers.”