It's Not Time For a Government Bankruptcy Facility
The COVID-19 pandemic has wreaked havoc on U.S. companies of all sizes. As businesses deplete their cash balances and funding options, experts are predicting a surge in bankruptcy filings. In response, several scholars and commentators have called for the creation of a government-backed facility to finance bankrupt companies. While well-intentioned, this is unnecessary based on our survey of the marketplace and would risk crowding out private capital by distorting company and investor incentives.
The financing of companies during bankruptcy occurs through what is known as debtor-in-possession, or DIP, financing. DIP loans resemble loans provided to companies outside of bankruptcy and are designed to keep businesses operating during the restructuring process. Thankfully, the private DIP loan market has remained strong in recent months.
For instance, troubled retailers such as J. Crew, Neiman Marcus and J.C. Penney each received DIP financing when they filed for bankruptcy last month. Some proponents of a public sector alternative may be surprised to learn that lender groups have actually competed to provide the DIP loans in some cases. Even bankrupt companies that are liquidating, such as Pier 1 and battery maker Exide, have received DIP financing to keep operations afloat as they work to wind down. Indeed, data compiled by The Deal shows that the frequency of companies filing for bankruptcy with DIP loans in hand has steadily increased in recent months among firms with liabilities of greater than $10 million.
Contrarians may ask: Why are DIP markets functioning so well? To be sure, injections of liquidity into financial markets by the Federal Reserve and Treasury Department have stabilized corporate bond and loan markets, including for DIP financing. More pertinently, investors focused on distressed companies have accumulated large amounts of capital over the last several years and have been well-positioned to make investments in this environment. The managers running these distressed funds possess specialized expertise in providing DIPs and, more generally, often work with bankrupt companies towards successful restructurings. These factors provide us with a great deal of confidence that private capital will continue to provide DIP loans for firms that need funding to reorganize in bankruptcy.
A back-of-the-envelope analysis suggests that there is ample private capital to cover a spike in DIP loans. According to Preqin, distressed investors currently hold, or are raising, nearly $150 billion that can be deployed as DIP loans. If we assume that a historically high 20% of the $2.8 trillion in risky U.S. corporate debt outstanding ends up defaulting over the next year, then $560 billion of corporate debt would need restructuring. Given DIP loans historically fund about 14% of defaulted debt, an estimate of upcoming demand for DIPs would be $80 billion (about one-half of the capital available from distressed debt funds) and a smaller fraction of the billions of dollars in other private capital that could be repurposed for DIP loans. It also important to highlight that banks have historically been large providers of DIP financing. In short, the risk that private capital will be inadequate during the crisis appears small.
Meanwhile, government involvement in the DIP market could crowd out private capital and create costly distortions to the bankruptcy process. Neither the Federal Reserve nor the Treasury Department has the in-house expertise to administer these loans and manage a bankrupt company through a court-led process. Thus, a government-run facility would risk disruptions and delays in getting requisite funding to bankrupt firms. Further, by pushing out private capital with subsidized loans, the government diminishes incentives to deploy capital to economically viable firms most in need, while also constraining competitive forces that weed out companies that are not viable going forward.
Rather than crowd out private capital in the DIP loan market and risk undermining the efficiencies in the bankruptcy process, the federal government should continue to focus on ensuring smaller distressed companies have access to liquidity. There is no need to fix what is not broken and put taxpayer dollars at risk.
