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Wall Street Journal
Tuesday, October 23, 2001
SMALL FIRMS SEEKING TO REORGANIZE FIND MONEY HARD TO GET
Building-Materials Maker Finds Alternative Debtor-In-Possession Financing From Bank
Phenix Biocomposites LLC filed for Chapter 11 bankruptcy-court protection in February. And, like many bigger U.S. companies seeking debt relief, Phenix had lined up so-called debtor0in-possession financing to keep its business going.
Such financing provides money to keep a company operating while it reorganizes its debt obligations in court. USG Corp. and Federal-Mogul Corp. are recent examples. But unlike those bigger companies, banks weren’t falling all over themselves to advance funds to Phenix, which makes building materials from agricultural byproducts. Many lenders think smaller loans aren’t worth the hassle.
And therein lies a problem for smaller companies as the economy heads into recession and bankruptcies rise sharply; Debtor-in-possession funds aren’t as widely available to them. That means that many may end up liquidating even though they may have viable businesses that could survive debt reorganization. “The smaller you get, the more difficult it is,” says Christian Onsager, a longtime bankruptcy lawyer and now general counsel at Broe Cos., a Denver Investment firm.
To encourage such loans, the federal bankruptcy laws typically allow the new lender to step in front of creditors waiting to get repaid. That senior, or secured, status has made debtor-in-possession lending a popular business for big banks such as J.P. Morgan Chase & Co. – which arranged a combined $1.026 billion in such funds for USG and Federal-Mogul – Wells Fargo & Co. and Bank of America Corp.
But many lenders that claim small business and the so-called middle market as their primary customers aren’t interested in making debtor-in-possession loans. With the extensive due diligence required on a bankruptcy loan, it’s easier to make money on bigger ones. And debtor-in-possession financing is often a short-term, one-time transaction, and middle-market lenders seek long-term relationships.
LaSalle Business Credit in Chicago, for instance, only does debtor-in-possession lending when an existing client files for bankruptcy. “We’re not actively out there soliciting DIP financing,” say Michael Sharkey, president of the unit of ABN Amro Holding NV, the big Dutch bank whose U.S. lending operations are among the nation’s busiest middle-market lenders. What’s more, jumping into a senior, secured status understandably angers existing lenders of a company filing bankruptcy. “That’s not something we’re interested in doing to others,” Mr. Sharkey says.
So, how did Phenix Biocomposites in Mankato, Minn., scrounge up financing to survive a bankruptcy proceeding?
The company was founded in 1991 to make panels for furniture, flooring, wall tiles and such from agricultural fibers such as wheat straw and other byproducts. Its 150,000-square-foot plant, operating at capacity, could generate sales of $30 million to $35 million a year, says Lanny Jass, chief executive. And Phenix’s material costs are so low that pretax profit could be about $20 million, Mr. Jass says.
That potential led Rabobank Nederland and others to lend and invest a combined $80 million. The plant was mostly completed in September 1999, leaving Phenix “very cashed out,” Mr. Jass says. It wasn’t able to install equipment to make the highest-end products, which limited revenue prospects, and lacked cash to hire a sales force. Phenix asked Rabobank for more money, but the bank said no. Phenix owed Rabobank $13.1 million, and the bank decided it wanted its money back, Mr. Jass said.
Jeff Vollack, senior credit officer at Rabobank in New York, says Phenix “went way over budget” on its plant. “They built up a heck of a history of not meeting projections.” Rabobank held off foreclosing, Mr. Vollack says, hoping Phenix could find new investors and on the agreement that, failing that, Phenix would liquidate. “They went back on that,” he says, filing instead for Chapter 11.
“That’s technically correct.” Says Mr. Jass. The liquidation issue “was shoved down our throat in a forbearance agreement.”
New investors were scared off by the debt. So a bankruptcy seemed the only way to convert most of the debt into equity, raise new money and crank up operations, Mr. Jass says. Talking to banks, he found no offers for DIP financing.
But there are new players in the DIP financing business: hedge funds and other investment funds that see value in distressed companies. “It’s the old loan-to-own,” says Bill Esping, managing partner of EFO Holdings LP, a family investment firm in Dallas managing more than $250 million.
EFO has made a handful of debtor-in-possession loans in the past two years and is looking, through its Cypress Lending Group Ltd., to increase that business. Mr. Esping views it as a low-risk way to get to know some smaller companies EFO might like to invest in or buy outright, preferring those with substantial real-estate assets that can be sold if the business sours. “If we don’t want to own it, we don’t loan it,” he says.
So far, Cypress has made debtor-in-possession loans to a golf-course development and an acute-care hospital, as well as lending $3 million to Phenix. Cypress says the underlying real estate at Phenix is appraised at $12 million, so its loan is well-collateralized. Mr. Jass, Phenix’s CEO, says Cypress was the only willing lender he found. Others “were standing on the sidelines hoping it would be a liquidation,” he says.
There was a fight in bankruptcy court with Rabobank over Cypress becoming senior to the bank’s loan, decided for now in Cypress’s favor, Mr. Jass says. Phenix’s plan isn’t yet confirmed by the court.
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