The term debtor-in-possession, refers to a company that has filed for bankruptcy, but continues to operate, controlling its assets for the benefit of creditors and shareholders.  The current borrowing environment is the “un-debtor-in-possession”.  Borrowers, despite strong balance sheets, healthy collateral, and even strong cash flow are being left high and dry by the lending community.  Their assets are at the mercy of the banks, not management.

I guess $750 billion in bailouts, including $250 million of direct investment, does not bridge the gap between debtors and creditors.   How bad is it?  The White House went on the offensive today, chiding banks receiving financial aid for not lending.  The harsh reality, until the lending environment improves, and companies and consumers starved for cash can get some assistance, economic expansion will not occur.

I don’t blame the banks for their actions.   If I had money, I’m not sure I would lend it either.  Sure lending at LIBOR + 1466, last weeks all in yield in B/B2 credits, seems juicy, but not relative to buying back your own stock, or purchasing senior paper at 70 cents on the dollar in the secondary market and holding it to maturity.  After all, if I am a bank officer, I’m probably incented using options on my underlying equity, not my good Samaritan IQ.

In light of the above, I thought I would go in search of some answers in the debt markets about what is going on and what will be going on over the next 60 – 90 days.  What I found was is summarized it below.  We will work from the bottom of the capital to the top.  Let’s leave out mezzanine as I think I have flogged that concept for now.

Unitranche Debt

Unitranche debt is a fandango instrument invented by the publicly traded business development corporations (BDOs) (Allied Capital, American Capital, Gladstone, etc.).  Unitranche debt combines the terms of senior and junior debt into one single debt facility.  BDOs have the ability to provide a one-stop-shop for all your capital needs.  Historically, unitranche was very attractive for sub-$15 million EBITDA companies.  Issuers targeted a 12% – 14% total return, making them an attractive alternative to mezzanine debt.

Unfortunately, the unitranche model is broken.  Very.  Consider the following yields on the equities of publicly traded BDCs (after a day when the market climbed 10%): a) ALD ~ 43.8%, b) ACAS ~ 39.4% and c) GLAD ~ 17.3%.   These stocks are trading under the assumption that their dividends are going to be slashed.  The BDC model relies on their ability to issue new stock in the equity markets to raise capital,  lend that captial at attractive rates and get equity kickers, pay your dividend with return from equity kickers.  Small problem — equity returns are in the tank, new issuance’s are at a standstill and these companies can’t issue equity to fund forward commitments.   The model is broken.   The best use of capital for these companies is to buyback their own stock or, as previously noted, purchase senior loans on the secondary market.  Unitranche debt is an endangered species until yields on corporates come down to reasonable levels.

Cash Flow Loans

We can keep the section on cash flow loans quite short.  There are more Do-Do birds than cash flow loans right now.  However, unlike our extinct friend friends, cash flow loans will eventually return.  I would not wait around however.

Other Senior Debt

On the senior debt front, I spent some time with a Senior Vice President from GE Financial Services.   He told me, that contrary to popular belief, and potentially only viable for this week (since things are so fluid), they remains open for business.  However, what he said was stunting their business was their ability to syndicate deals.  In fact, the entire GE syndication team was working on only a small handful of deals at this time.  Here is what else he told me:

> Equity contributions in private equity deals had reached 50% – 60% as collateral rates of asset based financing’s (ABL) had contracted 10% – 15% from historical norms.

> Syndications are near impossible right now.  The commitment terms on deals are not firm or even best efforts but rather “might fly” with partners.  The market flex language is bigger than a material adverse change clause in a traditional leverage buyout.

> When asked about equipment loans I was met with the following response, “I’m not sure who is going to take those.”  Enough said.

> Strong deals are going for LIBOR + 650 with upfront fees 4% – 5%.  That’s expensive money for a solid operating business.  Businesses are bypassing deals because the cost of funds takes them from accretive to dilutive.

> Facility extensions for add-on acquisitions are resulting in a full renegotiation of facility terms and conditions.  Given the cost of funds that issuers are now facing, this a market reality.

Net, net the debt market is on life support.  Despite the best efforts of the government, the velocity of money through the system has not increased.  The reality is most lenders are trying to gauge how deep and how long the current recession is going to be.  No one wants to be caught on the wrong side of a credit decision in the near term.  As a result, grid lock will prevail until the equity markets show signs of life.  While today was a step in the right direction, after hours trading shows profit takers are selling off.

Anyone want to loan me any money?  I’m good for it.  I swear.

/bryan

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