Loans to Chapter 11 Firms: Contract Design, Repayment Risk, and Pricing

With a hand-collected set of 545 debtor-in-possession (DIP) loan facilities for 2002-19, we show that these short-term loans are highly overcollateralized and contain a comprehensive set of restrictive covenants, mandatory prepayments, and restructuring milestones-all of which help produce a repayment risk near 0. Nevertheless, the all-in spread drawn averages 658 basis points-almost five times the average spread on matched investment-grade loans and nearly double the average spread on matched leveraged loans issued by highly risky firms outside of bankruptcy. Textual analysis of court documents shows lack of outside lenders' participation in the loan solicitation process, but spreads are somewhat lower when outside interest is high. We discuss alternative interpretations of the high DIP loan spreads, ranging from monitoring-cost compensation to rent extraction as DIP loan providers with strong bargaining power share in the preservation of going-concern value helped by the last-resort loan. "The question this debtor had to ask, is: Is this [debtor-in-possession loan] better than a liquidation?" (Mark Ellenberg, in Kary [2009])"In the Great Recession default cycle, no [debtor-in-possession loans] defaulted." (David Keisman, in Adler [2016])