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Debtor-in-possession financing: Size does matter

by Maria Carapeto in the PhD Program of the London Business School

November 20, 1998

Abstract: Debtor-in-possession (DIP) financing is new financing that arises through lending to bankrupt firms. Many scholars have discussed the theoretical implications of DIP financing in terms of its contribution to the value of the companies. Recently, Dhillon et al. (1996) and Chatterjee et al. (1998)[REF] analysed the effect of DIP financing in the stock and bond markets and found a positive impact.

In this paper I use a different approach to analyse the role of DIP financing in the bankruptcy process. I examine the plans of reorganisation of a large sample of 135 Chapter 11s with DIP financing and 191 Chapter 11s without DIP financing that went bankrupt in the United States over the period 1986-1997. I find that successful reorganisations benefited from DIP financing. This positive impact is, however, reduced in two circumstances: when the new loans are secured by a lien on already encumbered assets with equal or senior priority to the existing liens; when the new lenders obtain an increase in the seniority of their pre-petition debt. Also, a fast Court approval of DIP financing decreases the probability of success. The concession of DIP financing does not seem to significantly affect investment incentives, recovery rates and deviations from absolute priority. However, the size of DIP financing impacts on recovery rates.

I also find that claimants of firms that were acquired in bankruptcy exhibit lower recovery rates, due to the potentially strong bargaining position of the acquirer.

JEL Classification: G32, G33, G34.

Keywords: Bankruptcy, Debtor-in-possession financing, Successful reorganisation, Recovery rates, Deviations from absolute priority, Mergers & acquisitions.

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