Firms Grapple With New Chapter 11 Playbook

Buyout-backed companies facing bankruptcy know one thing for certain: today’s workouts are a far cry from the drawn-out, option-plentiful cycles of past downturns. Twenty-three strong, the LBO-backed bankruptcy class of 2008 shows how much the bankruptcy process has changed since the last cycle.

One lesson buyout firms are quickly learning is that a debtor-in-possession loan (a life raft loan meant to keep the company afloat during bankruptcy) isn’t as easy to secure as the credit used for the initial buyout. A big reason for that is because secured debt was extremely plentiful during the recent buyout boom, and highly leveraged companies now entering Chapter 11 are finding that most of their assets are in hock. That complicates things, since most DIP loans are secured by assets, and there are few assets left for the DIP lender to secure, said Bill Welnhofer, managing director and head of restructuring at investment bank Robert Baird & Co. “It means DIP lenders who do agree to loans will keep their companies on a very short leash,” he said.

This dynamic played out recently for Sharper Image Corp., which is minority-owned by Sun Capital Partners via the firm’s public equities fund. After raising $51 million through the liquidation of about 100 stores, the specialty retailer was forced to liquidate its remaining 86 stores last week after the restrictive nature of its DIP loan prevented it from carrying on operations, according to court documents. Sharper Image went bankrupt in February after several years of proxy battles, shareholder agitation, and unprofitability.

Likewise, Apollo Management met difficulty securing a DIP loan for its bankrupt home goods retailer, Linens ‘n Things. After receiving indications of interest from several parties, the company received a single offer from GE Capital Corp., which put up $700 million in DIP financing. The company last month sold off 120 of its stores and was reported to be considering the sale of 50 to 100 more as of press time.

In addition to causing headaches for sponsors, a lack of willing DIP lenders makes a pre-packaged filing more difficult, and pre-packaged Chapter 11 plans are clearly preferable. Diamond Castle Partners-backed PRC LLC, Willis Stein & Partners-backed Ziff Davis, and Clayton Dubilier & Rice-backed Sirva Inc. all filed with prepared bankruptcy plans. The former two are being sold as going concerns, and Sirva was hoisted from bankruptcy after just three months, following its pre-arranged plan to be taken private by its senior lenders.

Meanwhile, the new federal bankruptcy law holds out another incentive for companies to enter Chapter 11 with an exit strategy in place. The law, enacted in 2005, limits company control of bankruptcies to 18 months, so companies filing with no solution in sight are more likely to face liquidation, market sources say. “The shortened timeline puts a premium on pre-arranged bankruptcies,” Welnhofer said.

Perhaps the biggest warning restructuring pros sound is that sectors that were considered safe in past downturns won’t be so lucky this time around. In the bankruptcy cycle of the late 1990s and early 2000s, businesses in technology, telecom, and airlines suffered blows, while others remained completely intact, said Lorie Beers, managing director in KPMG Corporate Finance’s restructuring group. That era was marked by scandal-ridden blow-ups like WorldCom and Enron. But despite the attention grabbing insolvency cases, “if you look at the general economy, many businesses operated through that without a blip,” she said.

The cornucopia of industries on Buyouts’s list of LBO-backed bankruptcies runs the gamut from automotive companies and airlines to retail chains and restaurants; from furniture makers and advertising firms to manufacturing companies and media concerns. The breadth of the industries underscores many restructuring pros’ belief that this bankruptcy cycle will likely cut deeper than the last.