Also known as debtor-in-possession or bridge financing, bankruptcy financing is any type of lending extended to a business that is currently under a Chapter 11 bankruptcy process. The idea behind this type of financing is to help the company to eventually emerge from bankruptcy and begin to operate at a profit once more. Financing of this type must comply with the rules set in place by the court of jurisdiction, and generally requires the involvement of the bankruptcy trustee appointed by the court.
Since bankruptcy financing is extended to businesses that are experiencing financial distress, the degree of risk to the lender is somewhat increased. As a result, financing of this type is usually structured to include a higher rate of interest throughout the life of the debt. In many nations, bankruptcy laws allow these turnaround financing lenders to have seniority over other debts of the borrower, in the event that the company is unable to honor its obligations. While this does help reduce the degree of risk slightly, it is rarely enough to allow a company to receive interest rates similar to those extended to financially stable businesses.
One of the factors that does make bankruptcy financing a plausible alternative for lenders is that loans of this type can be highly profitable. This is not just because of the higher interest rate carried on the loan. Businesses that are able to successfully emerge from bankruptcy often continue to do business with the lenders who provided them with a second chance to get back on their corporate feet. From this perspective, extending bankruptcy financing can be seen as a strategy that can yield a return long after that first loan is repaid in full.
While the opportunity to earn more profit and establish a long-term relationship is present, lenders must still investigate all relevant factors before choosing to approve bankruptcy financing. With an applicant that is currently in bankruptcy, the lender will want to understand what changes the business has made in order to avoid the circumstances that led to the original financial distress. Often, the lender will want to look closely at the place of the business within its industry, especially its ability to compete with other companies that offer similar goods and services. The idea is to create an accurate projection of the company’s ability to honor the terms and conditions of the financing, based on not only internal factors relevant to how the company is operated, but also external factors that could impact the ability of the business to capture and maintain a sufficient share of the consumer market.
