The School Specialty chapter 11 case began in what has become all too typical fashion. The company, overleveraged and short of cash, had no choice but to accept a lifeline extended by its second lien secured lender, a private investment fund. The terms of the debtor in possession (“DIP”) financing required School Specialty to seek an immediate sale of substantially all of its assets, with the investment fund serving as the lead, or “stalking horse” bidder. The investment fund’s $95 million offer consisted mostly of a “credit bid” of its secured debt. The loan covenants required the sale to be approved by the bankruptcy court by March 27, 2013, less than two months after the commencement of the case.
Bankruptcy and restructuring professionals would immediately recognize this scenario as part of the “new normal”. These days the focus of a large portion of chapter 11 cases is not to rehabilitate companies, but rather to maintain going concern value through a sale of assets pursuant to section 363 of the Bankruptcy Code. Aggressive investment funds often extend funds to businesses in financial distress (or buy the existing debt at deep discount) with the clear intent of acquiring such companies if they fall into bankruptcy.
This practice, commonly known as “loan to own”, tends to work more often than not because the distressed borrower usually has no viable alternative. A company lacking unencumbered assets or positive cash flow can rarely access any other financing, and it is nearly impossible to loan new money to a chapter 11 debtor on a senior priority basis over the objection of an existing secured lender. The debtor must therefore accede to a debtor in possession (“DIP”) financing from its existing lender that mandates an expedited auction time frame. Although a competitive bidding process is required in nearly all section 363 sales, the hurried auction process strongly favors the investment fund and leaves other bidders unable to formulate meaningful competing bids. The “loan-to-own” investment fund wins the auction with a credit bid and unsecured bondholders and trade creditors are usually left with little or no recovery.
Protests in cases of this nature that the “loan-to-own” fund is “stealing” the company usually are ignored (because, as stated above, there is no real option), but School Specialty’s unsecured bondholders have bucked this trend. The bondholders agreed to back up their assertions that an expedited auction would undervalue School Specialty by funding an alternative DIP financing of $155 million that will pay off the existing loan of the investment fund, and provide School Specialty with an additional $50 million of new liquidity. The auction process will be extended out by nearly two months.
The School Specialty bondholders’ are making a substantial gamble that the additional time will either result in a higher sale price or permit the company to reorganize, and it will be interesting to see if it pays off. Many commentators and practitioners have lamented that chapter 11 has devolved into a little more than a glorified foreclosure process. Unsecured creditors, even bondholders, rarely have the capability to assume the level of risk that Specialty School’s bondholders have taken on. If it proves successful, School Specialty may prove to be a model for similar cases, which would help to once again make chapter 11 a fairer process for all creditors.