Rent Extraction by Super-Priority Lenders

Abstract

We present strong evidence of supra-competitive pricing of debtor-in-possession (DIP) loans in Chapter 11. Over-collateralized and with super-priority, restrictive covenants and milestones, we show that DIP loans have near-zero payment default risk, whereas their spreads average 600 basis points, five times those on matched investment-grade loans with comparable default risk. Prepetition lenders, who may block competition from new lenders, dominate DIP-loan supply. Surprisingly, spreads are even higher with new lenders. Junior claimants often contest DIP-loan terms in court - to little avail. The evidence points to an agency problem likely arising from debtor CEOs' personal continuation bias when debtor survival is on the line.

Keywords: Debtor-in-possession, Chapter 11, rent extraction, covenants, loan spreads, fees, roll-up, leveraged loans, prepetition lenders

JEL Classification: G14, G34