Taking a Fresh Look at DIP Budgeting
DIP Financing "101"
Typically, in the middle market, it is the pre-petition senior secured creditor whose cash collateral is at risk and to whom the debtor will turn for financing. The "DIP lender" will require the debtor to prepare a budget that will enable the lender to determine whether, and how much, to provide the debtor in new loans.
Not surprisingly, given the pressures of a bankruptcy situation, debtors frequently hurry through the process of generating a DIP budget. This can lead to costly mistakes in estimating cash flows—and to an increased risk of covenant violations. In preparing the budget, the debtor may—intentionally or not—act in ways that keep the "real story" of how the firm is doing hidden from its bankers and other creditors. For example, the debtor may be overly aggressive with sales and collections and at the same time be too conservative with cash disbursements. This could lead to a smaller DIP loan being made available than is actually required.
Debtors sometimes ask for more money in DIP loans than they need, justifying the request—once again, wittingly or not—with inaccurate assessments of projected cash flows. Underutilized facilities can result in unnecessary loan fees.
The bottom line is that distressed companies filing for bankruptcy often fail to be realistic about their business and generate pro forma cash-flow estimates that are off the mark—perhaps even considerably so. It therefore behooves any lender, creditor or advisor who has to work with debtors to be aware of some common items that should be accounted for and noted in a DIP budget.
Need for Accurate Sales Projections
The single most important item in a DIP budget—and one of the areas most likely to contain errors—is the sales projection.
Take holidays and seasonal variations into account. Most budgets will be created in a weekly format covering a period of at least three months—or more accurately, 13 weeks (i.e., one quarter of a 52-week year). In making sales projections for the DIP budget, some companies oversimplify the process by generating a weekly sales figure based on a quarterly number divided by 13. While this approach may be appropriate for firms with very regular revenue streams, for many others it is flawed. Companies whose sales are affected by holidays or seasonality, or whose shipping and billing is concentrated around month end, should be sure that this is reflected in their projections.
Debtors need to rebuild their credit histories through many months of timely payments. This can have a drastic impact on cash flows, so the relevant assumptions should be clearly laid out in the budget.
This seems an obvious step, but it is not always taken. In a recent case, a company that sold weekly subscriptions was operating under a DIP loan from its bank. In applying for the loan, the firm gave the bank weekly sales projections that failed to account for the impact of holiday weekends, when sales were typically only 25 percent of normal. The DIP budget timeframe had included two such holidays—Mother's Day and the 4th of July—but had projected normal rather than reduced sales for these time periods. Consequently, the company repeatedly tripped variance covenants. Not only did this impact the firm's credibility, it also gave rise to an increase in fees and rates.
Understand the assumptions behind the figures. A comprehensive and accurate budget needs to account for the assumptions behind the figures presented for each of the business's product categories, product lines and revenue streams. For example, if sales are estimated via projected volumes sold, a note to the budget or a supporting schedule should display unit volumes along with dollar figures. This will help limit overly optimistic sales forecasts.
In cases where a debtor will be factoring invoices or when it only has formula-generated "availability" for accounts receivable and possible inventory, it is imperative to project as accurately as possible. Over-projecting sales could leave the debtor with insufficient funds for disbursements.
Quantify the "taint of bankruptcy." When assessing a debtor's sales projection figures, constituents should factor in an assumption quantifying the "taint of bankruptcy," as this may have an adverse effect on actual sales. Certain companies and some government contracts preclude dealing with suppliers in bankruptcy. More generally, if the debtor's products or services are subject to significant lead time, customers may look for alternative sources. Sales assumptions should account for such scenarios.
Be Diligent on A/R
In cases where there is a cap on the credit line and invoices that age out or become ineligible for advances, the debtor will need to be particularly diligent in collections to prevent increases in the credit line or loss of availability as invoices become ineligible. In cases where the debtor is advanced money on invoices at an 80-85 percent rate, collections will not have as much of an effect but will still be important.
Beware of Rising Vendor Costs
In chapter 11, relationships with vendors can be strained. Even though vendors know that the debtor will either be authorized to use cash collateral or receive a DIP loan, and that post-petition invoices to the debtor are considered administrative expenses, they are (understandably) nervous—and often upset—about pre-petition debts. They may question their continuing relationship with the debtor.
In many cases, vendors will try to alleviate some of their concerns by requiring either cash in advance or on delivery. They may also increase prices in an attempt to recoup some of their losses.
It may not be possible to prevent suppliers from raising prices on a company in bankruptcy—as long as the price increases are not considered gouging. No supplier is required to do business with a debtor (unless there is some pre-petition supply contract). The debtor will probably have to bite the bullet and try to work through any difficulties with its vendors. Constituents should be aware that this kind of behavior by vendors is not uncommon, and its immediate effect is to increase the debtor's product costs. This means cash flow will take a hit, so an attempt to quantify the potential impact of vendor price rises should be made during the DIP budgeting process.
Debtors frequently overestimate suppliers' willingness to advance credit and are over-optimistic regarding the credit limits that will be instated. Many suppliers will be reluctant to extend credit, since they may have recently incurred write-offs due to the filing. Debtors need to rebuild their credit histories through many months of timely payments. This can have a drastic impact on cash flows, so the relevant assumptions should be clearly laid out in the budget. Constituents need to consider future vendor credit when reviewing the post-petition accounts payable balances. Each dollar of vendor credit means one less dollar needs to be drawn on the DIP loan.
Accurate Overhead and SG&A
As with sales projections and collections, a realistic assessment of overhead and SG&A expenses is important for accurate cash-flow projections, but unlike these, looking at historical income statements will not always suffice.
Since overhead and SG&A income statement figures are generally based on accrual methods, various items are smoothed out over the period. Hence, it may not be clear that large cash outlays are due during the time period covered by a requested DIP budget. Examples include insurance, various taxes and advertising, all of which may require large cash disbursements just a few times a year. While drawing attention to any imminent large expenditure would seem to be an obvious step to take, in the urgency surrounding a bankruptcy filing it is often forgotten (or deliberately overlooked). We have seen companies that failed to include sales and real estate taxes—even payroll taxes—in their DIP budget projections. Recently we encountered a debtor that had projected $10,000 per week for real estate taxes, but just two days into a 13-week cash flow had to pay out a lump sum of $260,000. This severely impacted availability and raised questions as to the debtor's competence and credibility.
The debtor (and the debtor's advisors) should be encouraged to take a close look at all expenditures and eliminate costs wherever possible in the light of the future requirements of the business. If time allows, a zero-based budget should be developed. Too often, expenses are extrapolated from prior months, utilizing the provisions of the Bankruptcy Code, resulting in significant changes to what may have been regarded as non-negotiable items. A new budget should also take account of interim changes in the business plan/model. Although the debtor may not be ready to make wholesale changes to its operations on day one, there are probably many costs that can, and should, be eliminated. These may range from personnel layoffs to the closing of whole facilities. The budget projections should reflect these items and any related costs that may be incurred.
Constituents in the DIP budgeting process should take pains to ensure that line managers who will actually be spending money on these various expenses have "signed off" on the amounts presented. As a further precaution, they should employ various ratios to test for reasonableness, such as inventory purchases compared to sales (for non-service related business), historical SG&A compared to sales, payroll compared to sales, and payroll as percent of total disbursements.
Itemize Bankruptcy-related Costs
Last but not least, constituents reviewing (or helping create) DIP budgets should be sure that all bankruptcy-related costs have been included. These cover a wide range of expenses.
Professional fees will doubtless be incurred. A partial list of professionals involved in a bankruptcy might include the following: debtor's attorneys and advisors; creditors' committee attorneys and advisors; bank attorneys and advisors; U.S. Trustees; and appraisers, auctioneers, bank auditors, tax advisors, investment bankers, real estate consultants and claims agents. Each professional fee item should be broken out so that all interested parties can understand the amounts. Constituents should also be aware that many professionals will request payment on a monthly basis rather than at the end of the case.
Any debtor contemplating a Key Employee Retention Program (KERP) should anticipate its costs in the DIP budget. KERPs are fairly common: There are significant advantages to retaining critical employees, and usually some type of compensation is required to encourage them to stay. KERP payments can be structured in numerous ways. Many are based on cash-flow milestones or linked to specific dates, such as when a reorganization plan goes live. The DIP budget should indicate when such payments may be required, but care needs to be taken in presenting the figures. A large number in the budget will raise expectations, while a low number may be an inadequate incentive for staff to stay on. We recently addressed this for a client by including a contingency line in the budget that, with the approval of the lender and the committee, would be utilized for the purposes of funding a KERP. This approach was successful because it was in all parties' interests to retain critical employees without incurring exorbitant costs to do so.
Bank interest and fees should also be budgeted. Fees and interest should accrue and be paid according to approved agreements with the post-petition lender covering the use of cash collateral and/or DIP financing, which will vary according to whether the pre-petition lender's collateral is greater than the pre-petition amounts owed.
Developing a realistic DIP budget is clearly well worth the extra time and effort required. A good DIP budget helps set appropriate expectations on all sides and greatly reduces the chances of covenant violations and other unwelcome surprises.
A guiding principle throughout the bankruptcy budgeting process is that everything takes longer than expected. Decisions on anything from the sale of non-essential assets to plant closures or product eliminations are subject to notice periods, court approval and the need for consensus. These somewhat bureaucratic procedures inevitably slow things down. However, debtors should make every effort to be cost-efficient and manage the case to a reasonable timeline. The budget should reflect that the status quo is changing by showing the steps being taken to rehabilitate the company.
Finally, a well-conceived DIP budget also focuses the company's management and helps provide the debtor with a realistic assessment of its current business. It can also serve as a solid framework for developing a reorganization plan down the road.