What Is Distressed Lending and How Does It Work?

Companies in financial distress often struggle to secure traditional loans, making distressed lending a crucial alternative. This type of financing carries higher interest rates and stricter terms due to the elevated risk for lenders. Investors and specialized lenders operate in this market, seeking high returns while navigating complex financial situations.

Eligibility Requirements

Lenders evaluate a borrower’s financial condition to determine funding eligibility. They review financial statements, cash flow projections, and liabilities to assess repayment ability. Businesses with a clear recovery path—through restructuring, asset sales, or operational improvements—are more likely to secure financing.

Rather than relying on traditional credit scores, lenders focus on debt-to-equity ratios, liquidity, and historical earnings before interest, taxes, depreciation, and amortization (EBITDA). Even companies with negative EBITDA may qualify if they have strong revenue potential or valuable assets.

Legal and regulatory considerations also play a role. Businesses in bankruptcy must obtain court approval before securing new financing, particularly under Chapter 11 of the U.S. Bankruptcy Code. Lenders may also require assurances that the borrower is not facing imminent legal judgments or regulatory penalties that could further destabilize its financial position.

Collateral Considerations

Distressed lenders often require substantial collateral to mitigate default risk. Unlike traditional loans, which emphasize creditworthiness and cash flow, distressed lending prioritizes the liquidation value of pledged assets. Common forms of security include real estate, machinery, inventory, and accounts receivable. Lenders apply conservative valuations, often discounting assets to account for market volatility and forced-sale conditions.

Collateral management is dynamic, with lenders adjusting borrowing bases based on asset values. For example, if financing is secured against accounts receivable, lenders routinely reassess the collectability of outstanding invoices. Rising customer defaults or lengthening payment cycles can reduce available credit, forcing the borrower to seek alternative liquidity sources.

Legal complexities also shape lending decisions. In jurisdictions following the Uniform Commercial Code (UCC), lenders perfect security interests through UCC-1 filings, ensuring priority claims over pledged assets. In bankruptcy, secured creditors must navigate automatic stay provisions, which temporarily halt collection efforts. This delay can prompt lenders to negotiate debtor-friendly terms such as roll-up financing, where new loans are granted in exchange for priority repayment status.

Loan Structures

Distressed lending arrangements vary based on the borrower’s financial condition, asset base, and restructuring prospects. These loans often carry higher interest rates, restrictive covenants, and priority repayment provisions to compensate for the elevated risk.

Senior Secured Financing

Senior secured loans grant lenders a first-priority claim on specific assets, reducing exposure to losses in liquidation. Security interests are typically perfected through UCC-1 filings, ensuring enforceability under Article 9 of the Uniform Commercial Code.

Interest rates on senior secured loans exceed those of traditional financing, reflecting the borrower’s weakened financial position. Lenders may impose financial covenants, such as maintaining a minimum interest coverage ratio or restricting additional debt issuance. If a borrower breaches these covenants, the lender can demand immediate repayment or renegotiate terms, often at a higher cost.

Debtor-in-Possession Arrangements

Debtor-in-possession (DIP) financing is available to companies undergoing Chapter 11 bankruptcy. Unlike traditional loans, DIP financing requires court approval and is granted superpriority status under section 364 of the U.S. Bankruptcy Code, ranking above pre-existing unsecured and, in some cases, secured debt. This priority incentivizes lenders to provide capital despite the borrower’s insolvency.

DIP loans typically include strict oversight provisions, requiring periodic financial reports and adherence to a court-approved budget. Lenders may impose milestones, such as deadlines for asset sales or restructuring plans, to ensure progress toward financial recovery. Failure to meet these conditions can result in loan acceleration, forcing the borrower to seek alternative financing or risk liquidation.

Bridge Financing

Bridge loans provide short-term liquidity to distressed companies facing immediate cash flow shortages. These loans carry high interest rates, often exceeding 10-15% annually, and short maturities ranging from a few months to a year. They help businesses cover urgent expenses, such as payroll or supplier payments, while negotiating long-term financing or asset sales.

Lenders often require warrants or equity kickers as additional compensation. A bridge loan agreement might grant the lender the right to purchase company stock at a predetermined price, allowing them to benefit from a potential turnaround. If the borrower fails to secure permanent financing, the lender may convert the loan into equity or demand repayment through asset liquidation.

Regulatory Framework

Distressed lending operates within a complex regulatory environment that influences lender behavior, borrower rights, and transaction structuring. Financial institutions must navigate oversight from agencies such as the Office of the Comptroller of the Currency (OCC) and the Federal Reserve, which impose capital adequacy requirements under Basel III. These regulations affect a lender’s ability to extend high-risk loans by mandating sufficient reserves to cover potential losses. Non-bank lenders, such as private equity firms and hedge funds, face fewer direct capital constraints but remain subject to securities laws when structuring investment vehicles around distressed debt.

Securities regulations also play a role, particularly when distressed loans are bundled into collateralized loan obligations (CLOs) or traded on secondary markets. The Securities and Exchange Commission (SEC) enforces disclosure requirements under Rule 144A of the Securities Act, ensuring institutional investors receive sufficient information about the underlying risk. Lenders acquiring distressed debt must also consider insider trading restrictions under the Securities Exchange Act of 1934, particularly when dealing with publicly traded borrowers whose restructuring plans could materially impact share prices.

Valuation Implications

Determining the value of a distressed company is complex, as traditional valuation methods often fail to capture the uncertainties surrounding financial recovery. Lenders and investors rely on multiple approaches to assess whether a distressed loan is adequately secured and whether the borrower has a feasible path to solvency.

Market-based methods, such as comparable company analysis, can be unreliable due to the volatility of distressed assets. As a result, intrinsic valuation techniques take precedence. Discounted cash flow (DCF) analysis is frequently adjusted to reflect heightened risk, incorporating higher discount rates to account for uncertainty in future earnings.

When cash flow projections are unreliable, asset-based valuation becomes more relevant, focusing on liquidation value rather than going-concern assumptions. Lenders may conduct forced-sale appraisals, applying steep discounts to assets like real estate or equipment to estimate potential recovery in a worst-case scenario. In bankruptcy proceedings, valuation disputes can arise, particularly when creditors challenge a debtor’s proposed restructuring plan. Courts may rely on expert testimony to determine whether an asset sale or reorganization provides the best outcome for stakeholders.