Debtor in Possesion (DIP), refers to the group that operates a company while its in bankruptcy, under the supervision of the Bankruptcy Court. Often the bankrupt company will require extra funding to continue operating, leading to such things as DIP financing, by which the DIP will borrow money to keep the company functioning and in return creditors receive primacy in the credit structure.

Q. Well, not hard to think of a lot of funny lead ins for this, but I have to guess that it’s is a serious term. Tell us about it.
A. It’s an acronym that stands for “Debtor In Possession”, the group that runs a company during the time it’s in bankruptcy. Often, this group is the exact executive team that took the company into bankruptcy in the first place…. They stay in place because nobody else really knows what the heck is going on.

Q. So they just keep running the company as if nothing special has happened?
A. Often, the answer is yes. You have to preserve the value of the enterprise, or nobody will get anything back from their investments. The DIP is under the supervision of the bankruptcy court, of course, and can’t start with a bunch of new initiatives until a plan of reorganization is worked out and agreed to… the DIP must stick to the ordinary course of business, and has a duty to the creditors to preserve the value of the business. So often things stay pretty normal for customers and employees.

Q. But how does that work? I mean, the company is bankrupt, right? So where does it get the money to keep operating?
A. Ah, a critical question. The Bankruptcy Code, the set of laws that govern these situations, provides for something called DIP financing. You can lend money to a debtor in possession, and get paid ahead of the company’s pre-existing creditors. Otherwise, of course, nobody would lend into it and the enterprise would collapse. So here’s another example of the buzzword from Monday, “subordination”. The company’s pre-bankruptcy lenders are “subordinated” to the DIP financing.

Q. I see. So there must be all sorts of financial jockeying going on during the bankruptcy among the various classes of claimants. What kinds of strategies do you see among hedge funds for how to play it?
A. One of the more popular hedge fund strategies here is actually pretty simple: figure out who’s ultimately likely to be paid—often that pretty clear—and buy up the claims of creditors who don’t have the stomach to wait for the settlement. That’s basic, and popular. But there are also all sorts of interesting arbitrage plays inside the various claims: you might buy trade claims against the company but sell its bonds. You might even decide that the equity won’t get wiped out, and make a play on that side. The whole area is a fertile field for hedge fund investors.