Game Changer

On Thursday April 9, 2020 the BDC Reporter discussed – in almost real time – the new programs the U.S. Government were launching to support middle market companies.

The central initiative is the Main Street Lending Program (MSLP), which is supposed to help that middle tier of American companies with less than 10,000 employees and less than $2.5bn in revenues.

Also included – should they choose to apply – are smaller companies that might be taking advantage of the support available under the Payroll Protection Program.

Lifeline

At a stroke, the government – through the Federal Reserve – opened up an avenue of  financial rescue  for virtually every BDC-financed portfolio company out there.

This was doubly notable as the government’s initial message to anyone but the airline industry in the non investment grade company sector was : “You’re on your own”.

Now the Fed and the Treasury appear to have realized that sending thousands of private and public companies into bankruptcy might not be good for the country or particularly fair given the reason for the crisis.

Cheered Up

We were enthusiastic – as were the markets – about the importance of this critical about face by the U.S. Government.

So-called “risk assets” such as junk bonds, leveraged loans, BDC common stocks and bonds and even CLO investments jumped up in price, as we reported in the article.

Sinking In

However, by the end of the day, some of that initial euphoria began to fade.

To offer up just one example: the BDC sector ETF with the ticker BIZD closed on Thursday at $10.53, up 9.9%.

However, intra-day BIZD reached $10.97 in the first half hour, 14.4% higher than the prior day’s close.

Hard Look

We believe that the cooling of enthusiasm has to do with the potential flaws in the government’s campaign to help middle market business which might leave many, many companies on the outside looking in.

We anticipated as much in our written-on-the fly initial article:

“..There is still reason for substantial caution because the government’s new programs are unprecedented; their terms and exclusions are not even fully formed or understood and there is some time to wait till any funds become available.

Furthermore – in our opinion – the Fed has made a key mistake in having the Main Street Lending Program operate only through banks”.

Mulling

Subsequently – after the market closed – we’ve had considerable more time to read the Fed’s Term Sheet for the proposed Main Street Expanded Loan Facility (MSELF) and initial analysis from government-watching law firms.

After that review – and a few hours contemplation – we’re doubling down on our concern about the role of the banks.

Furthermore, we’ve identified another flaw – as presumably did the “risk assets” markets – that will almost certainly ensure three-quarters of non-investment grade companies that need liquidity assistance will not be eligible.

In fact – as we explain below – the companies most likely – on paper – to be eligible will be the ones with the weakest financial performance.

Wrong Criteria

That’s because the government, the press and most anyone not involved in lending to the non-investment grade market conflate credit risk with degree of leverage.

Companies with debt to EBITDA over 4x are not permitted in the program.

In this case debt includes undrawn lines of credit and the new Fed-supported financing.

Most of our readers will know right off the bat that most every company in a BDC portfolio will not meet that criteria, except for the odd oil & gas explorer or stressed out retailer.

Hope Floats

The Main Street initiative, though, is not yet set in stone and the Fed – as required by the law – is still taking comments through April 16 before finalizing the final terms.

We have used this opportunity to prepare an article for the Fed, laying out very specifically why these two elements of the program must be changed.

Furthermore, we laid out how the program could both be made universally available and not a burden on the U.S. taxpayer.

Suggestion Box

We submitted our ideas – which we expect will disappear into a big black hole – on the Federal Reserve’s website.

We’ve not just fallen off the turnip truck and have no expectations we’ll receive a reading, let alone a response, but we thought it might be useful for our readers to see what we wrote.

(In fact, as the feedback form limits contributions to 1,500 characters, the Fed has received a much sparer version of our suggestions).

News You Can Use

Our article – and its warnings about the limitations of the Main Street Program as currently envisaged – may help investors and managers calibrate their expectations going forward.

A Main Street Program – as amended by the BDC Reporter would – in our humble opinion – essentially rescue most every non-investment grade company at risk from the current, ever growing liquidity crisis.

That’s if the monies could be rolled out no later than the last week in April or early May, and all market participants were confident the funds were coming.

In Reality…

However, the Main Street Program as envisaged will be much more spotty in its coverage and will be slower to take hold as banks get up to speed on prospective borrowers they have no or little relationship with.

Most of all, the vast majority of would-be borrowers will be turned away, leaving companies to cope with intransigeant creditors; overwhelmed sponsors/owners and ever worsening business conditions.

Thousands of companies will be back to preparing for bankruptcy filings; cutting payroll and costs ever harder and relying on the limited resources of their lenders.

Why This Matters

Which way the Fed chooses to go – and the current direction is not auspicious – will have real-life implication for BDC investors, managers, professionals, regulators and all our readership.

By our estimate that might cause – once the reality of the situation sets in – a dramatic give back of the price gains the BDC sector – and all risk assets – have racked up in recent days.

BIZD has increased nearly 50% in price since an intra-day low on April 3.

Two Way Street

What goes up can come down if these government support programs miss the mark, especially as the day when economic activity resumes seems to being put off.

The pews were supposed to be filled by now for Easter, but that’s not happened and most of us may still be at home when June rolls round.

Middle market companies – more than their small business counterparts – can duck and weave a little longer and have more support resources but these are finite.

The U.S. Government’s actions – more than anything else – stands between success and failure in the critical months ahead.

A sudden realization by the Fed that it’s program is missing the mark in the summer will be too late to help.

A Simple Plan

Here is our recommendation to the Fed:

The basic structure and financial terms of the Main Street Lending Program (MSLP)  are fundamentally fine. One could get lost in debating items such as the appropriate maturity, interest rate charged, loan size and amortization period. However, time’s a-wastin and those are not – by themselves – critical to its success or failure. However, there are TWO elements that are critical and, if not drastically altered, may result in the program being a damp squib; hundreds of companies failing that did not have to and bankruptcy lawyers being kept busy for years to come.

 

First and foremost, the program cannot have the Eligible Lenders be solely banks and S&Ls. These institutions are no longer the front line lenders to non-investment grade companies. That’s a role long passed on to a multitude of non-bank players: finance companies; private funds and Business Development Companies (“BDC”). In most cases banks have either no role in lending to non-investment grade companies or are limited to a narrow slice of overall borrowings at the top of the balance sheet, and usually secured against hard assets. S&Ls barely figure in this part of the financial landscape at all.

 

The MSLP must be run through the institutions who know the thousands of non-investment grade borrowers with less than 10,000 employees and under $2.5bn in revenue size: the non-bank lenders. They are the ones with the bulk of debt capital already advanced to non-investment grade companies; who have thousands of specialized personnel responsible for underwriting, monitoring and operational relationships. They are the ones who have the institutional knowledge of which borrower had been operating normally until Covid-19 struck and which was already in trouble. They are the ones with the phone numbers of the management of every candidate company and who are already receiving constant updates at what is happening in factories, distribution centers, stores and warehouses nationally. 

 

At first, corralling all those non-bank lenders might seem difficult. However – for better or worse – in recent years the large asset managers have expanded into non investment grade credit. These groups – through common senior leadership and  centralized staffing and systems- each control multiple lending operations, sometimes dozens. These are the best vehicles for deploying the new capital.

 

The second element that has to be changed is the requirement that Eligible Borrowers may only have debt to EBITDA of 4x and under, and that’s including any undrawn lines of credit. This is supposed to keep out the riskier borrowers but will have exactly the opposite effect. Regulators and lawmakers have to understand – and it’s a common misperception that extends to the financial press as well – is that high leverage is not an indicator of borrower weakness. On the contrary, high leverage occurs because very sophisticated lenders are prepared to put a great deal of money at risk on a non-recourse basis and with little in hard assets to fall back on because they are confident borrowers – in normal circumstances – will be able to service and repay that debt. It is the weaker, more cyclical borrowers who have debt levels below 4x: the oil and gas explorers; the mining companies and the loss making and marginal businesses of every stripe. Ironically, these are the sort of companies which will have access to the program while profitable, fast growing enterprises in tech, healthcare and a host of other industries, branded with the scarlet letter of high debt to EBITDA, will be excluded.

 

According to Bloomberg – the average middle market borrower (EBITDA under $50mn) has a debt to EBITDA multiple of 4.8x. The bigger non-investment grade companies leverage is at least one turn higher: 5.8x.  Effectively that means most companies – small, medium and large – will not qualify to even be considered for the program. And what about venture-debt supported companies whose EBITDA does not yet even exist but which may have hundreds of millions of capital already invested in them ? These companies that represent the future of business in America, too, will be blocked at the door because of this ill-advised exclusion. 

 

We track every day – as the BDC Credit Reporter – some 4,000 different non-investment grade companies. Our best guess is that 75% or more will be left out in the cold by this rule. Yet, till February 2020 and for the ten years before – and despite all that hand wringing about leverage by those who don’t understand how leveraged lending works – credit  losses have remained below their historical averages in the very low single digits. Over the whole non-investment grade universe we’re talking about companies with an enterprise value – before the crisis began – of $4 trillion. At least $3 trillion worth of companies will be affected by this rule. 

 

If the thousands of companies involved are left to fend for themselves, the consequences will be catastrophic in terms of job losses; endless downsizings and a massive and permanent loss of investment capital in the hundreds of billions that will erode pensions, 401-Ks and institutional and individual investors across the country. Nor will smaller or larger companies – each with their own Fed programs – be unaffected by the mass destruction in the middle market. Customers and suppliers will be lost; receivables won’t be received; orders will be cancelled and liquidity – despite all the efforts to the contrary – will be squeezed. 

 

The fundamental point is that the government – neither ethically or pragmatically – can exclude huge swathes (or even small swathes) of companies from the financial rescue efforts. The business of America – to rephrase Calvin Coolidge – is built on leverage (as is the U.S. Government, by the way).  To choose this moment to adopt a puritanical – and misguided – philosophy of turning away the best performing non-investment grade companies because of how much debt they have on their balance sheet is wrong headed. When this is all over, there might be a time for the private and public sector to debate whether debt is good and in what proportions, but not now. The Fed – and the American taxpayer – will end up helping the weakest companies;  spurning the best and ensuring the very recession that the program seeks to avoid. 

 

The solution is in the combination of our two suggestions. Allow the non-bank lenders who are familiar with the non-investment grade companies – and without their hands tied by a maximum leverage requirement – and the free market will take care of the problem. Those companies that are temporarily in trouble but fundamentally sound will receive their share of MSLNF capital and those that are already beyond saving will not. We’d also suggest charging a front end fee – like the SBA does – for every loan booked that would go to subsidize any credit losses that might come from this program. We’d also suggest an even higher rate on the loans to encourage lenders to participate and borrowers to find private sector alternatives as soon as possible. This will ensure the program will not cost the American taxpayer anything at the end of the day. 

 

Those two changes to the MSLNF – and the fine tuning on pricing – would make this program hugely successful and effectively save the huge American middle market – which involves the majority of employment and GDP in this country – from an implosion not of their own making and which could have been readily averted”.