September 2020 - Providing (Ill)-Liquidity?

Now a good five months into the “Coronavirus Economy” the Fed has made it its mission to avoid prior recession pitfalls by creating a middle-market credit program (aka the Main Street Lending Program) to encourage lending for small businesses. Unfortunately, the Program’s delayed roll-out missed the pinnacle of demand in April and May and is now met with lackluster interest.

The Fed’s attempt to provide liquidity to the middle-market is noble as it responds to criticism for the Federal Government to provide more equitable solutions to small businesses hammered by economic stress. This idealism is met with the harsh realities that middle-market lending does not operate like the large corporate and government credit markets. These markets are simply less liquid and more diverse, limiting the program’s effectiveness compared to what can be achieved through open-market bond purchases. While it’s our hope the the Main Street Lending program will support businesses in these challenging times, the programs ability to function as advertised is seriously questioned. For this reason and, as the points below discuss, its unlikely the program will be a viable credit option.

Current 3-Month LIBOR, the cost of borrowing from commercial lenders has already come down for many borrowers.

With the swift return to zero on the Fed Funds Rate, borrowers have seen a reduction in the cost of capital from private lending sources. To note, we’ve seen LIBOR floors remain elevated (between 0.5% to 2%) and non-bank capital still comes at price premium, but despite these factors, non-government capital (i.e. traditional capital sources) appears to be more attractive than a loan from the Main Street Lending program for three reasons.

Initially, the Main Street Lending Programs (there are three programs, or types of loans) had a very aggressive amortization schedule, requiring a 70% balloon payment in year 4 for all three types of loans (Original Term sheet). The Fed has since provided more borrower-friendly terms with changes including 5-Year maturities and no principal payments in years 1 & 2 for all three types of loans. While a considerable improvement, the continued delay in the roll-out and initial perception that such loans were “expensive” may have caused considerable damage.

This hiccup pales in comparison to what we would argue as the more fundamental issue: how will the Fed/Treasury operate as a lender in an illiquid security. Loans are different than bonds. The Fed is attempting a much more complicated task as opposed to more straightforward market intervention in public markets such as: providing liquidity to the “market” (via Treasury purchases); or broader support for large corporate borrowers or bondholders (via corporate bond purchases); or relief to federally backed agencies (via mortgage bonds purchases).

To illustrate this point, we’ve pulled the language for the covenants and certifications by borrowers in the Main Street Lending “Term Sheets”:

“The Eligible Borrower must certify that it has a reasonable basis to believe that, as of the date of origination of the Eligible Loan and after giving effect to such loan, it has the ability to meet its financial obligations for at least the next 90 days and does not expect to file for bankruptcy during that time period.”

It goes without saying that providing a loan (in the normal course of business) to a near bankrupt or bankrupt business is not a good idea. But the unexpected happens in business (understatement!). This entire year has been met with uncertainty and for many businesses the next 90 days are no clearer now than they were three-months ago. What happens to a borrower who is more severely hurt by deteriorating economic conditions or is forced to further curtail operations because of new restrictions in the next 90-days? What is the bank’s role in this situation as a minority loan participant? This type of uncertainty is undoubtedly limiting interest in the program.

Plain and simple, the Fed is lending to thousands of businesses through a variety of national and regional banks. The PPP program has already shown how difficult it is to manage a federal government-sponsored credit program. Therefore, unsurprisingly, a relatively small amount of banks have agreed to participate in the program. As of the beginning of July, only 400 or so banks have signed up, and those that have signed up are hesitant to take on new customers through the program (NY Times). Banks are still very much in “risk-off” mode (see “Lending Activity” chart) and a new and untried government sponsored lending will likely cause more headache for these lenders. Mind you, this “risk-off” is in conjunction with a massive inflow of deposits (which provide a greater asset base to lend against) and the fact that banks will only be holding 5% of the loan value issued under the Main Street Lending Program. This leads us to conclude that for many banks this program just seems too risky and cumbersome to participate in.

The final challenge to highlight is underwriting standards. As the Boston’s Fed website states:

“Interested businesses will work with an eligible lender to determine if they meet the program requirements…as well as the lender’s own underwriting standards.” (Boston Fed).

This set-up is vague, seems contrary to the spirit of the program and will slow-down the lending process. By running the program and taking on 95% of the risk, it would seem that the Fed’s underwriting guidelines (which should be as clear as possible) would supersede individual bank underwriting guidelines. To be clear, this is not an endorsement of rubber-stamping loan applications, but with hundreds to thousands of banks participating in the program, underwriting standards are going to vary and will make for conflicting definitions of adjusted EBITDA. Adjusted EBITDA is highlighted as it is the main metric by which businesses will be measured to determine their borrowing limit.

To further elaborate, the footnotes in the Main Street Lending Program provide the following guidance for calculating a borrower’s maximum loan eligibility e.g. maximum leverage based on adjusted EBITDA:

"The methodology used by the Eligible Lender to calculate adjusted 2019 EBITDA must be the methodology it has previously used for adjusting EBITDA when extending credit to the Eligible Borrower or similarly situated borrowers on or before April 24, 2020.”

Can this include an adjustment for COVID-19 impacts? Who defines similarly situated borrowers? As anyone who works in finance or accounting will tell you, EBITDA adjustments are not standardized and acceptance can vary dramatically across organizations.

There are no quick fixes to these questions or uncertainties, but they demonstrate how challenging it is to implement a nationwide lending program for essentially any and every small and medium type business. The Main Street Lending program might work some, it’s likely not going to be a fit for many. In reality, borrowers that are eligible for a Main Street Lending loan will be better served through more traditional credit avenues, while those ineligible for traditional credit options are unlikely to meet the eligibility of the Main Street Lending program and will sadly be left with no additional credit options. The program has changed many times already. If the program gets little use in August and September hopefully future amendments can be made to support those borrowers that would benefit the most.