This is not an article regarding the merits or morality of government support for businesses during the COVID-19 economic shutdown. Nor is it about the allocation of state aid between companies and employees (or perhaps more broadly, ordinary citizens). Both topics have merit of course, but my focus in this case is to simply ask one major question: which companies or industries should have access to government support and which ones should not?
I will also examine the much-discussed benefits, either direct or indirect, that equity holders and bond investors in larger companies realise from this support, in most cases at no cost whatsoever. Is there a way to avoid benefiting these risk takers whilst not jeopardising the company? If not, how should the government (or central bank as the case may be) be remunerated fairly in exchange for providing such support? These are difficult questions that will generate a variety of responses. I will touch on a few of these below.
Is it “fair” for government aid to flow to companies that were likely to fail anyway before COVID-19 showed up?
The aid from governments in both the U.S. and U.K. is generally (but not exclusively) targeted to smaller businesses (Small & Medium Enterprises, or “SMEs”). In the U.S., the support is provided via loans, potentially fully or partially converting to grants, for businesses with under 500 employees. In the U.K., grants are available to small businesses with a ratable (tax base) value of less than £51,000, including a special provision for retail, hospitality and leisure businesses. Of course, the assistance comes with plenty of strings attached, but rather than get sidelined by the details, let’s just say that this assistance is meant for genuinely small businesses. It is hard to argue with this form of support, as smaller companies tend to have less resources and “wiggle room” to navigate through a prolonged shutdown because of this pandemic.
The question then becomes, “how do the government, banks, Small Business Administration or other disburser of the funds distinguish between those companies that were in the process of failing before COVID-19 due to mismanagement or market-induced forces, and those that are suffering only because of COVID-19?” In other words, some companies that should not receive such support might find themselves in the right place at the right time because of this pandemic-inspired aid, and therefore will be able to access funding that allows them to carry on for a longer period of time, although their fate might have very well been sealed anyhow.
It will be almost impossible for governments to avoid spending money it shouldn’t when providing assistance like this. The process of distinguishing between those SMEs that should receive support and those that should not is both incredibly difficult and time consuming, requiring vastly more time and resources than I imagine most banks and lending agencies (e.g. the SBA in the U.S.) have, in light of the urgency in disbursing the funding.
Should private equity firms - or their portfolio companies - be given access to government grants or “cheap” funding?
This is one question to which I am convinced of the answer - no. The focus of the private equity business is to buy companies using as little equity and as much debt as possible, so as to generate superior returns. Therefore, most companies owned by private equity firms have or are using leverage aggressively, since these companies are – after all – leveraged buyouts. Private equity firms should not be given assistance for three reasons.
Firstly, some of their portfolio companies, at least those domiciled in the U.S. that have high yield bonds or loans outstanding, will receive support indirectly via the Federal Reserve’s programme to buy primary and secondary high yield bond issues of fallen angels, to provide private placements directly as the sole purchaser, and / or to purchase high yield ETF’s. These all enhance highly leveraged companies’ access to funding at artificially low prices because of the involvement of the Federal Reserve in the bond market.
Secondly, private equity portfolio companies might have assistance available to their employees via the various government programmes to support SME’s and select industries. This include things like the temporary elimination of payroll taxes (U.S.) or the deferment of VAT (U.K), and remuneration for furloughed employees during the business hiatus.
Lastly, many private equity firms, especially the larger ones, have well-advertised deep pockets and plenty of “dry powder”. It is times like these that this substantial reservoir of dry powder should be utilised to support ailing portfolio companies rather than relying on government handouts.
I suppose one could take a contrary view and drift into an argument about the potential of private equity-owned businesses going bankrupt, resulting in people losing their jobs and so on, but I have little sympathy for this argument. After all, it would be absolutely disgraceful for private shareholders with the means to support their companies to put a gun to the government’s head with an ultimatum to receive government support or walk away.
Should the competitive advantage of conservatively capitalised and prudently managed companies be destroyed (or eroded) because of government aid to more aggressively capitalised competitors?
Whilst SME’s benefit from government-provided loan and grant programmes to support their businesses during this difficult period, larger businesses have generally been given other lifelines, at least in the U.S. via support - as mentioned already in the section above - from the Federal Reserve in the primary and secondary debt markets. Many companies use debt as a component of their capital structure to generate the most attractive cost of capital, some more aggressively than others (see preceding paragraph regarding LBOs for example). More conservatively managed companies generally hold significant cash or liquid securities, to ensure that they have sufficient liquidity on hand to manage through difficult operating periods. Other companies run with significantly less cash by choice, having made a decision to use their (in some cases) significant cash flow generation over the last several years to return cash to shareholders via share repurchases rather than setting aside some cash “for a rainy day”. Should the more aggressive companies that have consciously chosen to sail close to the wind by running with more aggressive capital structures and lower liquidity be helped during this crisis by having the Federal Reserve buy their primary and secondary debt in the capital markets?
Normally, it is bondholders that hold companies accountable for being overly aggressive, but when central banks step in and become a buyer, both the pricing mechanism and the market discipline is destroyed. My issue is not so much with the support because this was probably necessary during the few days when market liquidity broke down completely, but rather with the fact that this intervention allows businesses that have been aggressive in the past to somewhat level the playing field with those competitors that have operated with lower debt levels and higher amounts of cash to withstand difficult periods. Of course, both existing bondholders and equity investors in weaker non-investment grade rated companies benefit from this support, providing further distortion in the market.
Is the government getting paid properly for the risk it is taking when lending money?
For non-SME companies under the U.S. CARES Act, including specifically airlines ($25 billion) and air cargo companies ($4 billion), the government should be providing these loans at market-clearing prices which fairly represent the risk of the debt. My understanding is that generally speaking, these loans will be provided at prices for each issuer that existed prior to the COVID-19 crisis. What an amazing outcome for these companies!
In the most severe and highest-risk cases, the reality is that coupon-only debt might not be feasible in a current market context. Ask yourself this: is it right for existing equity holders to be allowed to preserve their pro rata interest in any company in which the government has to provide a loan that - regardless of what it might be called - is effectively a hybrid debt-equity financing? A taxpayer in any country that is providing an unprecedented amount of direct or government-guaranteed debt to assist companies in seeing this crisis through deserves the opportunity to not only recoup their money but also to get a return commensurate with the risk that they – indirectly through their taxes being used for government support – are taking.
During the financial crisis, the U.S. government assisted a number of large U.S. banks through a toolkit pursuant to TARP. Starting as a $700 billion programme but subsequently reduced to $475 billion, the U.S. government eventually recouped all if its money plus some, and in the process returned the financial system to firm footing and saved tens of thousands of jobs. (Having said this, it is far from clear that the government earned enough given the risk of many financial institutions completely collapsing.) There is no reason that money lent directly or guaranteed by the government to support ailing companies this time around should not earn a return commensurate with the risk. This is only fair, although it conflicts with the government’s intention to provide loans at pre-COVID-19 pricing.
Having just finished this paper, I learned that the U.S. government has reached an agreement with a number of U.S. airlines, pursuant to the $25 billion basket targeted for the airline industry, to provide assistance through a combination of grants, low interest loans and equity warrants. Only some of the details have been disclosed, but it is fair to say that the U.S. government felt correctly that they should have a chance to recoup this investment and have the opportunity to earn a fair return when COVID-19 passes. You can read about this more in the #bloomberg article here.
How selective should landlords or mortgage providers be with respect to rent or mortgage forbearance?
The various assistance programmes offer opportunities for businesses of a certain size to forgo rent or mortgage payments for some period of time during this crisis. But should companies that can afford to make these payments be allowed to opt out? Or should they even want to opt out in the first place? This is another case of levelling the playing field assuming that more liquid companies continue to pay their rent or mortgage – as they probably should – and weaker companies that cannot pay are given the right to defer their payments. Look at it this way: this is yet another way for weaker companies to potentially close the gap on better capitalised and stronger competitors, as the latter utilise their liquidity to meet their obligations whilst the former are given government support at limited / no cost. Lest we forget, there is a domino effect here. Landlords usually have their own expenses – employees, mortgages, property or other local taxes, utilities, etc. If landlords aren’t collecting the rents, then they will probably also default on their own obligations. The repercussions can reverberate throughout the broader economy, causing what appears to be a manageable problem to mushroom into something much larger.
Should small financial institutions, specifically hedge funds or small asset managers, be eligible for the same type of support available to other SME’s?
On the surface, it sounds rather distasteful because the first thing that comes to mind are mammoth hedge funds, a handful of which were probably positioned to profit from this crisis (and deserve in my opinion accolades for recognising the severity of COVID-19 early on, not blame). But it is not the larger funds to which I am speaking. Rather, I am speaking of small hedge funds or asset managers that might – for example – have fewer than 10 employees and less than $500 million under management. These firms still have to pay rent as well as other infrastructure and support costs, including support staff working for them. This is a tough one, and for many harking back to the financial crisis of 2007-09, an emotive issue as many believe governments “saved” several banks, insurance companies and other finance / investment companies that were deemed “too big to fail”. However, this is not the scale to which I am speaking. This topic was covered in a Bloomberg article yesterday: “Hedge Fund Managers are Claiming Bailouts as Small Businesses.”
Final Thoughts
I have included just a few examples that come to mind in this article, although there are most certainly many others. People might debate the merits of government and central bank support in any magnitude, but when it is provided, it needs to maintain as level a playing field as possible without giving an edge to any competitor. Those that need support due to COVID-19 should be the ones receiving it, not others. Companies that have mismanaged their businesses or capital structures before COVID-19 should not be supported to the extent that this support disadvantages competitors. No company should be able to take advantage of this assistance to thrive when they otherwise would have failed. The support should cause as little market distortion as possible, and most certainly should not rescue bondholders or equity investors, especially deep-pocketed private investors like private equity firms.
I am sure that many of you have other ideas. Still, we all must put ourselves in the shoes of those in the public sector leading the charge to see off COVID-19 quickly and preserve as much of the economy as possible in the meantime, as this unforeseen pandemic brought unprepared world economies, their governments and their leaders to their knees in record time.