Funding Opportunities for Private Equity Portfolio Companies
Fluctuating consumer demand and worldwide supply chain disruptions have affected virtually every business, regardless of industry or geography. Strategy shifts, cost savings initiatives, and alternative capital sources are just some of the ways that companies are adapting to the changing economy as a result of COVID-19. In an effort to avoid loan defaults or bankruptcy in this market environment, general partners (GPs) of private equity (PE) funds are working with portfolio company management teams to assess the liquidity position of each individual company; at the same time, they must maintain focus on their entire portfolio to ensure each investment is properly set up to meet their short- and long-term cash-flow needs.
GPs have access to certain sources of private capital that non-sponsor backed companies typically do not; however, not all forms of funding in this post-pandemic marketplace are available to PE portfolio companies in need. Once they have undertaken a thorough liquidity assessment, GPs must understand the sources of funding that are available in order to make the right funding decisions for their portfolio.
Government Relief Programs
Paycheck Protection Program
On July 4, the deadline to apply for a Paycheck Protection Program (PPP) loan was officially extended from June 30 to August 8, giving small businesses more time to obtain some of the approximately $130 billion in remaining PPP funds. These loans are generally available (with certain exceptions) to small businesses with 500 or fewer employees and are 100% forgivable as long as certain criteria are met. According to Internal Revenue Service Notice 2020-32, expenses paid with PPP loan proceeds will not be tax deductible to the extent that such amounts are forgiven under the CARES Act; however, under Section 265 of the Code, PPP loan amounts that are forgiven are considered tax-exempt income.
The SBA and Treasury released loan-level PPP data on July 6, revealing certain PE portfolio companies that have received PPP loans, despite the application of the Small Business Administration’s (SBA) affiliation rules excluding eligibility for most. The PPP is widely considered to have successfully helped small businesses in need of funding, but with the loan forgiveness period looming, recipients of PPP funds should be aware that—for many—audits are coming.
If the United States experiences a prolonged economic downturn or second wave of lockdowns, banks will become further strained, making the Fed’s promise to purchase 95% of the interest in MSLP loans from eligible lenders an economic backstop to support lending capacity.
Main Street Lending Program
The Main Street Lending Program (MSLP) was launched by the Federal Reserve on June 15 and broadens size eligibility for government funding to include businesses with up to 15,000 employees or $5 billion in fiscal year 2019 revenues. The MSLP has been slow to gain momentum from borrowers and lenders in its first month, but with an economy experiencing the effects of what could still be the early stages of COVID-19, and a looming presidential election, lending money holds more risk. Additionally, low interest rates have caused lenders to realize lower margins on loans that are made. If the United States experiences a prolonged economic downturn or second wave of lockdowns, banks will become further strained, making the Fed’s promise to purchase 95% of the interest in MSLP loans from eligible lenders (as long as certain criteria are met) an economic backstop to support lending capacity.
As the MSLP gets underway, PE fund and portfolio company management should be aware of some of the associated benefits and roadblocks they could face.
- Benefits of the MSLP to PE portfolio companies
MSLP loans have five-year maturities and floating interest rates at LIBOR plus 3%; no interest is owed during the first year of the loan and no principal payments are owed during the first two years. Such terms make MSLP loans especially attractive to companies with debt maturing within the next two years. Maximum loan size is up to 4x or 6x leverage multiples (depending on the MSLP facility), based on FY 2019 adjusted EBITDA less existing outstanding and undrawn available debt. Thus, the largely negative financial effects of the pandemic in recent fiscal periods are excluded from borrowers’ EBITDA calculation under terms of the MSLP.Borrowers can use funds received at the time of origination of an MSLP Priority Loan Facility (PLF) loan to refinance debt (regardless of maturity date) with any lender, as long as that debt is not with the PLF lender. Although under the program’s other two facilities offered to for-profit businesses refinancing of debt is not permitted at loan origination, borrowers may refinance debt with any lender that is maturing within 90 days throughout the life of the MSLP loan.Further, since Main Street loans are not forgivable and will have to be paid back, the optics around receiving funding under the MSLP are friendlier to certain businesses than those surrounding the PPP.
- Roadblocks to participation in the MSLP by PE portfolio companies
An affiliated group of companies can participate in only one MSLP facility; thus, if more than one portfolio company of an entire PE firm wants to apply, the application of the affiliation rules could result in all portfolio companies having to aggregate their information to determine program eligibility and maximum loan amount. GPs and portfolio company management teams must understand how the affiliation rules apply to them, as it is the borrower’s responsibility to certify its eligibility to apply for an MSLP loan. Generally, affiliation exists when one business controls or has the power to control another, or when a third party (or parties) controls or has the power to control both businesses. Control can be affirmative or negative and may arise through ownership, management, or other relationships or interactions between parties. In the case of a PE portfolio company, minority shareholders that have the ability to prevent a quorum or block decisions are determined to have negative control and will therefore be considered affiliates of the company.Borrowers must certify that they are “unable to secure adequate credit accommodations from other banking institutions” to be eligible for an MSLP loan. Guidance clarifies that this doesn’t mean that no credit from other sources is available; rather it means that because the amount, price, or terms are inadequate, the borrower is unable to secure other adequate credit accommodations.MSLP debt is required to be senior to or pari passu with borrowers’ other debt. The program allows for other principal and interest payments that are mandatory and due; however, any prepayments triggered by the incurrence of new debt are only allowable under the program if such prepayments are de minimis. Requirements of pari passu sharing of existing senior debt collateral for certain MSLP facilities risks diluting the collateral position of existing lenders and will in many cases require their consent.Additionally, there are direct loan restrictions under the MSLP in which borrowers are not permitted to pay dividends or make other capital distributions with respect to common stock equivalents, including any discretionary dividend payments, until 12 months after the MSLP loan is no longer outstanding. However, if preferred stock or equity interest in a borrower provides for mandatory or preferential payment, payment of dividends and distributions is permitted as long as both the equity interest and the obligation to pay existed as of March 27, 2020.It is important to note that MSLP term sheets represent the minimum requirements for MSLP loans; lenders are expected to apply their own underwriting standards in evaluating the financial condition and creditworthiness of each borrower, and it is ultimately the lender who determines whether a borrower is approved for an MSLP loan and for what amount. The Fed has published a state-by-state list of lenders participating in the MSLP who are currently accepting applications from new customers. Due to the complexity of the program and the 5% risk retained by MSLP lenders, there are certain banks that plan to participate in the program but will only consider underwriting MSLP loans to businesses with whom they have an existing relationship. There are other banks that plan to participate in the program and accept new customers but did not wish to be listed publicly.Due to the MSLP’s use of EBITDA as the key metric for evaluating businesses’ eligibility for the program as well as maximum loan size, asset-based borrowers whose credit risk is not evaluated on the basis of EBITDA are at this time excluded from participating in the MSLP.
Other kinds of debt
Various other opportunities for funding exist for PE firms and portfolio companies as well to help bridge the gap in cash needs.
In response to the economic downturn, banks are offering more deferrals and over advances on their debt issuances, as well as changes to the borrowing base. But in this evolving credit landscape with increased focus on bank balance sheets, the diligence process for borrowing businesses to receive funding is only getting more diligent and complex; if banks assess a company’s problems to be indefinite or too long-lasting, they will be less likely to expand their risk.
Debt can offer a lower cost alternative to investors than the issuance of additional equity would and doesn’t dilute LP ownership. But similar to the MSLP, adding new senior or pari passu debt risks diluting the position of existing lenders and could require their consent. There are no tax implications for receiving or repaying debt; however, interest payments are deductible as an ordinary business expense (with certain limitations).
PE dry powder was at $1.45 trillion globally as of June 2020; though, with the majority of that money tied up in newer fund vintages, structural constraints are leaving many portfolio companies of older funds in need. If a GP lacks sufficient undrawn capital commitments and reserves to fully fund the needs of its portfolio companies, there are certain equity options available to them.
In a cross-fund investment, a PE firm uses capital from a newer fund to invest in a portfolio company that is already owned by one of its older funds; however, potential conflicts of interest could arise when moving invested capital between funds. Another option is recycling earnings from a successful investment to support other companies within the same fund. Limited partners (LPs) must approve the use of capital in this way and GPs have a fiduciary responsibility to ensure each investment makes sound financial sense to their LPs. GPs can also issue preferred equity, and certain secondaries market options exist to PE funds as well. This requires buyers who are willing to put up the capital and, as many companies are learning, raising capital is a much easier task when business is good.
Shares issued and sold at fair market value is generally not a taxable event. If, though, shares are sold at less than their fair market value, the difference between the actual purchase price and fair market value of the shares may be taxable to the acquiror. Additionally, the tax consequences vary depending on the tax classification of the issuing entity. Leadership teams should understand and consider the varying tax consequences associated with issuing shares before issuing additional equity.
Asset or business sale
As merger and acquisition activity begins to pick back up in Q3, many PE firms and their portfolio companies may choose to divest noncore businesses or sell their assets in an asset sale to get an infusion of cash. PE firms may also choose to cut certain unpromising investments loose through a sale of the company, assuming a buyer exists.
In an asset sale, the seller may experience a tax disadvantage in situations where gains are treated as ordinary income, which are taxed at a higher rate than those that are treated as capital gains. In a stock sale, the seller may receive a tax advantage because equity that is sold receives capital gain treatment. All tax consequences associated with a transaction should be carefully considered and treatment may vary depending on the facts and circumstances.
As GPs and portfolio company management teams work together to identify the best source of funding to meet their needs at this crucial time, stakeholders should weigh the opportunity cost for each alternative funding option and carefully consider corporate governance requirements to ensure any actions taken are aligned.