The second quarter of 2020 is drawing to an end, and the four-month long recession has left many businesses struggling. The Paycheck Protection Program (PPP) created by the Coronavirus Aid, Relief and Economic Security Act (also known as the CARES Act, Public Law 116-136) will stop accepting applications at the end of June, with over $100 billion left in the program. As borrowers apply for loan forgiveness, implementation-related issues may continue to emerge. The road to recovery is still full of challenges for many, including mid-sized businesses and nonprofit organizations. This blog reviews loan programs and proposals that aim to fund these two types of entities.
The Main Street Lending Program
Besides the PPP, Section 4003 of the CARES Act authorizes the Secretary of the Treasury to support lending through programs offered by the Federal Reserve. The two major programs include a mid-sized business loan program and the Main Street Lending Program (MSLP) that supports lending to small- and mid-sized businesses.
In contrast to the quick rollout of the PPP by the Small Business Administration, the Federal Reserve has unveiled the MSLP in a controlled manner. Since the CARES Act authorized the MSLP in late March, the Federal Reserve Board has announced preliminary terms of the MSLP (in early April), solicited public comments, held webinars and revised the program rules twice before the program was rolled out on June 15. Both revisions made the program more flexible and qualified more borrowers.
U.S.-based businesses with less than 15,000 employees or up to $5 billion in annual revenue are eligible for the MSLP. Specifically, eligible businesses can borrow from banks or other lenders under the program, and the Federal Reserve will purchase 95% of the loans from banks prior to September 30, 2020, up to $600 billion. The Treasury Department provides $75 billion as a backstop to absorb credit losses. Although the London Interbank Offered Rate (LIBOR) will be unavailable after 2021, the Federal Reserve chose to use LIBOR as the reference rate instead of the alternative Secured Overnight Financing Rate (SOFR) in order to achieve timely implementation. All loans under the MSLP have interest rates of LIBOR plus 3% and 5-year terms. Principal payments on the loans will be deferred for two years, whereas interest payments will be delayed for one year.
The MSLP has three options. First, the Main Street New Loan Facility (MSNLF) allows a maximum loan of the lesser of $35 million or an amount that, when added to outstanding and unused available debt, does not exceed four times the amount of a company’s 2019 adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). The minimum size of the loan is $250,000, and the lender will retain a 5% stake in the loan.
Second, the Main Street Priority Loan Facility (MSPLF) provides a maximum loan of the lesser of $50 million or an amount that, when added to outstanding and unused available debt, does not exceed six times the amount of a company’s 2019 adjusted EBITDA. This option permits a minimum loan of $250,000, and the lender will retain 5% of the loan.
Finally, the Main Street Expanded Loan Facility (MSELF) offers a maximum loan of the lesser of $300 million or an amount that, when added to outstanding and unused available debt, does not exceed six times the amount of the borrower’s 2019 adjusted EBITDA. The minimum size of the loan is $10 million, and the lender will have a 5% risk retention.
Although the objective and structure of the MSLP is different from the PPP, some observers believe that the MSLP will be better received because it allows more flexible use of funds even after the passage of the Paycheck Protection Program Flexibility Act (Public Law 116-142), which lessened certain restrictions of the PPP. While the recipients of PPP loans are required to use most funds to maintain a certain number of employees and compensation levels, MSLP borrowers only need to make commercially reasonable efforts to maintain their payroll and employees during the terms of the loan. As such, businesses can use the funds to facilitate operations besides making payroll expenses. For instance, energy industry companies that are affected by the low oil prices during the pandemic could be major beneficiaries.
Additionally, the Federal Reserve has expanded the eligibility requirements for the MSLP to make the program accessible to more borrowers, especially smaller businesses. For instance, over the last two months, the Federal Reserve has reduced the minimum size of MSNLF and MSPLF loans from the initial $1 million to $500,000, and finally to $250,000 to include smaller borrowers. Although the MSLP is intended to reach businesses that are too big to qualify for the PPP, it is designated as a small and mid-sized businesses assistance program in the CARES Act. Smaller businesses, including the ones that have benefited from the PPP, are eligible for the MSLP loans as long as they certify that they need additional financing due to the exigent circumstances presented by the Covid-19 pandemic.
On the other hand, some analysts take a more skeptical view and doubt the MSLP will be well-received. They claim that, although the MSLP funds are not limited to maintaining payroll, there are still strings attached. Specifically, in addition to the limitations on executive compensation, a borrower cannot use the funds to repay other loan balances or debt, repurchase its own stocks or issue dividends until one year after the repayment of the loan. Some analysts believe these requirements may be restrictive enough to deter certain businesses from participating.
A separate and potentially more prominent issue involves the risk profiles represented by the borrowers. Although the Federal Reserve’s objective is to keep credit flowing in the economy and to ensure a robust recovery, the loans could disproportionally attract high-risk borrowers with heightened chances of default. Practitioners believe that businesses with strong balance sheets will borrow in open markets without going through the MSLP, and only non-investment grade companies that cannot borrow elsewhere at the interest rate offered by the MSLP will participate.
The Federal Reserve has also been taking on more risks as a result of the rule revisions, which alleviate banks from most credit risks. In its first revision, the Federal Reserve added the MSPLF, which involves more leveraged borrowers as the facility allows borrowing at up to six times the amount of EBITDA. This revision also required banks to retain 15% of MSPLF loans. In early June, the Federal Reserve’s second revision increased MSPLF’s maximum loan amount from $25 million to $50 million and reduced the banks’ required holding from 15% to 5%.
A sector that has not been mentioned a lot during the design of stimulus package is the mid-to large-sized nonprofit entities. Many of them have been engaging in social assistance activities in high capacity while having difficulty recruiting volunteers.
From a financial perspective, many nonprofit entities had limited operating margins and cash reserves even prior to the Covid-19 pandemic. The pandemic has worsened their financial positions, causing them to suffer from both reduced revenue and increased costs. Overall, the top three sources that account for over 90% of mid-to large-sized nonprofits’ revenue are donations, program revenue and government support. Since the start of the pandemic, all three sources have been substantially reduced. For instance, food banks have experienced unprecedented demand but need to spend extra funds to purchase cleaning supplies, protective gear and masks, while at the same time facing a shortage of donations. Some YMCA locations, which typically provide important resources for their communities, including workforce development initiatives, youth programs and community support, have had to cancel programs that generate a majority of their revenue.
A thorny issue about providing assistance to nonprofit entities is the diverse nature of the nonprofit universe. Comprehensive, wide-ranging relief plans that provide support to nonprofit entities not only benefit social service providers, parks and civil associations, and medical research organizations, but also entities that advocate for politically sensitive issues, such as the recent PPP-related controversies involving Planned Parenthood and faith-based organizations. In addition, private universities that received assistance from the Higher Education Emergency Relief Fund established by the CARES Act also generated debate. Several private universities were asked by the Trump administration to return the funds because the administration wanted them to draw funds from their endowments prior to getting public assistance.
Loan Programs and Proposals for Nonprofit Entities
Although the Federal Reserve expanded the MSLP to benefit more businesses, the program explicitly excluded nonprofit entities. The Federal Reserve stated that EBITDA — the key metric used by the MSLP to evaluate borrowers’ credit risks — is not a good proxy to benchmark the credit risks for nonprofit entities. However, the Federal Reserve recognizes the unique needs of nonprofit organizations and will be looking into other metrics that better approximate their credit risks.
The mid-sized business loan program authorized under the CARES Act, which is currently not operational, would allow nonprofit entities to participate. The program instructs the Secretary of the Treasury to make up to $454 billion available for loan programs created by the Federal Reserve to assist mid-sized entities, defined as entities with 500 to 10,000 employees. However, borrowers would only be able to use the funds to retain employees or to restore the workforce, meaning that nonprofit entities would not be able to use the loans to run their programs and services, and businesses would not be able to use the funds to ramp up operations. Neither the Treasury Department nor the Federal Reserve have provided much guidance on this program, and as mentioned above, the program is currently not active.
Several nonprofit organizations have called on Congress for additional support, especially for mid- to large-sized entities. Their suggestions include making the mid-sized business loan program operational and providing a loan forgiveness option to nonprofit borrowers. For example, one provision in the Health and Economic Recovery Omnibus Emergency Solutions Act proposed to have nonprofit borrowers eligible for loan forgiveness if they predominantly serve low-income communities and are ineligible for the PPP.
To some lawmakers, the reopening of businesses and the promising May jobs report have redirected the focus of additional government actions from stopping the economic damage caused by Covid-19 to facilitating a stable recovery. Although the economy may have shown the first signs of improvement, the concerns regarding a second peak of Covid-19 and the continued stock market volatility suggest that economic recovery is still in an early stage.
Despite the mixed reviews of MSLP, defining the program’s success by the number of borrowers is tricky. On the one hand, a low take-up rate signifies low demand for the program, but it may still signal that the credit market is functioning reasonably well for mid-sized businesses that do not need the MSLP as a “last resort.” On the other hand, if the program has many participants, its popularity may come at the expense of taxpayers. The concern that the program may disproportionally attract high risk borrowers is justified, and the costs of excessive credit losses will ultimately be borne by taxpayers.
Although Covid-19 has resulted in tremendous tangible economic damage, much of the post-pandemic recovery will involve rebuilding the interpersonal connections lost due to social distancing and stay-at-home orders. Nonprofit entities make up an important fabric in our society and are well-suited to bring this sense of community back. In many cases, nonprofit entities supplement government activities and could be better positioned to deliver certain services compared to government agencies or even for-profit entities. Providing targeted loan programs to these valuable entities will be a good starting point to revive their operations.