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BDC Reporter Opinion: Thoughts On The Government Intervention In The Credit Markets

Posted on April 9, 2020

 

Bam !

In the matter of a few hours the entire environment for non-investment grade companies, lenders and investors has changed dramatically for the better.

That’s because the Fed and the Treasury and other agencies have announced the outline of new lending and support programs for “risk assets”.

As a result, “junk bonds” are up (see JNK ); floating rate loans (see BKLN, which owns the largest 100) ; banks (see KBE ETF) and the financial sector generally (see XLF).

 

Us Too

The BDC sector has not been left out.

The BDC ETF which owns virtually all the sector stocks – with the ticker BIZD – is up double digits to $12.99 or 13%, close to the day’s highs.

BIZD is now down (37%) from the beginning of the crisis, well off the lowest level of (56%) on April 3.

In fact, since that low point – using the closing price on April 3 and comparing against the still very volatile intra-day price today, BIZD is up 41% !

 

Not To Be Left Out

There’s no easily quotable equivalent for BDC Fixed Income, but our comprehensive list of publicly traded BDC debt securities shows 40 of 42 up in price.

Prices in many cases are up over 5% or even 15% in a matter of 90 minutes.

 

Rah-Rah

All the above to underscore that the markets have reacted very favorably to the Fed saying “there is no limit” to what they are prepared to do to support American business.

The BDC Reporter has been tracking and commenting – and even undertaking a little on the run analysis –  since 5 p.m. this morning PST on our News Feed.

For everything we’ve written about, we suggest checking out our Twitter Feed, which we use for communicating what we’re learning in real-time.

You can also see our latest posts from the News Feed on our website, but the space cannot contain the volume of our output.

 

First Thoughts

We’re taking a few minutes here (9:30 a.m. PST/12:30 EST) to offer up to readers a few VERY preliminary thoughts, which might be helpful.

We reserve the right to make an about face at any time as new information flows in or as we think through matters a little more deeply.

We remain a one finger typist so our output cannot keep up with the input.

 

Getting There

Here are the key points:

The Fed and Treasury and SEC have announced the intended launch of programs to provide debt capital to companies in the mid-zone between small and big business.

One program – the misnamed Main Street Lending Program – is targeted at companies with up to 10,000 employees.

That large employment number ensures most every non-investment grade company in the country is technically eligible by that criterion.

Moreover, the government is comfortable for there to be overlap between the Main Street Lending Program and the Paycheck Protection Program (PPP), which caps employee limits at 500.

That means some companies may – in theory – qualify for both programs…

 

Getting Less Attention

In addition, the SEC is loosening or expanding its rules to specifically help BDCs finance non-investment grade companies.

We’ve read what we can on the run about this BDC-oriented program, but don’t yet understand how the mechanics will work.

 

All Together Now

In theory virtually any of the 4,000 – 5,000 private and public companies that are financed in full or in part by BDCs COULD  be beneficiaries of the government’s enlarged support.

(By the way, by our review of hundreds of BDC portfolio companies in the period since February 20 using Advantage Data market records, as many as 50% of the universe may already be in some degree of distress).

Left out will be the small number of foreign companies that BDCs have financed.

Overall, though, 98% of BDC portfolio companies are U.S. based and employ less than 10,000 employees.

 

Real Money

Moreover, the program terms  we’ve reviewed suggest the amounts that could be tapped by borrowers would be sufficient (up to $150mn to a single borrower) to meet any reasonable short to medium term needs.

The capital being made available is structured to add to existing debt rather than to refinance, which would allow borrowers to pay employees, trade payables; service existing borrowers and maintain solvency.

 

Game-Changing

If this works, thousands of companies that might have taken emergency steps to cut their business activity to the bone; or filed for Chapter 7 or 11 or have been forced to raise emergency capital on onerous terms would be helped.

In turn, that would inure to the benefit of BDC lenders and investors to those non-investment grade companies.

This would ensure debt service payments could continue and less demand for additional borrowings by borrowers that many funds may not have the resources to meet.

That’s the Good News.

 

Both Sides Now

However, 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.

 

One Minute History Lesson

Many years ago, the banks were the main interface with middle market companies.

Since the Great Recession, though, banks have been replaced by a host of different non-bank lenders – including BDCs – as the principal financiers of non-investment grade companies that use debt to any material extent.

Banks have relegated themselves to providing cash management services;  very senior asset-based loans (as in the oil sector) or abandoned the space entirely to finance companies; private lenders;  regional banks and BDCs both public and private.

 

Packaging Is Not Lending

Yes, banks are still active in booking loans that get stuffed into CLOs but try to avoid keeping those loans on their own books for anything but a few weeks.

None of this should come as any surprise to the government as this was the plan after the Great Recession and the infamous need to “rescue the banks”.

 

Soap Box

The Fed should have included BDCs in the Main Street Loan Program.

Its failure to do so will  weaken the availability of credit and it’s going to the right places and at the right time.

The banks simply do not have the infrastructure or the market knowledge to identify and analyze which borrowers are appropriate candidates for this potentially huge surge in borrowing.

 

Missing

Unfortunately, there is a risk with this omission of the BDCs – with their thousands of professionals with access to virtually every leveraged middle market company  – that many companies with dire needs will be left out.

There is a risk that the Main Street Program could have the same structural weaknesses as the PPP but with far greater consequences in terms of the magnitude of defaults and unemployment that would ensue.

 

Details Count

Furthermore – like with the PPP – the final terms of the financings, and especially eligibility requirements, could still greatly diminish the usefulness of the new programs.

Our first review of the Main Street Lending Program was not auspicious in this regard as the Fed seems intent on using what we call a “blunt instrument” of debt to EBITDA to exclude borrowers.

 

Confusion 

Ironically – because the Fed and most commentators unfamiliar with how credit works – continue to see leverage levels as an indicator of a company’s health and want to use that number as a qualification tool.

The result could be that some of the most (previous to the crisis) profitable companies in the country could be excluded from the program.

Ironically, the beneficiaries would be some of the weakest companies whose debt to EBITDA levels are low.

There’s a reason why oil companies; some retailers; miners etc can only borrow 1x-2X their EBITDA and it’s because of the weakness and risk in their business models.

 

Timing Is Everything

Finally there’s the timing.

No government bureaucracy – however well meaning – is built to develop new ideas on the back of an envelope in a very short period and implement them in a hurry.

Again, we point you to the PPP Program…

With all the goodwill in the world, the Fed still has to solicit and review comments (till April 16) for the Main Street Lending Program.

Then terms have to be communicated to the lenders.

As we’ve said the lenders will be bankers – a group not accustomed to quick reactions or taking risk or capable of absorbing the flood of new requests.

Then, borrowers have to be educated on what are completely new financing arrangements where neither their chosen lenders nor advisors have all the answers.

(We’ve spent untold hours reading the terms of the PPP program alone and in consultation with our accountants and counsel and are still unsure of what the SBA intends and requires).

 

Changing Times

This at a time when business conditions – and thus financing requirements – are changing at warp speed compared to normal times.

Maybe the cavalry will arrive, but will there be anyone left to save ?

 

Analogy

The wartime analogy has been used a great deal in recent weeks to do with all aspects of the Covid-19 situation.

That analogy is useful here too.

In war – as the Allies did so well in World War II – everybody involved has to be both organized (and thus bureaucratic) and highly flexible at the same time.

That’s the challenge here for the Fed and everyone else involved.

Can the parties adapt quickly enough so that all the parties that were supposed to be helped by this “bazooka” can benefit ?

Or will bureaucratic limitations; prior mind-sets (such as those about punishing “over-leveraged companies” and “wicked” PE groups) and the choice of delivery mechanisms sabotage this “war effort” ?

 

We Must Remember This

We all remember how World War II ended and who won but we sometimes forget to the huge amount of waste and dead-ends encountered along the way.

 

BDC Reporter’s Role

In this current endeavor, the BDC Reporter’s motto is a paraphrase of Ronald Reagan’s famous saying: “Trust the Fed/Treasury but verify that the outcome matches the intention”.

(Yes, we’ll be selling T-shirts).

We will be reviewing the various government programs fine print in the days and weeks ahead and keeping our finger on the pulse of what is really happening at BDCs and their portfolio companies.

Hopefully, we will have good news to report.

In the short run, though, after the initial euphoria created by the headlines, the markets may understandably have doubts.

This government intervention – though welcomed by almost everyone – could yet go any number of ways.


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