In early 2012, The Atlantic published an article, “Private Equity Is a Force for Good” that gave a clear-eyed look at the industry and its impact on the economy..
Eight years later, the private equity industry, with billions in capital ready to put to work, is in a position to help the economy recover from the coronavirus pandemic by investing in growing companies, helping them add employees, increasing capacity with their supply chains, investing in critical infrastructure systems and improving the communities they serve.
In data from PitchBook, the chart below shows a rise in activity by investment firms purchasing majority equity interests in middle market businesses.
These private equity firms have limited committed capital from their investors to put to work in private companies. When that capital is fully deployed and lines of credit are maxed out, that limits the options for the managers to help their portfolio companies. That’s what we are seeing now.
The CARES Act and the SBA
As the human and economic toll of the coronavirus mount, middle market businesses are in trouble as shortages of cash flow and working capital threaten jobs for millions of Americans.
That’s where the Cares Act and Small Business Administration can help. But there are restrictions.
The $2.39 trillion CARES Act created a number of loan options, including the $349 billion Paycheck Protection Program. The program is administered by the Small Business Administration through its 7(a) lending program under which the SBA guarantees loans made by banks to qualifying borrowers.
But a number of those borrowers in the middle market might not qualify because their equity structure will restrict them from applying for this specific program.
Defining affiliation
On April 3, the SBA released affiliation rules applicable to the Paycheck Protection Program. The guidance listed four tests for applicants to the program. An affiliation occurs when one entity controls or has the power to control the other, or a third party or parties controls or has the power to control both. In the case of the program, if affiliation exists, then from a headcount perspective, you would need to count the number of employees across businesses to see if you meet the employment requirements.
According to the guidance, control can be based on several factors, including:
- Equity ownership – control more than 50% of the voting equity
- Stock options, convertible securities and agreements to merge
- Management
- Identity of interest
This is where private equity firms will have trouble qualifying. A number of their portfolio companies fall into the factors listed above, restricting them from applying to this program. The guidance does list a few exemptions focused on the hospitality and food service sectors and faith-based organizations. A waiver is also possible if a business has received funding from a Small Business Investment Company. An SBIC is a private investment fund licensed by the SBA under the Small Business Investment Act of 1958, and provides loans to small businesses.
Private equity firms should discuss with their legal or tax counsel to see if opportunities exist with shifting voting control to become eligible to apply for a loan with the SBA.
Dollars versus people
A number of private equity funds may be discouraged by the above guidance and decide to stop their efforts, but an alternative does exist.
On September 27, 2010, President Barack Obama signed into law the Small Business Jobs Act. The law established a temporary alternative-size standard for business loans made under SBA’s 7(a) program. Ever since then, the SBA has not revised the alternative-size standard, meaning that this temporary method remains available to determine if a company is considered a small business.
Under this temporary standard, and taking into consideration all affiliates related to the private equity fund, a business is a small business if it has:
- A maximum tangible net worth that is not more than $15 million.
- An average net income after federal income taxes (excluding any carryover losses) for the previous two full fiscal years of no more than $5 million.
A careful analysis on how the SBA calculates the above will not be a simple task as outside counsel will be required.
Potentially, for some private equity and venture capital funds, their portfolio companies might qualify under these guidelines on a stand-alone basis; then adding to the complexity is the fact that the affiliation rules still apply and cannot be ignored.
If all factors above are satisfied and the affiliation rules are considered, you may be able to apply for a loan regardless if you have more than 500 employees – the current limit under the Paycheck Protection Program.
As always, please consult your legal counsel to see if this alternative-size standard will apply in your situation. In addition, bringing in your banker and other stakeholders will ensure that all angles and necessary calculations are met.
Will affiliation rules be changed?
Private equity sponsors, with the backing of trade and professional associations, have argued that the affiliation rules should be refined to allow struggling businesses to receive aid regardless of their equity or management structure.
Members of Congress from regions that are hubs for the venture capital industry such as California have also been publicly advocating that Treasury adjust the affiliation rules to allow businesses backed by private equity and venture funds to be eligible to receive funding from the $349 billion earmarked for PPP.
They argue that the intent of the CARES Act was to help small businesses cover their payroll costs and other key expenses through the coronavirus pandemic, and they see no reason why a distinction should be made based on ownership. Any such exclusion could lead to bankruptcies and broader economic impacts beyond the businesses that are being shut out of the PPP, they say.
In the meantime, private equity and venture funds will need to navigate the current rules in their existing form.
The takeaway
Private equity funds and their portfolio companies looking to apply for a loan under the Payroll Protection Program might have another option with the alternative-size standard. If not, they may have to look to the Small Business Administration Economic Injury Disaster Loan Assistance or the recently announced Main Street Lending Program.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
