COVID-19: Emerging Credit Risk Challenges for Main Street Business Lending

As a result of the current economic crisis, banks, pensions, insurance companies, funds and other institutional investors and investment managers are at the early stage of a massive increase in non-performing assets (NPAs). They will need access to public and private equity capital, and new business platforms, strategies and underwriting staff capabilities will need to be developed.

The pending NPA influx has been percolating for a while. Prior to entering the current economic crisis, corporate and small business debt were at an all-time high, fueled by near zero interest rates, a shadow financial system and leveraged loans under emerging stress. Moreover, roughly 43% of small and medium-sized enterprises (SMEs) in the US were at break-even or incurring losses.

Fast forwarding to the present, rating agencies have just begun the process of corporate bond downgrades, and corporate and leveraged loan debt are at all-time highs.

Taking all of these factors into account, the coming surge in NPAs across the institutional money management space should come as no great surprise. The influx will undoubtedly lead to increased provisions. However, at this early stage in the crisis, with respect to aggregate dollar need, the potential expense of this surge remains unclear.

As a result of the pending tsunami of NPAs - both inside and outside the banking system - new forms of equity will be needed to support viable small businesses. Not debt: equity.

Banks and other financial entities, such as shadow-system private lenders, must begin to develop business strategies and bank-wide enterprise capabilities that can rapidly deploy needed public and private equity capital to displaced small businesses. This will require a significant adjustment to the thinking of many small business bankers.

The Paycheck Protection Program (PPP) Isn't Enough

The CARES Act provides over $350 billion in federal aid to SMEs. It's primarily targeted at existing SBA 7(a) lenders, as well as existing and prospective new SBA borrowers.

The central element of the program for SMEs is the Paycheck Protection Program, which provides loans up to $10 million to SMEs. Its central purpose is to incent SMEs to keep their workers on payroll, but it is only a stop-gap solution. Indeed, as of the week ending April 17, 2020, the PPP already ran out of funded capital, and banks are now scrambling to process new PPP applications under part two of the program and get capital to SMEs. (It's important to note that the PPP was primarily an employment protection program, and was never intended as rescue capital to ensure SME viability or survivability.)

While banks hustle to fill the short-term need, there remains the medium-term issue (weeks, not months) of managing the coming surge in NPAs. We must create a complete equity-funding platform that can not only coordinate federal aid for PPP but also provide a framework for attracting, coordinating, and administering additional public and private capital needs - beyond both the current and anticipated level of federal aid.

Private capital businesses are looking at ways to assist impacted firms requiring more nuanced capital strategies. While this is good news, the bad news is that, at the moment, all eyes are on the PPP, and little discussion is taking place on how to risk-manage the impending surge in non-performing and distressed assets - on a nationwide scale.

One thing is for certain: it's going to require far different thinking than what we've witnessed to date. Separate feeder-funds and possible merchant bank investment will be required, as well as cooperation with CDFIs, BDCs and the Federal Reserve's emerging Main Street Lending Program.

Equity investment will also be needed, and should be encouraged. However, it's important to remember that US banks cannot invest directly in equity, so we need to consider what structure this should take.

The development of "recovery funds" that coordinate the flow of private equity capital to needy SMEs is one idea that is gaining steam. Today, a recovery fund would be a mutualized, community-conscious initiative. It would provide a private-sector solution to viable small businesses, not just during the COVID-19 crisis but throughout recovery.

A recovery fund could, moreover, act as a more efficient reference model for the coordination, management and transparency of public- and private-sector capital donations. (For grants and federally-sponsored aid, proper reporting and transparency are especially important.)

Oscar A. Jofre, co-founder and CEO of KoreConX, says that amid the pandemic, with rising NPAs and capital-needy SMEs, recovery funds would represent a strong step in the right direction. "Raising capital is not enough. The entire securities lifecycle must be managed, governed, and made fully compliant," he says. "The same thinking applies to the recovery efforts by the Fed and the banks. The PPP is an important first step, but the bigger question of responsible governance of funds must be addressed. In this, we are in a fortunate position of being able to assist in the reset and recovery of the SMEs."

Surging NPAs: A Risk Management Problem

While the PPP will be a helpful short-term solution for some small businesses, there will be ongoing and more acute capital needs from many firms. It will therefore be increasingly important for credit and risk departments to have strategies to deal with the rapid inflow of non-performing loans (NPLs).

Risk departments and capital management teams will need to maintain access to "off-the-shelf" strategies that work to bring private companies that were viable, prior to the pandemic, back to financial health. In many situations, this may require supplementing federal aid with private equity and/or debt. This should be done with an eye toward maintaining bank earnings and value, while minimizing the balance sheet impact of increased credit-loss.

Even with the temporary suspension of CECL and deferred application of TDR rules, the financial reality is that economic losses have already occurred, and these losses will result in increasing levels of NPAs and ongoing adjustments to earnings and loan-loss reserves.

For many banks, there is a level of NPAs that can be selectively managed. As a benchmark, this would be a Texas Ratio of more than 45%. Banks will need to make their own quantitative determination on risk limit and appetite.

Historical Precedent

This idea to fund SMEs with private capital isn't new. Many people have it wrong that Franklin D. Roosevelt's New Deal was all about government spending. Indeed, private capital was a big part of the plan, and we need a new plan now.

One of the main elements of the New Deal was the establishment of the Reconstruction Finance Corporation ("RFC"). The RFC helped coordinate the flow of private equity capital into viable Main Street businesses, all without the government spending a dime.

Today, similar ideas - such as the aforementioned private-sector recovery funds - have been discussed. These funds could be sponsored by banks and other institutional entities, as part of an effort to coordinate private-sector capital investors.

Moreover, they could even include federal participation - if an entity like the RFC were to emerge. During the Great Depression, working in tandem with the RFC, such structures served to get Main Street business back to work.

Equity Investment and Risk Mitigation

Using a public/private partnership, and leveraging existing fintech capabilities, it's possible to develop a platform that could rapidly deploy public and private equity to viable main street SMEs. This is especially critical for those SMEs unable to support additional debt, and for whom federal aid is either (1) insufficient in size; (2) too slow in provision; or (3) undesired.

Viable SMEs, with the new capital influx, could bridge from a current distressed condition to a post-crisis position of strength. Offering preferred equity and/or common equity in private transactions to business owners would give them the option to "buy-back" any sold ownership interest over a time-horizon that fits the firm's post-crisis cash flow capabilities.

Moreover, this type of private-equity platform may be used to leverage and partner with other available capital sources, such as community development financial institutions (CDFIs), business development companies (BDIs) and other firms offering capital or assistance to impacted SMEs.

The benefit to impacted banks is that they can sell their NPLs at less-distressed pricing, while continuing to service underlying relationships and nurse their companies back to financial health. The private equity investors can facilitate this investment by placing the underlying NPL investments in a private fund, or series of funds, established specifically for the purposes of helping viable SMEs displaced by the COVID-19 crisis regain solid financial health. The investment criteria would be simple, and the investment would remain evergreen throughout the "work-out" period.

What's more, if the industry continues to effectively respond to SMEs borrowing under the PPP, the private-equity platform could act as a conduit for buying PPP SBA 7(a) exposure and assisting in primary market issuance and secondary market trading. The platform would also help the on-boarding of "overflow" exposure, which we expect will be supported by an emergent secondary market in bank-originated PPP/SBA guaranteed loan exposure.

Parting Thoughts

Clearly, our economy needs a revamp, and it is time to act. Significant revisions to the current order are required, and it now makes sense to push forward with a longer-term, private-sector solution to the "recovery."

A good place to start is through the development of modernized recovery funds that allow greater and more affordable access to equity capital.

Thomas Day is the Chief Credit Officer of Themis Capital Management Group. He is an engaged investor in distressed assets, and is highly interested and actively involved in digital smart-contracts that represent debt obligations. He is a leader of several business start-ups, and sits on the board of directors of two different organizations. He can be reached at Thomas.E.Day@me.com.