May 18, 2020 | By Guillaume Hannezo, Associate Professor at the École Normale Supérieure
1 The instrument, which was developed under urgent circumstances, therefore warrants closer examination.
It seems to us that it suffers from serious design flaws: a 6-year extension option at the borrower’s discretion, underpricing, and a single risk premium that condemns the government to likely significant losses, as well as a failure to consider the priority ranking of the guaranteed debt, which will cause it to take a back seat to bank debt. Used as an «1% mezzanine with a put on Bercy,» the product will expose the government to constant blackmail over jobs to force it to write off the debts. Above all, the use of state-guaranteed loans discourages companies from raising what they will need to absorb pandemic-related losses: equity capital.
We therefore propose:
1/Now that we are beginning a gradual return to normal, adjustments should be made to reduce the design flaws in the government-guaranteed loan programs (PGE); 2/In cases where permanent capital is needed, the government should move away from the stopgap measure of state-guaranteed loans and establish a funding envelope and instruments to professionally manage equity and quasi-equity investments tailored to companies of different sizes. While this solution is more demanding for current shareholders, who will have to accept some form of dilution, it is more beneficial for the company, which will gain equity capital, and for taxpayers, who will be able to share in capital gains commensurate with the risks taken.
The crisis resulting from the economic lockdown required the government to take measures that were very different in nature from those implemented during previous crises. While the Treasury had learned to handle emergency situations involving a few major industrial players or the financial sector—which are fairly concentrated—it cannot respond with the level of granularity needed to address a multitude of urgent situations that also, and primarily, affect the construction and services sectors, SMEs and mid-sized companies whose operations have come to a halt, and so on.
To address this exceptional situation, the government very quickly—and despite the constraints of limited consultation capacity—put in place an emergency measure to channel the liquidity, fortunately guaranteed by monetary policy, back into the economy. To do so, they used an instrument already tested during the financial crisis—the government guarantee (an instrument that has the advantage, or convenience, of costing nothing immediately)—and the most widespread regulated distribution channel for meeting the needs of businesses: banks… , in its French version, therefore consists of providing banks—for new eligible loans they grant through the end of the year to businesses needing to secure their cash flow during the crisis— a 90% government guarantee in the event of borrower default (or 70 to 90% for the largest loans).
The loan is granted up to a limit of 25% of revenue, initially for one year, but may then be repaid over an additional five years at the borrowing company’s discretion. In exchange for this guarantee, which is provided in practice by the BPI, the government charges a very modest insurance fee ranging from 0.25 to 0.5% at the start of the loan. Since banks agree not to charge any margin on these loans, and since the cost of bank liquidity is negligible and the risk-free rate is negative, this insurance cost constitutes the bulk of the interest expense for the borrower. After some initial hesitation related to formalizing the state guarantee commitment, the program has been a considerable success, particularly since the state guarantee automatically applies to loans for all companies with annual revenue of less than 1.5 billion euros; above that threshold, the terms are tailored to each company’s financial situation. The total budget allocated is 300 billion euros, equivalent to 15% of GDP.
According to the «dashboard» on government-guaranteed loans (PGE) published by the Ministry of Finance as of April 24, €43 billion had already been disbursed to 277,000 companies, and another €30 billion was under review, with a very low rejection rate of around 2%. Of this initial allocation, 53% went to very small businesses and nonprofit organizations, 36% to SMEs, and 11% to mid-sized companies. However, this breakdown is likely to change, as mid-sized companies are increasingly turning to the program, as are certain large conglomerates that are negotiating specific plans—such as those already secured by FNAC Darty (500 million), Air France (€4 billion in state-guaranteed bank loans, plus €3 billion in a shareholder loan from the government), Europcar (220 million), and soon Renault (several billion under discussion according to press reports), as well as numerous other large corporations. It is therefore likely that the total amount of commitments likely to be granted by the end of the month will exceed €100 billion and that the €300 billion allocation will be a reasonable estimate of the total amounts to be guaranteed by the government if the product remains unchanged.
Never since the last financial crisis (when massive guarantees were granted to a few dozen players in the financial sector to restore systemic confidence) have public finances been committed to such massive amounts in such a short time; never before—not even at the height of the previous crisis—have such large sums been committed to such a wide range of diverse entities regarding whose creditworthiness the Treasury cannot form its own assessment. Since these loans are intended to last six years, the stakes are therefore considerable both for public finances and for companies’ equity and investment capacity. However, these instruments were developed in a rush, without time to address the technical issues that are normally considered when drafting a loan agreement; furthermore, there is now a consensus—after two months of shutdowns and a recovery severely slowed by social distancing rules—that many companies need measures beyond mere liquidity; Following what are likely to be massive losses in 2020, many will face solvency issues, which are typically resolved by raising equity or quasi-equity capital. In the absence of sufficient reserves or legal proceedings, this is the only way to absorb losses. However, government-guaranteed loans (PGE), aside from minor perverse effects that should be kept in mind to mitigate their consequences (1), have the major drawback, in their current structure, of discouraging companies from raising equity capital (2), which will lead to intractable and very costly situations for the government in future restructuring proceedings (3). We therefore believe it is necessary to examine ways to correct these perverse effects (4) and to significantly rebalance the public response, with far fewer state-guaranteed loans and far more equity investments, which are better suited to companies’ needs and allow the government to receive a return commensurate with the risks taken (5). 4 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap
- SOME SECOND-ORDER UNINTENDED CONSEQUENCES TO KEEP IN MIND
1.1. The Preferential Treatment for Banks The first relates to the distribution channel, which to date consists primarily of banks. Since banks are protected on 90% to 70% (depending on the size of the companies receiving state-guaranteed loans), and earn no margin on the remaining 10% to 30%, they are tempted to prioritize their «clients,» particularly those who already have debt with them and who, while not facing a serious long-term threat, might encounter temporary difficulties with their existing debt. The PGE is therefore reserved for each bank’s closest clients, particularly those for whom the bank believes it can secure its existing receivables by taking on a small additional risk (the 10%) alongside a large line secured by the government (the 90%). Consequently, debt-free companies, or those that have favored disintermediated financing channels (bonds, debt funds, crowdfunding), or those whose debt is held in fragmented pools, or those that have channeled their cash flows through neobanks, or those that have recently awarded advisory mandates to entities other than their universal banks, etc., are less likely to be served, regardless of their creditworthiness or the nature of their financing needs.
1.2. A Threat of Obsolescence for Certain Financing Providers The second effect is that the implementation of government-guaranteed loan programs (PGE) threatens to render certain financing providers obsolete (senior or subordinated debt funds, straight or convertible bond funds, mezzanine funds, unitranche lenders, crowdfunding platforms, etc.) that offer financing at rates falling between the cost of debt backed by tangible collateral (typically 1 to 2%) and the cost of equity capital (7 to 10%, or even higher for growing or highly indebted companies), with a risk profile and position that fall midway in the cash flow priority hierarchy. These instruments will be useful for reviving investment, particularly for unlisted companies that are reluctant to dilute their equity.
1.3. The Windfall Effect The third effect, of minor importance, is the «windfall» effect: many companies will apply for government-guaranteed loans without really «needing» them, simply to protect themselves against «worst-case» scenarios amid uncertainty, at a cost far lower than their normal debt; or simply because their competitors have obtained them and they want to maintain a level playing field with them. And this is nearly impossible to standardize in a situation of great uncertainty where the duration of the shutdown, the pace of reopening, and the impact on working capital requirements (WCR) are unknown. In a way, this point is the least significant: we can hope that the majority of «comfort-of-mind government-guaranteed loans» will be repaid, which will improve the average default rate; conversely, we should be more concerned about the companies with the most urgent needs: since those companies may not generate enough cash flow after the recovery to repay their new debt on top of their existing debt.
- A MAJOR PROBLEM: THE PGE IS INTENDED TO BE USED AS VERY LOW-COST SUBORDINATED DEBT, WHICH DOES NOT PROVIDE AN INCENTIVE TO RAISE EQUITY OR QUASI-EQUITY
2.1. The low cost of the PGE underestimates the statistical risk. The documentation provided to borrowers states very clearly that they have the option to renew the loan after one year to spread the debt over an additional five years, without, however, being required to gradually amortize the debt over those five years; it is therefore conceivable that a portion of these debts will be repayable only ’at maturity.« This is in exchange for a gradual increase in the guarantee rate: from 0.25% per year in year 1 to 0.5% p.a. in years 2 and 3, then to 1% p.a. at the end of the loan term for companies with less than €50 million in revenue, with these costs doubling for companies with higher revenue. In other words, the government sets the risk premium over 6 years at approximately 0.7% per annum for companies with revenue of less than 50 million €, and 1.4% per annum for companies with revenue of more than 50 million €.
A realistic assessment of the actual risk levels of «average performers» under normal conditions; the fact that, after two months of lockdown, a slow recovery, and a weakened economy, the credit quality of all companies will deteriorate; On the other hand, this risk is treated uniformly regardless of credit rating (Bank of France rating for SMEs, agency ratings for large companies), which completely ignores statistics showing the exponential rise in default rates and credit spreads on both sides of the line between «investment grade» and «high yield»[1][2]. This cost of risk is much lower than the default rates observed under normal conditions, even more so than market prices under normal conditions, and even further below what might be expected in the wake of an external shock that likely has no equivalent in the past half-century.
For SMEs, which are also rated using the Banque de France (BDF) rating system, the bulk of the group consists of companies rated «4 » (64,000 companies, or 42% of the first PGE loans), which have an average 3-year default rate of 1.91%—or 0.64% per year—and companies rated «5» (approximately 78,000 companies, 21% of the initial PGE loans), which have average default rates of 6.4% over three years, or 2.1% per annum[3]. For large companies, the annual default rates for S&P’s BBB ratings (the three grades above the high-yield threshold) range from 0.3 to 1% depending on the year, which is consistent with the pricing applied; but as soon as one crosses the «investment grade» threshold—for companies rated BB (the highest-rated «high yield» issuers)—annual default rates range from 0.5 to 4% per year, depending on the period[4].
It is clear that the risk-cost calculation used—in addition to reversing the risk factors between SMEs and large corporations—is calibrated based on the average historical default rates of «top performers,» which leaves no room for [1] https://www.economie.gouv.fr/files/files/PDF/2020/dp-covid-pret-garanti.pdf.
[2] «Investment-grade» securities are those for which repayment is certain or highly probable, and which are likely to default only under absolutely extreme conditions; the «BBB» rating is the lowest in this category. «High yield» refers to lower ratings, starting at «BB» for slightly speculative securities, with six notches on the scale below that leading to default. Investors place a very significant difference in the required yields between «BBB» and «BB»
[3] Banque de France rating, 2017 performance evaluation, BDF publication [4] https://www.spglobal.com/ratings/en/research/articles/200429-default-transition-and-recovery-2019-annualglobal-corporate-default-and-rating-transition-study-11444862 the fact that the default rate, calculated here as a long-term average, is bound to skyrocket during a crisis; and the inevitable effect of adverse selection: companies—particularly large ones—that remain «investment grade» after this crisis will be able to refinance their debt at a spread of less than 200 basis points, leaving only the poorest-quality risks behind. It should also be noted that the «tailored» government-guaranteed loans for large companies—which have already been announced or are under public debate—apply exclusively to large «non-investment-grade» companies such as FNAC (BB) or Europcar (BB-), or publicly owned groups operating in highly cyclical sectors that have been severely impacted by the crisis (Air France, Renault). For all these reasons, it is foreseeable that the default rate on these government-guaranteed loans will be very high, and the losses ultimately incurred by the government will be very substantial.
2.2. Since they are priced at rates that are significantly lower than the market price of risk, government-guaranteed loans (PGE) offer no incentive to be replaced by equity capital. The discussion above focused solely on statistical default rates, not on the market price of risk. For this risk to eventually be assumed by private operators, they must have the prospect of a return relative to the mathematical risk of default, since investors—unfortunately, and despite what is often claimed—do not behave like casino gamblers: While casino gamblers know they will lose «on average» and gamble anyway, investors, on the other hand, only invest if they expect to gain more than they will lose, on average, across their investments. Beneath their opaque exterior, the rules of financial economics are, in fact, extremely simple. Investing in a financial product—whether a stock, bond, loan agreement, etc.—always involves giving up certain cash today in exchange for the hope of perhaps more cash tomorrow. Between today and tomorrow lies the time premium, which is currently zero. Between the «certain» and the «perhaps» lies the risk premium. The higher the risk of each product, the higher the return the investor expects, on average.
And the level of risk depends on the company’s line of business (more or less stable over the long term, more or less cyclical), its level of debt, and also on the priority ranking of each financial instrument—from senior debt (the least risky), which is repaid unless the company goes bankrupt, to equity (investment in shares), which bears all the risks associated with fluctuations in earnings and value in the absence of bankruptcy, and is lost entirely in the event of default. To give a rough idea regarding debt, the «spreads»—that is, the differences in yield between AAA-rated debt (absolutely safe, safer even than French government debt) and BBB-rated debt («investment grade» for a normally indebted company), are 100 basis points (1%) under normal conditions and have recently risen to 200 basis points; between AAA and BB (the best in the high-yield segment), they were 300 basis points under normal conditions and stand at 500 today. Assuming a return to normal conditions, only companies that have remained firmly «investment grade» will be able to refinance their state-guaranteed loans (PGE) on equivalent terms. But these will be either those completely unaffected by the crisis or those that have increased their capital. However, raising capital to refinance a PGE means replacing funds that cost less than 1% (SMEs with less than €50 million in revenue) or 2% (mid-sized companies) per year with funds that cost 5 to 15%. It is unclear why a company would do this unless forced to. Subordinated or mezzanine debt typically costs 4 to 10%, which is normal since it is repaid only after senior debt and only if the senior debt is honored. The cost of equity for a company listed on the SBF 120 index ranges, depending on the period, the risk level of the company’s business, and its debt level, between 6 and 9%, which is the sum of the current dividend and the expected long-term capital gain; both of which come at a cost to the investor, who sees their equity diluted. The historical long-term return on stocks (dividends plus capital gains) is, according to the Ministry of Finance’s website, approximately 5.5 % in real terms[5], which roughly corresponds to the calculation of the «market premium» on stocks, (equal to the expected return when the risk-free rate is 0), which, according to the institutions that calculate it, was in the range of 6.5 to 8% before the crisis in nominal terms[6].
[5] https://www.economie.gouv.fr/facileco/epargne/couple-rendement-risque
[6] http://www.market-risk-premia.com or https://www.fairness-finance.com/fairnessfinance/finance/echantillon/sbf120/produit/primederisquedemarche.DHTML: that a capital increase—even once the crisis has passed—poses problems of valuation, dilution, governance, and liquidity for the new investor; that entrepreneurs suffer from an «optimistic bias » (which, incidentally, is what makes them entrepreneurs) that leads them to put off addressing the issue, remaining burdened with high debt for as long as it is bearable; that, in addition to the low cost of the guarantee, if the company or jobs were to be threatened, it is much simpler to pressure the government to force the write-off of the debt (this is the «Bercy put,» see below). As for an unlisted company, that is, one presenting the additional risk of being illiquid in the short term or heavily indebted in the form of an LBO, an equity injection will be made based on the investor’s expected medium-term return of 10 to 17% per year. If the company can have the government assume the risk of bankruptcy in exchange for a risk premium of 1 or 2% (even if an initial payment is required), why would it replace these funds with subordinated debt, quasi-equity, or common stock, which would cost it between 5 and 15%, depending on the circumstances? It will have even less incentive to do so: 2.3. The PGE is an instrument designed to be «juniorized» in the priority ranking of financial instruments and access to cash flows. Perhaps most seriously, over the 5-year term of a PGE renewed in this manner, the instrument is intended to be «juniorized,» while remaining the cheapest form of debt. A company that takes out a PGE often has other debts; the key issue of the PGE’s seniority ranking does not appear to have been addressed. In principle, a company should not raise a PGE at 1% to prepay another loan at 4%, but it is unclear whether this will be verified after the fact, let alone prevented in advance. In any case, over the course of the 5-year loan term, certain debts will be repaid upon maturity and refinanced. How will the Will we refinance?
In the absence of any further clarification, they will be replaced by debts whose collateral, maturity, or seniority will take precedence over the PGE, such that the PGE will become subordinate to those debts, if it is not already. 10 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap: attach specific guarantees to the new loan (e.g., backed by operating assets), or use a lease or «sale and lease-back» arrangement, so that in the event of default, the new creditor can recover the assets, and the old creditor will no longer have collateral; grant the new loan to a subsidiary, which is closer to the cash flows, and leave the old loan (and thus the state-guaranteed loan) in a holding company, so that the latter can only be repaid from dividends remitted by the subsidiary after it has serviced the new loan (what rating agencies call «structural subordination») ; obtain guarantees for the new loan against the shareholders’ personal assets—something banks routinely do for family-owned groups; grant a new loan with a shorter maturity than the previous loan (and thus the PGE), etc. There are many ways to subordinate a prior loan to a new loan if the loan agreement does not address this risk: It should be noted that it will be in the mutual interest of the company, the banks, the shareholders, and the debt funds to proceed in this manner. We will therefore find ourselves in the unusual situation of seeing companies that are typically indebted at 3 or 4 times their gross operating surplus (GOS), with half of their debt well-secured and costing 3 %, and the remainder consisting of subordinated government-guaranteed debt at 1%.
3. WHETHER OR NOT THE PGE IS JUNIORIZED, THIS SITUATION WILL CREATE INEXTRICABLE PROBLEMS IN FUTURE RESTRUCTURINGS, AND WILL EXPOSE THE GOVERNMENT TO CONSTANT BLACKMAIL OVER JOBS TO FORCE IT TO WRITE OFF THE DEBT OF COMPANIES IN DIFFICULTY
In liquidation proceedings, all claims of the same rank are treated equally. The lending bank will record its loss and be reimbursed 90% (or 80 or 70%, depending on the size of the company) by the government (which has provided an irrevocable guarantee), in exchange for which the government will join the pool of unsecured creditors[7], holding a claim that will be repaid only exceptionally and partially, solely if the realized assets of the company in liquidation are sufficient after priority has been given to wages, taxes, and creditors holding security interests in the assets or the assets of third-party guarantors; that is to say, almost never.
An unsecured creditor is a creditor who has no specific security, as opposed to a secured creditor. The creditors are the banks; the government is merely the guarantor. If the debt is simply partially forgiven or written off in a liquidation, it’s straightforward: the government repays it. But if the debt is rescheduled over a maximum of 10 years under a plan approved by the court, it appears that the government must reimburse the bank immediately and is then subrogated to recover the rescheduled debt. If this repayment schedule results from a negotiation, to the best of our knowledge there are currently no details regarding the actuarial method that will be used to calculate the loss to be compensated. In judicial settlement, sale, or safeguard plans, the commercial court judge is, in principle, the guarantor of equitable treatment for the various parties. But given the pressing demands placed on him (first and foremost, to try to preserve jobs, and to that end, to encourage and prioritize new financing), it is unlikely that, when choosing between different plans, he will have much qualms about cutting back on a creditor of more or less secondary rank—one who cannot contribute further to the fund and who, moreover, is 90% guaranteed by the State. And before it comes to that, conciliation plans or ad hoc mandates are generally negotiated. At this stage of the proceedings, there is nothing to prevent the different categories of claims from being rescheduled or repaid differently, or from waiving some claims but not others, etc. It is a negotiation, under the auspices of the court or an insolvency administrator—with varying degrees of direction depending on the procedures—between shareholders, unsecured creditors, secured creditors, and employee unions, with each party having to give something up to avoid losing everything. Obviously, in this kind of situation, the toughest or most cynical creditors lose the least… When these plans are negotiated for companies with a government-guaranteed loan (PGE), it is more than likely that all stakeholders—insolvency administrators, commercial courts, unions, banks, shareholders, funds, «old money» to be written off, and «new money» to be prioritized… will agree to shift as much of the burden as possible onto the government. Moreover, who will decide the fate of the state-guaranteed loan in the restructuring? We don’t know yet, but all the options are problematic: 12 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap. The question, of course, is also who will participate in conciliation proceedings or in defending the state in court decisions. It’s easy to see the perverse effects of leaving the creditor bank—which is exposed to only 10% on the PGE and potentially more on other lines of credit—solely responsible for defending the interests of PGE lenders. Conversely, however, if the government’s approval is required for a repayment plan or debt forgiveness prior to liquidation proceedings—or, a fortiori, in out-of-court settlements—we end up in a situation where, for hundreds or thousands of companies, the government decides which ones must repay their debts—or which ones can have them repaid by taxpayers. Aside from the employment blackmail to which the government will be subjected, the potential abuses of such a system are clear (crony capitalism, corruption, etc.). Finally, if the government writes off or reschedules its debts, is this state aid within the meaning of European regulations, and should the European Union’s services or the competent national authorities ensure compliance with competition rules and require the necessary concessions in terms of reducing the capacity of the company receiving the aid? From a systemic perspective, this would undoubtedly be the least bad solution, but this raises questions about the fate of the Air France-KLM state-guaranteed loan program, among others (indeed, when lending an additional €7 to €10 billion to a company at the heart of the crisis—one that is already €6 billion in debt, of which €2 billion is capitalized, and whose operating income is around €500 million in normal years— it seems quite clear that the loan is intended to help the company weather the crisis and will never be repaid; it is therefore destined to be converted into equity and/or aid). The state-guaranteed loan program was a response to an emergency. But if the government’s aid package remains limited to this, we can already foresee the outcome in a few years: a considerable budgetary cost to the government for failing companies without any significant benefit for those that survive, a lasting distortion of market-based financing mechanisms and competitive conditions, and a buildup of disputes in Brussels over restructuring plans. 4. AMEND THE G-GUARANTEE PROGRAM FOR NEW LOANS It therefore seems urgent to amend the G-guarantee program for new loans in order, at the very least, to encourage companies to replace G-guarantees with equity or quasi-equity as quickly as possible, which will limit adverse effects. 13 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap With regard to existing state-guaranteed loans, a modification of the system would also be appropriate, but is likely unrealistic as it would require a new finance law and/or executive order—and, above all, the prior consent of the borrowers. Indeed, it is a general principle of law that legislation applies only to the future and therefore cannot have retroactive effect. 4.1. Making Renewal Conditional It is difficult to call into question the 5-year renewal option, which is part of the product’s core promise. However, every loan must serve its intended purpose, and the purpose of this loan is to provide working capital: even if this is not straightforward—given the large number of applications and the fungible nature of the funds—it should therefore be possible to refuse renewal, or to renew only for one year (to allow time to secure alternative financing), or to make banks bear the risk of losing the guarantee for uses that do not comply with the loan’s purpose, in cases where an ex post analysis of the first year reveals uses that clearly do not align with the purpose—such as the early repayment of a more expensive debt or the repurchase of shares. It is more difficult to refuse repayment to a company that has simply invested, whether through gross fixed capital formation (GFCF) or external acquisitions. 4.2. A Steeper Increase in Remuneration Terms The standard way to exit a product of this type is to apply a «step-up » (progressive increase) in the terms of return—one that is much steeper—to encourage redemption and bring the return in line with the «normal» level of return on the capital it represents; not rising from 0.5 to 1 or 2%, but from 0.5% in year 1 to 1.5 or 2% in year 2, 3, or 4; % in year 3, 5, or 6; % in year 4, and so on. This seems difficult to implement for existing loans upon renewal, as the decree of March 23 explicitly mentions low fixed-term rates, and it is hard to imagine borrowers accepting an increase in the cost of their state-guaranteed loans. But it might be possible for new loans, even if it means sharing this higher remuneration with the banks, and also for large «customized» loans. Furthermore, it is highly unusual that the state guarantee rate is not differentiated based on credit ratings—which exist for all companies, with BDF ratings used in the absence of third-party rating agencies—since both are statistically highly predictive of default rates. It is undoubtedly this desire on the part of the government to price risk at a single rate—and to compel banks to pass on this administered price—that has given rise to the dangerous characteristics of the state-guaranteed loans. 14 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap The banks pretended to have their arms twisted by not charging a margin on their risky 10% loans, but in exchange secured an instrument that socializes their losses over the long term and protects their outstanding balances. All of this makes perfect sense for setting up a simple product to boost immediate liquidity, but it should not be allowed to persist for six years. It should also be noted that many other Western countries have implemented loans with shorter terms, at higher interest rates, or with rates that rise more quickly[8]. 4.3. Drafting Strict «Negative Pledge» Clauses The standard way to prevent debt from being «juniorized» is to include very strict «negative pledge» clauses in loan agreements—clauses that are common in loan agreements everywhere but, it appears, are not present in current «standard» government-guaranteed loans (the «customized» loans are not yet detailed enough to allow this point to be analyzed based on publicly available information). The aim is to prohibit the company, on pain of accelerated repayment, from providing any collateral for new financial debt (including, in certain cases to be agreed upon, any type of debt) or, at a minimum, from providing collateral without also extending that benefit to the PGE lenders on a pari passu basis[9]. Based on the same principle, loan agreements could also include other so-called «standard »no-act« covenants,” namely a prohibition on raising new debt in a subsidiary (structural subordination), on raising any new refinancing debt without first refinancing the PGE, to sell or transfer to a subsidiary a portion of its business or goodwill, to enter into a finance lease, to lease new significant assets, etc. The prohibition on paying dividends is also found in many LBO-type loan agreements, which is a standard reflection of the subordination of shareholder returns to those of creditors when debt levels are high. It is not included in standard documentation (for companies with less than 1.5 billion in revenue or 5,000 or more employees) and could be introduced, subject to the case of very small businesses where the dividend constitutes the compensation of the shareholder-manager. 15 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap [8] Financial Stability Institute, «Public Guarantees for Bank Lending in Response to the COVID-19 Pandemic,» P. Baudino, April 19. [9] That is to say, establishing a legal priority in favor of the State as guarantor for new loans should be given the same level of priority. However, this may discourage banks from granting such loans, without providing an absolute safeguard against the risks of abuse. This would operate on the model of the Bercy tax lien, with a statutory prohibition against requiring the government to write off debt—thereby demonstrating to Brussels, in writing, the government’s determination to ultimately be repaid—even though, in practice, any creditor not part of a creditors« committee (and thus the government) already benefits from this principle in insolvency proceedings; this privilege, however, appears to be nothing more than a priority ranking among unsecured creditors; otherwise, credit institutions lending under the State-Guaranteed Loan Program (PGE) might be reluctant to extend new loans if thethe government were ultimately to take priority over their other secured debts in the event of borrower default. The enactment of legislation requiring banks to first manage the entire default process—and thus the negotiations among creditors—with the government intervening only to cover the balance of the debt that has not been paid to the banks: this principle would, of course, not call into question the irrevocability of the government guarantee but only its timing of implementation. All these constraints, applied after the loan is renewed, will of course limit the strategic flexibility of the beneficiary company. But in the absence of a step-up in the terms of remuneration, this is exactly what needs to be done if we want solvent companies[10] to be incentivized to refinance their state-guaranteed loans with equity, quasi-equity (or unsecured debt, or secured debt if their state-guaranteed loans are fully repaid). 4.4. Other solutions to strengthen the government’s seniority: 4.5. Adjustments that may vary depending on the terms of early repayment Proposals to gradually increase, over time, the steepness of the repayment schedule, and those aimed at improving the »seniority« of the PGE claim can be combined in certain cases, but their respective importance actually depends on the purpose of the loan—that is, the conditions under which it must be repaid: 16 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap [10] »in bonis« companies operating under normal financial conditions, not subject to ongoing legal proceedings; in companies facing temporary difficulties, where the goal is, for example, to replenish working capital after a crisis; it is very common to grant the new debt a »new money privilege« that gives it priority, both in terms of timing and under the law, over the repayment of the old debt. This is common practice for companies experiencing temporary difficulties; when the loan is intended to be repaid through a subsequent capital injection, the most important factor is that its cost increases over time, in order to incentivize the borrower to raise capital; 4.6. What cost should be applied to companies that repay after an extension but before maturity? A complex issue arises for companies that will repay their state-guaranteed loan after a one-year renewal but before maturity. They will have paid the cost of the guarantee »upfront« for the entire period. Should they therefore be reimbursed on a pro rata basis? This could encourage them to repay once the extension is granted, but conversely, it could also encourage them to request the extension. 4.7. Resisting Pressure to Extend the PGE Program Naturally, we believe it is essential to fiercely resist the pressure to extend the program, which is already beginning to mount: increasing coverage from 90 to 100%, extending the term from 6 to 8 or 10 years, making debt forgiveness easier, etc. 5. REDUCE Guaranteed Loan Programs and Prioritize Equity-Based Solutions Should we therefore stop the Guaranteed Loan Programs? At the very least, we should reduce their number, tighten the conditions, and prioritize equity-based solutions. 5.1. Provide grants to very small businesses based on clear and transparent criteria For businesses that clearly cannot raise capital—particularly very small businesses (fewer than 10 employees) or SMEs that have been permanently closed (such as hotels, performing arts, etc.) and that cannot survive while heavily indebted, the appropriate tool is not a state-guaranteed loan to be restructured later according to opaque criteria, but a grant awarded immediately based on clear and transparent criteria. 17 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap This is what the Germans did by allocating tens of billions for micro-enterprises, whose business model involves applying the compensation mechanisms for short-time work to non-wage fixed costs during the period of mandated closure: building rents, equipment rentals, etc. The simplest approach is to replicate this plan, with the payment of the grant being charged to the State-Guaranteed Loan Program (PGE) for businesses that have already benefited from it. It should be noted that, in addition to short-time work benefits, compensation for micro-enterprises during the shutdown period is provided in the amount of 1,500 euros under fairly strict conditions regarding loss of revenue (which can be increased to 5,000 euros to prevent bankruptcy). This measure is therefore a step in the right direction, but it remains far below the German program, which provides compensation ranging from 9,000 to 15,000 euros based on very flexible criteria, depending on the number of employees; the difference in scale is also reflected in the budget allocation: 7 billion in France versus 50 billion in Germany. 5.2. Providing Equity Capital to SMEs, Mid-Sized Companies, and Large Enterprises In any case, it is essential for SMEs, mid-sized companies, and large enterprises to refocus communication and funding allocations on other intervention products offered by the government and public entities (CDC, BPI, FSI, or any other entity capable of managing investments on an »arm’s-length’ basis as a prudent investor), which allow companies to be provided with equity or quasi-equity while ensuring the government receives appropriate compensation for the risks assumed, without burdening the budget balance. The full range of financial products can be utilized: common stock, preferred stock, non-voting shares, exchangeable bonds, convertible bonds, «Cocos,» TSDI, etc. The key is to prioritize instruments that meet the companies’ needs, using the simplest terms possible, and to avoid succumbing to the temptation to postpone difficult issues (such as dilution and governance) by relying on the State-Guaranteed Loan Program (PGE). For large publicly traded companies, the two most relevant instruments are: 18 Terra Nova | State-Guaranteed Loans: A way to avoid the «emergency trap» by acquiring «plain shares» (participation in a capital increase) at today’s depressed prices, with the aim of reselling them for capital gains. While demanding for shareholders, who will have to accept the dilution, this is undoubtedly the solution that best serves the state’s financial interests, since the share of the «upside» is proportional to the risks. Of course, both parties will legitimately be concerned with establishing governance arrangements that will prevent companies with public entities in their capital from being burdened by the conflicting political directives that are characteristic of the public sector: maximizing value and dividends without jeopardizing jobs; repatriating industrial activities and manufacturing drugs in France without harming the environment; expanding internationally while retaining its original nationality; make the state gambling monopoly profitable, while combating addiction, etc.). These conflicting objectives exist in all companies, but there are ways to ensure that companies with public capital are not at a disadvantage compared to their purely private counterparts. The government can temporarily waive its voting rights. Alternatively, it can act through a public manager with its own fiduciary responsibility and a specific governance structure that enables it to resist short-term political pressures (the CDC/BPI/FSI model, etc.). Convertible bonds (CBs) may serve as an alternative, provided they offer sufficient compensation for the risk taken in the event of redemption. It should be noted, however, that CBs—unlike common stock and exchangeable securities—are not counted as equity by rating agencies. For family-owned SMEs welcoming minority investors, the products generally most readily accepted—unless there are plans for a public listing or sale—are «redeemable equity» arrangements, which can take the form of convertible bonds or preferred stock, and whose terms are fairly straightforward for the business owner. It involves providing the business owner with preferred stock or a highly subordinated debt—that is, assuming the risk of bankruptcy—and telling them: either you buy back my stake within 5 to 7 years at a rate of return acceptable for the risk taken (generally 6 to 10% per year), or we sell the company and the shareholder is repaid on a priority basis… This avoids getting too bogged down in the details of the initial valuation or governance rights. Alternatively, one could consider refinancing certain government-guaranteed loans (PGE) with non-amortizable «TSDIs» featuring high coupons (4 to 8%, depending on prices that make them eligible for institutional investment), which can be redeemed at the issuer’s discretion, with the coupon being subordinate to bank debt payments but taking priority over dividends. 19 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap For companies owned by private equity funds, the infrastructure is in place for medium and large companies, and funds are available, as these funds raised large amounts of deployable capital prior to the crisis. If there are concerns that private equity funds are insufficient or that risk assessments are overly conservative, the simplest way forward is for the BPI, the CDC, or any other public entity acting as a professional investor to invest on equal terms alongside reputable funds. Since this industry operates “by cohorts,” with fixed entry and exit dates, “post-crisis” cohorts are always the best, and there is a significant chance that these investments will be profitable for the government—just as investments in publicly traded equity are. The only question that arises is how to encourage the development of an infrastructure capable of handling “small deals”—so small that they do not break even with standard private equity management fees (averaging 1.5 to 2% per year).
The «TEPA» law had established an upfront tax benefit for equity investments in SMEs (50% of the investment, representing an average annual tax credit of 7% over the product’s lifespan), which, like all tax incentives, was entirely captured by the product’s distributors and managers. A less costly solution in the short term—though likely less effective—would be an even lower tax rate on any capital gains realized in five years, reserved for SME funds. The solution recently proposed in a «Terra Nova» memo «[11] seems to us to be the most appropriate: it would involve the State and the regions granting funds specializing in small SMEs an advance of approximately 2% per year on their commitments, in order to balance their business model, with this advance potentially repayable in the event of success, up to a certain proportion of the »carried interest” (the share of capital gains accruing to the management company) from funds that generate surpluses. 20 Terra Nova | State-Guaranteed Loans: Escaping the Emergency Trap [11]
CONCLUSION
We entered the crisis at a time when corporate debt levels were already quite high. Government-guaranteed loans are adding to this debt. No matter how low interest rates may be, companies kept afloat with debt amounting to 20 to 25% of their revenue—on top of their usual debt—become «zombies,» like those that have persistently hampered Japan’s economic recovery. Even for a normally profitable company, with an operating margin of around 10% of its revenue, such a debt burden is unsustainable and cannot be absorbed under favorable conditions in the medium term. A portion of the cash flow generated must be reinvested just to maintain operations. The funds available to repay debt are therefore significantly lower—for example, 5% of revenue. It will therefore take many years during which the company will be unable to invest, grow, meet working capital needs, or pay dividends to shareholders—even assuming that no new shocks threaten its operations. These companies do not need secured debt or cheap debt, but rather equity capital. If traditional investors, in the midst of the crisis, switch to «panic» mode («risk-off») and are unwilling to assume these risks under normal terms, it falls to the public sector to act as a countercyclical investor, using professional methods. The federal budget will benefit from this, since the market premium for risk is currently high and valuations are low. The issuance of government-guaranteed loans (PGE), which makes the government assume the risk of bankruptcy in exchange for a negligible premium, is an emergency measure; but in the medium term, it merely grants a reprieve to existing capital, without helping companies that need equity capital or defending the interests of taxpayers, who will bear the cost of bankruptcies without sharing in the capital gains of companies that weather the crisis. The hope is that the public sector will, to the greatest extent possible, replace state-guaranteed loans with equity investments, and that these investments will be substantial enough—and the state-guaranteed loans limited enough—so that, in the long run, the capital gains from the former will offset the likely losses from the latter.
