DC Discusses: The long-term impact of short-term government funding in Europe, US and India

Employee protection

Most European governments’ pandemic responses were to – initially - protect employees of businesses likely to be affected by the lockdown. This was rolled out in the form of subsidies where governments provided between 60% to 85% coverage of employee salaries. But now, the impact of these initiatives is coming to light.

In Spain, for example, Temporary Redundancy Agreements (ERTEs) have helped companies mitigate the impact of the lockdown, with the Social Security systems providing a 70% coverage of employees’ salaries up to September 2020. Equally, in the UK a furlough scheme was offered to businesses enabling them to have up to 80% of their employees’ salaries paid up to £2,500 a month until 31 October 2020.

We believe these schemes hoped to provide significant immediate cost cutting to companies and also access to immediate state-backed liquidity – helping to stabilise the economy long term and keep businesses afloat.
State-backed loans

Like most countries, France and Germany offered state-backed loans to help businesses affected by the global pandemic in the hope of stimulating their economy and mitigating the short-term economic damage of the pandemic. In France, this was in the form of a PGE (state-guaranteed loans) totalling €300bn, with an amortizing period of six years, and in Germany, the government is providing those threatened with bankruptcy with direct payments of up to €15,000 that are yet to be required to payback.

In doing so, we believe these governments have - initially - avoided outright bankruptcies and the potential ‘chain effect’ of the pandemic, on a large scale. This has given many businesses, including those owned by the French private equity communities (who have also benefited from government funding), time to agree necessary strategy changes for the coming year, in the hope of further protecting their businesses or portfolio companies.

Similarly, the Spanish government also put in place schemes to help companies with liquidity issues in the short-term. Many Spanish companies have been able to access the Instituto de Crédito Oficial (Official Credit Institute or ICO) funding, a €100bn programme in which loans have a 70% government guarantee. The loans have been provided by banks to those businesses who could prove they were not experiencing issues prior to the pandemic, similar to the eligibility criteria of Germany and France.

In terms of quantum, there is a limitation where businesses were only able to access 25% of their revenue or two times their total yearly salary. We believe those who already had long-standing, positive relationships with banks were able to access the funding easier and faster than businesses who were having to forge new relationships.

However in Germany, any business which was seen as over-leveraged (which is not unusual for PE-backed businesses) was unable to access the aid and had to find liquidity elsewhere. These restrictions meant many private equity-backed businesses have been unable to access the funding. Likewise, in the UK, many less sophisticated SMEs and PE-backed businesses were unable to access the capital. It is therefore not surprising that we have seen an uptick in refinancings in Germany - a trend we expect to continue in the next two to three years as the Kfw loans are due for repayment and businesses continue to search for ways to bridge the liquidity gap.

Conversely, like France, Italy, who also have a state-backed loan scheme in place for all business (PE-backed or otherwise), the duration of the guaranteed loans is up to six years, so a source of financing for businesses in the medium term. However, given the proceeds are used to cover immediate liquidity shortfalls, and cannot be used to refinance any indebtedness, they will likely need to be re-assessed in the coming years, together with a company’s overall capital structure.

Ultimately, though many of the loan pay-backs will be reduced over the next six years, numerous other liquidity support measures will end in 2021, which should result in slower economic growth and the potential for a recession. Equally, there is inevitably going to be an increase in restructurings in the coming months for the sectors that have been most affected, such as travel, retail and aerospace. That said, with the loan costs relatively low in France, it is unlikely that there will be an increase in refinancings, as predicted in Germany. Those who are able to access the loans will likely have a long road for repayment and will have to lengthen investment horizons, resulting in a long term impact on return .

Tax reliefs - a focus on local

Unlike Europe and the US, the Indian government did not roll out significant government funding schemes for businesses. Instead, opting for financial stimulations and job saving initiatives, the government used the pandemic-induced opportunity to encourage growth in the agriculture space. By bringing in several fundamental regulations relating to procurement and storage of agricultural products, and relaxing regulations around the supply chain significantly, the government’s aim has been to enhance investments across the industry’s value chain.

Separately, as part of the Indian support packages, and to encourage local capital and economic growth, tax incentives for local manufacturing have also been enacted. Preferential issue guidelines for listed companies have been instilled to allow the securities regulator to relax, making fundraising from public market investors and private equity investors much easier for companies in sectors heavily impacted by the pandemic, such as retail and automotive.

These regulations have been further relaxed for ‘stressed’ companies. In addition, a six-month moratorium on interest and debt repayment was also announced - however, this moratorium ended on August 31. The Indian Central bank has also permitted banks to restructure loans of pandemic impacted companies. While this is intended to provide some liquidity support, we expect an increase in equity capital raises to reinforce balance sheets.

Similarly, French tax authorities offered to postpone payments of up to six to twelve months on various taxes and social security expenses. Again, with the view of protecting businesses from immediate liquidity issues in the hope of them remaining afloat through the lockdown period.

Debt absorption – US and its ‘Fallen Angels’

By comparison, in the US, America’s Federal Reserve announced multiple initiatives of unprecedented scale to stabilize the economy and capital markets. Federal action included capital investment in almost all aspects of the capital markets, including - among others:

purchasing trillions of U.S treasuries, mortgage-backed securities, and even corporate debt.
The buying of corporate debt is a new strategy from the Fed, who had historically left corporate debt untouched, even in the depths of the great recession. Notably, this buyback program included downgraded investment grade issuers, commonly referred to as ‘Fallen Angels’

For the US, the immediate impact of these investments has been dramatic. Today, average debt yields are around pre-pandemic levels with record volumes in the high yield market over the summer. Many corporate issuers, both public and private, have been able to access the capital markets again to manage their balance sheets and bolster liquidity.

However, companies that were stressed prior to the pandemic, continue to struggle. While federal action may have pushed out the day of reckoning for many companies and their creditors, the long-term effects of the pandemic on the U.S economy are largely yet to be seen.

Corporate leverage has ballooned, and demand may not recover enough to sustainably support these inflated capital structures. Additionally, we believe sector operators, economists and private equity investors could be concerned that the Fed has overextended itself resulting in a ‘corporate debt bubble’ while simultaneously reducing the Fed’s firepower to respond to a potential second liquidity crunch.

Though deal flow has slowed in the last few months when compared to the same period last year , there are still deals to be had in strategic sectors such as B2B software, healthcare and e-commerce. For example, venture capital investment has slowed, however the average investment size has remained near the same as the same period last year – showing that where there are opportunities, private equity investors are still willing to put money to work.

Private Equity – what do government policies mean for M&A

Private equity has been a focus of conversations on funding in almost all countries. Seen as being able to ‘fund themselves’, or too high risk if assets appear over-leveraged, PE-backed businesses have been separated from wider economic policies throughout the pandemic.

For those governments who have excluded businesses deemed as over-leveraged or having liquidity-rich parent companies, there will likely be an influx in refinancings in the near future. More broadly, multiples and valuations are expected to slow and the sectors that have been significantly affected by the pandemic (such as aerospace, retail and travel) are likely to see hard restructurings in the coming months.

However, we believe that there could be opportunities for organisations looking for alternative financing options to traditional bank lending. Private equity partnerships could therefore be appealing as companies look to navigate the medium-term recovery period – driving deal flow in the coming year.

Conclusion

Though each country has approached the issue of funding and economic stability differently, the long term goals are clear – keep as many businesses afloat as possible to mitigate the long-term liquidity risk that the global pandemic has presented. While many have successfully plugged the short-term gap, in the next two to three years we believe that there is going to be a series of refinancing and restructuring opportunities across almost all industries. With the global economy over-leveraged from large loan pay-outs, there will also likely be slowed economic expansion.

For businesses that were able to access funding or had policies that buoyed up their revenue, it could be years before they return to pre-Covid levels.

For private equity investors, the next few years are likely to be difficult but still fruitful when the right businesses are found in sectors that are already being seen to bounce back from any pandemic induced dip, such as: IT Services; Healthcare; and Technology & Software.

References

[1] How the UK furlough scheme compares with other countries, The Guardian, May 2020

[2] Covid-19 employment measures Spain, Osborne Clarke, March 2020

[3] Changes to the coronavirus job retention scheme, Gov.UK, July 2020

[4] Dispositif de chomage partiel, Ministrie de l'Economie, 2020

[5] Covid-19: German government financial assistance measures, April 2020

[6] Spain unveils unprecedented 200 billion coronavirus package, Euractiv, March 2020

[7] Spains new guarantee lines to foster financings in the context of Covid-19, Ashurst, June 2020

[8] Italian economic incentives for companies in connection with Covid-19, ICLG, April 2020

[9] Covid-19 so far state sponsored help for European companies, Debevoise, August 2020

[10] Indian agriculture during and after the pandemic, Microsave, July 2020

[11] Coronavirus modi transfers rs 17000 crore to over 8 crore farmers sets up agriculture fund, Scroll In, August 2020