Martin Stein was like most private equity investors who expected another strong year of growth in 2020 with the firm he founded, Blackford Capital, where he serves as managing director.
A large part of the Grand Rapids, Michigan-based firm’s investment focus is lower-middle-market manufacturers located throughout the Upper Midwest, which anticipated the momentum of the previous year would continue. Then the coronavirus hit, dealing a serious blow to those projections and threatening large portions of the jobs at its portfolio companies.
“We’ve got a few businesses that are in industries [where jobs] are going to decline by 90%,” Stein says.
What Blackford is facing is not uncommon in the economic aftermath of the coronavirus outbreak. According to the National Center for the Middle Market, more than 80% of midsize companies now say they will face negatively impacted balance sheets in the months ahead, and 25% said the crisis will have a catastrophic effect on business activity.
“The fact of the matter is it’s hard for every business not to be affected in some way,” Stein says.
“THE FACT OF THE MATTER IS IT’S HARD FOR EVERY BUSINESS NOT TO BE AFFECTED IN SOME WAY.”
Founder and Managing Director, Blackford Capital
To prevent the catastrophic effects of the COVID-19 outbreak, the Trump administration signed into law on March 27 the Coronavirus Aid, Relief, and Economic Security Act, known as the CARES Act, which will provide around $2.2 trillion in emergency assistance.
The largest stimulus package in U.S. history, the CARES Act will make hundreds of billions of dollars available to small and midsize businesses to help cover payroll and operational expenses to counter the enervating effects of the coronavirus outbreak through the Paycheck Protection Program, or PPP, which the Small Business Administration will administer through its 7(a) loan program.
These loans have the potential to be forgiven if companies retain their employees, but imprecise language in the law and SBA regulations could mean businesses with private equity backing will find themselves outside qualifying parameters.
In order to qualify for loans as part of the PPP, businesses generally must have fewer than 500 employees. On their own, all of the small businesses in Blackford’s portfolio would be eligible. But because of the SBA’s “affiliation rules,” all employees across a private equity firm’s portfolio are included in a business’s employment tally, placing all of them above the qualifying threshold.
With around 2,100 employees across its holdings, Blackford’s portfolio companies—and those of most PE firms—would not meet this criterion.
According to a recent survey completed by the Association for Corporate Growth of more than 1,000 of its members, 92% said exclusion from PPP will result in layoffs. Around 60% of respondents said they anticipate laying off workers in the next two weeks.
Yet affiliation rules can be waived if the business is currently receiving financial assistance through the SBA’s Small Business Investment Company program, according to the legislation. Half of Blackford’s portfolio companies qualify under this exemption, according to Stein.
Another exemption allows PE-backed businesses that are categorized under the North American Industry Classification System as in accommodation, such as hotels, or food service, which includes restaurants.
“IF HOPING FOR THE BEST IS EVEN STILL POSSIBLE AT THIS POINT, EVERYONE IS PREPARING FOR THE WORST.”
Partner and Co-Chair of Private Equity Practice, Katten Muchin Rosenman
According to Stein, three of Blackford’s investments are projected to experience their highest earnings ever during the coronavirus outbreak and won’t need any federal aid at all. Those businesses are in the medical, food and power transmission industries.
However, the remaining companies aren’t as fortunate. Blackford’s manufacturing businesses suffered badly since the pandemic began, Stein says, and avoiding layoffs without qualifying for CARES relief will be impossible. “They’re just going to have to lose the jobs,” he says.
The hardships caused by the coronavirus could put nearly half of all the employees in Blackford’s portfolio at risk, with many layoffs already occurring.
And guidance handed down from Washington, D.C., doesn’t seem to be clearing up the confusion over affiliation rules. When the guidance from the Treasury came late last week, it was not viewed as creating more opportunity for PE-backed businesses to qualify for the PPP loans, according to Kimberly Smith, a partner and co-chair for law firm Katten Muchin Rosenman’s private equity practice.
“For some PE-owned companies, the funds would be a lifeline and true game changer in terms of the ability to make payroll and avoid cutting employees,” she says. “If hoping for the best is even still possible at this point, everyone is preparing for the worst. And a PPP loan offers a compelling way to do that.”
If there’s continued confusion around 7(a) loans, Neal Kaminsky, a partner and chair of law firm Haynes and Boone’s finance practice group advocates for what are known as B(4) loans, a lending facility created by the CARES Act.
According to the legislation, these loans are provided to companies with between 500 and 10,000 employees. Recipients must use the money to retain at least 90% of their workforce until September, among other requirements.
If the company is owned by private equity, then the firm is prohibited from issuing dividends and distributions during the term of the loan and must restrict pay for portfolio company executives.
The Cannabis Exception
While it may be difficult for some PE-backed companies to receive federal relief, entire industries have been barred from taking part, leaving their investors without much recourse.
“It’s a punitive oversight for the government not to specifically include the cannabis industry in the relief package,” says Matt Hawkins, managing partner for Entourage Effect Capital, a private capital provider that invests exclusively in the cannabis industry.
Because federal law still recognizes cannabis as a Schedule 1 drug, companies struggling from the fallout of the coronavirus outbreak are prevented from using any stimulus dollars.
This is in spite of cannabis being deemed an essential business is most of the states that have legalized its recreational or medicinal use—and employing more people than the coal industry, Hawkins notes.
To make up for the lack of government support during the economic crisis, Entourage is helping its companies stay afloat through capital injections of its own.
Regardless of the federal government’s stance on cannabis, Hawkins says, consumer demand is at an all-time high for the product.
“We’re bullish just like anyone else, but as long as we can keep our doors open, the supply chain is going to be at least semi-healthy. We don’t have the foot traffic that we once had because of the staying at home, but people want their cannabis. We believe it to be somewhat recession-proof because of that,” he says. “We’re going to get through this.”
Despite hardship faced at Blackford, Stein also remains optimistic about the future.
“We have a $350 billion aid package that’s going to go to somewhere between 50,000 and 3 million businesses in the United States,” he says. “That’s an amazing support effort by the federal government. I don’t know if there’s ever been this much money that has been deployed this quickly in U.S. history. It’s unprecedented and well-intended. It’s just not an easy administrative process.”
Benjamin Glick is Middle Market Growth’s associate editor.