No major relief expected for portfolio companies

Help from the federal government during the growing economic crisis is not expected to do much for the portfolio companies of private equity and venture capital firms, which are already starting to decide which ones might survive.

Institutional investors are worried, too. An April survey by placement agency Eaton Partners found that 59% of alternative investment investors are concerned that many private equity-backed companies may not be eligible for federally backed COVID-19 assistance, and 69% are only "somewhat confident" of the government's ability to navigate the economic impact.

Global institutional investors are committing a lot of capital to private equity. In the first quarter alone, private equity funds raised a combined $133 billion in 267 funds, up from $118.6 billion in 366 funds in the year-earlier quarter, according to London-based alternative investment research firm Preqin.

Fundraising added to private equity dry powder that totaled $1.4 trillion as of Dec. 31, according to McKinsey & Co.'s 2020 global private markets review.

Over the 10 years ended Dec. 31, alternative investment firm assets under management grew by 170% to $6.5 trillion, the McKinsey & Co. report shows. In just one year, private equity AUM grew 12.2% to $3.9 trillion.

"Venture capital firms are working hard to figure out what they can do, the impact of the crisis on their portfolio companies and how to survive a likely period of less capital in the startup ecosystem," said Justin Field, Washington-based senior vice president of government affairs for the National Venture Capital Association. "There's a chance it could be a rough time, especially if it is a longer recession."

Amid that uncertainty, some businesses could find a bit of breathing room from a new $349 billion Small Business Administration loan program included in the latest $2.2 economic stimulus package, the CARES Act. The Paycheck Protection Program offers loans with 1% interest rates that are forgivable if a borrower directly affected by the crisis retains a certain number of employees. PPP loans are limited to payroll and fixed costs like rent and utilities.

Companies have been frustrated by an application logjam and reluctance on the part of some SBA-backed lenders to deal with new customers. It doesn't help that the PPP ran out of money in mid-April, while another $250 billion being negotiated by Congress and the White House is also expected to go quickly.

The problem for many portfolio companies is that few will qualify. SBA guidelines limit aid to companies with fewer than 500 workers and count all workers affiliated with the companies. Affiliation standards are waived for small businesses in the hotel and food services industries or already involved with SBA programs, but other applicants are subject to four control-based affiliation tests that look at ownership and other control rights common in venture capital and private equity financing arrangements.

Edward Zimmerman, a New York-based partner with Lowenstein Sandler LLP and chairman of its technology group, believes that some venture-backed startups and growth companies have a shot if the manager holds less than 50% of the startup's equity and does not control a majority of its board or have other significant control rights. Despite a lack of clarity and some bad press, "people are getting approved" and Mr. Zimmerman expects many more to apply. "For some, the (SBA) loans are the difference between staying in business" or not, he said.

It is a tougher situation for smaller private equity firms, whose portfolio companies are already laying off workers, and fear losing those skilled workers, said Thomas Bohn, president and CEO of the Association for Corporate Growth in Chicago, which represents middle-market private equity firms invested in 200,000 companies. A quick member survey found that 62% expect to be shut out of the small-business relief effort, leaving few options beside laying off as many as 5 million workers.

Advocates for making the program more workable for portfolio companies are pushing to have the affiliation rules relaxed, especially for smaller firms that "do not have an endless well of money," Mr. Bohn said. "The majority of private equity is in smaller companies. Private equity creates a lot of jobs. To simply say 'no' makes no sense. People's jobs are on the line."

Mr. Field of NVCA credits SBA for letting lenders allow borrowers to self-certify that they do not trigger the affiliation issue instead of sifting through reams of documentation. Now, "the program is messy but may work," Mr. Field said. While "the uncertainty is huge ... the portfolio companies that can get into the PPP can hold their workforce together longer while we see just how deep and long of a recession the COVID-19 crisis will create."

Private equity firms of all sizes are already choosing winners and losers among their portfolio companies.

"As in other crises, many (private equity) managers don't have enough capital or resources to support all of their investments," said David Fann, New York-based vice chairman of alternative investment consultant Aksia LLC. "We expect that PE managers will be deploying capital in their highest-conviction portfolio companies and walking away from those that are marginal. We expect that COVID-19 will damage most PE funds in some way."

Even when the world is not in a recession, there's a gap between portfolio company needs and venture capital dry powder, according to the NVCA 2020 Yearbook. In 2019, $133 billion was invested in U.S. venture capital deals, but domestic venture capital firms had only $121 billion in dry powder, according to the yearbook, which is based on PitchBook data.

Even House Financial Services Chairwoman Maxine Waters, D-Calif., a frequent critic of private equity, supports relaxing the affiliation rules. But she's also pushing for more strings to be attached, including maintaining or raising pay and benefits and adding workers to corporate boards.

Lobbyists for private funds are also working with government officials to make another CARES Act provision, the $600 billion Main Street Lending Program, available to portfolio companies by offering alternative eligibility tests. The program offers four-year loans to companies with up to 10,000 workers or revenues of less than $2.5 billion that were in good financial standing before the crisis and will commit to making reasonable efforts to keep workers in exchange for deferring principal and interest for one year. Banks retain a 5% share of the loan and sell the rest to the Federal Reserve under the program, which is still being finalized.

Some portfolio companies may also benefit from the CARES Act's new employee retention tax credit or higher interest deductibility allowances. Not all portfolio companies or their investors will have the appetite for these hastily built types of government assistance and the bureaucracy involved.

Still, Washington groups like the Institutional Limited Partners Association, the private equity advocacy organization American Investment Council, and the U.S. Chamber of Commerce remain hopeful. "There shouldn't be a prohibition just because it is private equity," said Jason Mulvihill, AIC's chief operating officer and general counsel.

Some members of Congress are sympathetic to offering relief to private equity investors as further stimulus packages and programs are created, said Kevin Neubauer, a partner with law firm Seward & Kissel LLP in New York. "The big question will be what is provided for in any PPP 2.0. People are hopeful for 2.0 to be more beneficial," he said.

The market may wind up policing who deserves the assistance. Concern that some private equity and hedge funds are considering applying for PPP loans for their own accounts led Aksia to warn off managers not significantly affected by the COVID-19 crisis. A manager with locked-up capital and management fees exceeding salary and running costs "is opportunistically taking advantage of the PPP and its loan forgiveness. Aksia will be looking for that in our due diligence process and viewing that negatively," it said.