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A Fresh Take

Insights on M&A, litigation, and corporate governance in the US.

| 12 minutes read

CARES Act: considerations for financial sponsors

Note: This post has been updated to reflect supplemental programs implemented by the Federal Reserve on April 9, 2020.

The Coronavirus Aid, Relief and Economic Security Act (the CARES Act) was signed into law on March 27, 2020. 

One of the key types of relief offered by the CARES Act is in the form of loans to certain eligible businesses. These loans fall into three main categories:

  1. loans for small businesses (the Paycheck Protection Program (PPP)); 
  2. loans for medium-sized businesses; and 
  3. loans designated specifically for aviation-related businesses and businesses critical to national security.

The CARES Act also includes amendments to US federal tax laws intended to allow corporations to turn tax attributes into cash, including:

  • the ability for net operating losses (NOLs) arising in 2018-20 to be carried back for up to five years (including to tax years where the corporate rate was 35 percent); 
  • allowing 100 percent of taxable income to be offset by NOLs (otherwise limited to 80 percent under the 2018 tax reform legislation); and 
  • increasing the interest expense limitation from 30 percent to 50 percent of adjusted taxable income (largely similar to EBITDA).

In addition, the Federal Reserve on April 9, 2020 introduced supplemental programs creating two new credit facilities – the Main Street New Loan Facility and the Main Street Expanded Loan Facility – to support credit to medium-sized businesses. This program provides for the purchase of up to $600bn of loans provided to medium-sized businesses.

Paycheck Protection Program: affiliation rules a thorn to portfolio companies

The PPP is a temporary new product added to the U.S. Small Business Administration (SBA) loan program that:

  1. authorizes the SBA to temporarily guarantee qualifying loans to eligible businesses;
  2. provides that the full principal amount of such loans may qualify for loan forgiveness; and
  3. relaxes certain otherwise applicable lending criteria for SBA loans. 

The maximum loan amount is the lesser of $10m and 2.5 times the average monthly payroll costs determined in accordance the Small Business Act. Funds from the PPP may be used to cover payroll costs, interest on mortgage or rent payments, utilities and interest on existing debt during a certain period. A detailed summary of the PPP is available here.

Eligibility for loans under the PPP is based primarily on the borrower having 500 or fewer full- and part-time employees or, if greater and applicable, the employee-based size standard established by the SBA for the industry in which the small business operates. 

The SBA has also since the announcement of the PPP issued guidance clarifying that a business will alternatively qualify for a PPP loan if it meets SBA’s revenue-based size standard, if any, for the industry that the small business operates in. 

However, many small companies in the US that would appear to qualify for PPP loans, using the employee-based size standard are at risk of being disqualified due to the SBA’s existing “affiliation” rules. Those rules require a company to aggregate with its own employees the employees of companies that are under common “control” for the purposes of meeting the employee-based size standard of the PPP. 

As a result, portfolio companies “controlled” by private equity sponsors, venture capital funds, private family offices and other investment firms may not be eligible to participate in the program (although certain qualifying businesses in the accommodation and food services sector, in which the size of the employee pool is determined per location, and businesses operating as franchises may be able to avoid the employee aggregation roadblock to accessing PPP funds). Businesses that receive funding from licensed small business investment companies are also exempt from the applicability of the affiliation rules.

Determining whether a business is “controlled” by an institutional investor is, therefore, a critical question for a portfolio company considering applying for a PPP loan. 

The answer is clear for a company with an institutional investor that has affirmative control – e.g. by holding 51 percent or more of its voting securities or controlling the board. It is less clear for companies with a broader investor base where certain institutional investors maintain limited control over their portfolio companies through veto rights, minority board seats and other contractually agreed oversight roles. 

The affiliation rules under the Small Business Act provide that these types of “negative control” rights may also deem a portfolio company under the control of an investor to whom they have been granted. “Negative control” may exist where a minority shareholder “has the ability, under the concern’s charter, by-laws, or shareholders’ agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.” The affiliation rules do not include an express list of the types of rights that would constitute negative control, but the National Venture Capital Association has published a helpful non-exhaustive list of examples of rights that have been found by the SBA to trip the affiliation test in the past. In general, the SBA deems a minority owner that has a right to block day-to-day operational decisions of a business to have “negative control” over the business. A minority investor is not typically deemed by the SBA to have “negative control” over a business only on account of the investor’s ability to block extraordinary matters that go to protecting the value of its investment.

When the PPP was initially announced, the potentially broad disqualifying effect of the affiliate rules on PE and VC portfolio companies did not go unnoticed, and many investors and their investees hoped the SBA would issue guidance relaxing the affiliation rules for the purpose of allowing a greater number of companies to access PPP loans. For many early stage companies, in particular, obtaining institutional investor funding is often both a sign of confidence and a measure of success and it is exactly this subset of companies that would be unable to access PPP loans. The supplemental guidance issued by the SBA thus far, however, has not provided any such relaxation for portfolio companies and instead has re-confirmed that even a minority shareholder with negative control rights may be deemed to “control” a company for purposes of the affiliation test. While this does not necessarily mean that a veto right over a single matter is sufficient for there to be deemed to be “negative control,” typical approval rights sought by sponsors over operational matters could trigger affiliation under this test.

Whether there is a workable solution for portfolio companies with minority investors whose rights would disqualify them from accessing PPP loans remains to be seen. The SBA’s supplemental guidance does clarify that if a minority shareholder “irrevocably waives or relinquishes” the rights that would otherwise constitute control, the company will no longer be considered an affiliate of the investor for the purpose of the employee-based size threshold. The SBA has not clarified what constitutes an “irrevocable” waiver and to date we have not identified any analogous precedent suggesting that it means anything other than “permanent.” Guidance in the market from law firms and advisors appears to be coalescing around that conclusion, although there could certainly be a reasonable basis to conclude that “irrevocable” should apply only to the period prior to the repayment, maturity or forgiveness of the PPP loan. We intend to update this article to reflect any further SBA guidance on this topic.

It is difficult to imagine that institutional investors will as a general matter rush to waive, permanently or otherwise, their negative control rights in minority-owned companies in order to facilitate access by those companies to PPP funds. Investment committee decisions with respect to minority investments are not made lightly in the first place, and the negative control rights institutional investors obtain are often critical to a decision to invest. Analyses of future performance of a portfolio company may depend in part on the level of control an institutional investor can exert. In a market currently defined by uncertainty and fluctuation of valuations, an institutional investor may well prefer, with respect to a company for which the absence of a PPP loan could result in liquidation, to risk liquidation (and collection of its portion of any proceeds therefrom).

Investors that hold minority stakes in companies that might seek to benefit from a PPP loan should consider proactively deliberating how far they would be willing to go to allow the business access to a PPP loan. Portfolio companies that are in need of liquidity have begun reaching out in earnest to minority investors seeking waivers that would allow such companies to obtain a PPP loan and investors will want to be prepared to respond to such requests and avoid overbroad waivers. In particular, investors may want to start thinking about whether they should seek other rights, including economic rights such as down-round protection, anti-dilution or liquidity rights in exchange for a waiver of their veto rights.

Medium-sized businesses

Institutional investors, and private equity firms in particular, might find the CARES Act “Main Street” lending program targeted at medium-sized businesses more relevant to their portfolios. Businesses with up to 10,000 employees or $2.5bn in 2019 annual revenues and with a majority of their employees and significant operations in the US are eligible to participate in this program. While not expressly specified, eligibility under this program is likely to be determined at a portfolio company level and not across portfolios as the SBA’s affiliation rules do not apply to this program.

The terms of the program, however, will make it useful to only certain portfolio companies. Under this program, borrowers may seek either new unsecured term loans up to $25m or term loans that expand existing term loans facilities from existing lenders on a pari passu basis up to $150m. Since it is run by the Federal Reserve, loans supported by the program may be obtained only through insured depository institutions, US bank holding companies and US savings and loan holding companies and therefore, highly levered companies whose lenders are not US banks may effectively be limited to the lower new-money loan program. These maximum loan amounts are also limited by total EBITDA leverage ratios of 4x for new term loans and 6x for expanded term loans, which means that very highly levered companies are shut out of the program. Expanded term loans are further limited to an amount not greater than 30 percent of the portfolio company’s other bank debt. 

Beyond the restrictions on size, the loans also must have a maturity date of four years. Most outstanding debt in the leveraged loan market matures between 2024 and 2026, so many borrowers will find that the program loans mature inside their existing debt and are not permitted to be incurred without a waiver from their existing lenders. 

The pricing of the loans under the program may also be challenging for certain borrowers. The margin is required to be SOFR plus a spread of between 250 and 400 basis points. While the exact amount for an individual borrower is not yet clear, the spread is wide enough that borrowers that currently benefit from low interest rates may be caught by ‘most favored nations’ clauses that will require an increase in the interest rate of their existing debt. A 1 percent upfront fee payable by borrowers to lenders is also required to be calculated into yield, and most existing loans do not use SOFR as a reference rate, adding another layer of complexity to the yield calculations and difficulty in implementing any loan into existing documentation (as well as exposing borrowers to an interest rate index that has previously exhibited marked volatility).

Finally, there are restrictions on the use of proceeds of the loans under both the new and expanded loan options. They may not be used to refinance existing debt, and a borrower must attest that it will not cancel or reduce any existing lines of credit. Loans under the program are also required to be repaid or prepaid in full before borrowers are permitted to repay any other existing debt of equal or lower priority (other than mandatory principal prepayments). Thus, in the case of new unsecured debt, repayments or prepayments of existing secured debt appears to be possible. Of course, the amount available in the form of unsecured new term loans (up to $25m) is significantly less than the amount available under expanded facilities (up to $150m;). 

Sponsors seeking to have their portfolio companies participate in this program should also keep in mind some practical consequences to doing so, as the Main Street loans, unlike the PPP loans, will come with restrictions on day-to-day operations and decision-making, including the following:

  • attestation that the borrower requires financing due to the exigent circumstances presented by the pandemic;
  • reasonable efforts to maintain payroll and employees during the term of the loan (note that this current guidance reflects a slight relaxation of the original CARES Act mandate to retain at least 90 percent of the workforce, at full compensation and benefits, until September 30, 2020);
  • restrictions on dividends, capital distributions and equity repurchase while the loan is outstanding and for the 12 months after it has been repaid; and
  • limits on executive compensation.

Unlike the PPP, these loans will not be forgiven. A detailed summary of this program is available here.

Air carriers and businesses critical to national security

Portfolio companies in the passenger or cargo air carrier businesses or involved in businesses critical to maintaining national security may be able to access loans to be provided directly by the Treasury. 

The terms of loans in these categories will be determined by the Treasury. The government has not specified which companies will be considered critical to maintaining national security. We expect that those businesses that support clear and critical national security functions of the US government (Department of Defense, Department of Homeland Security, Intelligence and the Department of Justice) would be covered. 

Other critical infrastructure functions may also be deemed to be critical to national security—such as certain telecommunications, energy, and financial services functions. We would not be surprised if the government takes an approach similar to the CFIUS regime, which involves a review of foreign investment in the US based on national security concerns, and where “national security” is interpreted broadly. CFIUS has historically swept in a number of sectors, including but not limited to technology, biotechnology, healthcare, pharmaceuticals, real estate, data and even manufacturing. These loans may cause companies and their boards to consider claiming they are critical to national security in order to qualify for aid when they otherwise (and particularly in the CFIUS context) would have advocated the opposite view. Sponsors and their representatives on portfolio company boards considering taking this position should also consider the implications, for example for future CFIUS review of subsequent investments.

The government has also indicated that, in connection with these loans, it will require that the company grant it a non-voting equity ownership stake, most likely in the form of warrants. Sponsors and their representatives on portfolio company boards considering these loans should seriously consider the implications of issuing equity to the US government in exchange for aid. Regardless of the size of any equity investment by the government, a pristine board process will be a priority due to the high profile and extraordinary nature of such a transaction and the risk that it may appear to be a sweetheart deal for the government in hindsight (see, for example, the lawsuits – albeit ultimately unsuccessful and against the government, rather than the issuer – following the 2008-09 financial crisis that were largely premised on the allegation that AIG issued equity to the government at too low a valuation). See our advice to boards considering this category of CARES Act financing here.

Like the Main Street loans, these loans will also come with restrictions, including the following:

  • requirement to maintain employment levels as of March 24, 2020 and not reduce employment levels by more than 10% as of that date;
  • restrictions on dividends, capital distributions and equity repurchase while the loan is outstanding and for the 12 months after it has been repaid; and
  • limits on executive compensation.

Additional details regarding this program can be found here.

Business tax benefits

The CARES Act included several changes to US federal tax law intended to allow corporations to turn tax attributes into cash. These changes may be particularly helpful for portfolio companies that have significant interest expense, recently stepped-up asset basis and/or NOLs. 

First, and of most immediate potential benefit, the CARES Act now allows NOLs arising in 2018-20 to be carried back for up to five years. The IRS has recently published guidance extending the time period in which corporations can file tentative carryback refund claims to accelerate the cash benefit of an NOL carryback (until June 30, 2020 for the 2018 calendar year). Many of the years to which NOLs can be carried back also were years in which the corporate income tax rate was 35 percent. The IRS generally has 90 days to review and pay tentative carryback refund claims (but may subsequently review the claim in audit). 

The CARES Act also allows NOLs to offset 100 percent of taxable income for tax years 2018-20, raising the 80 percent limitation introduced in the 2018 tax reform act. 

Of equal potential benefit to highly levered portfolio companies (but on a longer-term time frame) is a change made by the CARES Act to the interest expense limitation rules. Specifically, for tax years 2019 and 2020, net interest expense of up to 50 percent of their adjusted taxable income (conceptually similar to EBITDA) can be deducted, which is an increase from the previous 30 percent limit. In addition, corporations can elect to use their 2019 adjusted taxable income to determine their 2020 interest limitation. 

Finally, the CARES Act also offers additional relief in the form of:

  • payroll tax credit for businesses suspended due to government orders relating to COVID-19 or that have experienced a significant drop in revenues; 
  • deferral of employer social security taxes (50 percent until December 31, 2021 and the balance until December 31, 2022); and 
  • other tax impacts that might be of interest, details of which are available here.


united states, covid-19, private equity, venture capital