The Federal Reserve's Main Street Lending Program is shutting out a significant chunk of U.S. mid-sized companies, excluding some whose pre-coronavirus business models make them appear too indebted.

The program's restrictions have largely excluded companies that rely on asset-based borrowing, a financing method prominent in real estate but also used in a variety of other industries, including retail and manufacturing.

Those firms often borrow based on the value of collateral such as property, inventories, and other assets, but the measures used in asset-based lending do not fit neatly into the Fed's Main Street program. Even if they did qualify for Main Street loans, companies looking to borrow from the program would face a major obstacle: Their existing lenders would be hesitant to dilute any claims they have on the company's collateral if it goes bankrupt.

Those two reasons help explain why the take-up on the Fed's $600 billion business loan program has been limited in its first two months, with only about $1.2 billion in loans made so far.

New Orleans-based HRI Properties LLC is among those left out under the program's current terms. The company renovates historic warehouses and office buildings across the U.S. and turns them into hotels and apartments. It laid off approximately 1,000 employees after the pandemic caused a sharp drop in hotel bookings.

"I think it's a great program, a great attempt, but it doesn't really help industries that have been severely impacted," President and CEO Tom Leonhard said.

'Asset-rich but EBITDA-poor'

Leonhard's company has been unable to take out a five-year Main Street loan due to the current eligibility criteria, which limits the program based on a company's debt when compared to its EBITDA, a measure of pretax earnings. The restrictions ensure borrowers' debt cannot be more than four or six times greater than their 2019 adjusted EBITDA when combined with a Main Street loan, depending on which loan option a company seeks.

Those safeguards are meant to shut out overly indebted companies, given that the Fed is limited in the losses it can absorb and has therefore focused on lending only to creditworthy borrowers. But debt-to-EBITDA measures are not commonly used in the real estate industry, where firms' hefty property loans are paid off with several years' worth of earnings.

Fed officials have said they are looking at ways to better capture the credit risks of asset-based borrowers. Examples of such borrowers might include a manufacturer financing its operations by using machinery as collateral; a clothing retailer borrowing based on its inventory; or a raw goods distributor taking out a revolving loan based on its accounts receivable.

Those borrowers are often "asset-rich but EBITDA poor," said Richard Gumbrecht, CEO of the Secured Finance Network, which represents banks and nonbanks that engage in asset-based lending.

"Finding the right borrowers under the program as it's structured today is a little like threading the needle," Gumbrecht said.

Some asset-based borrowers are indeed too risky to meet the Fed's mandate to lend to healthy companies, according to corporate finance lawyers and advisers. But others are healthy and prefer the flexibility of asset-based loans, including revolving credit lines that can be adjusted up or down throughout the year, said Joseph Heim, a partner at the accounting firm Dopkins & Co.

Usage of those revolvers jumped early in the pandemic, as companies sought to bolster their balance sheets with as much cash as possible. Lenders have also staffed up their asset-based departments this year, given that downturns usually draw more businesses to such financing options.

Lenders cautious

But the jump in private-sector credit options has not flowed everywhere, and the Main Street program has struggled to fill in some of the holes.

Jim Riedman, chairman and CEO of Phoenix Footwear Group Inc., said he "felt as though we were the poster child" for a Main Street loan when he first heard of the program.

The women's shoe manufacturing company — which operates the brands Trotters, SoftWalk and Bueno — saw its sales drop by 60% to 70% as homebound Americans bought fewer shoes. Its existing asset-based lender put Phoenix Footwear's loan on default this year, prompting Riedman to look into the Fed program.

But finding a bank that is willing to make a Main Street loan "has not been easy," Riedman said. Phoenix Footwear meets all the eligibility criteria based off its health in 2019 and its debt-to-EBITDA ratio last year. But banks are looking at current conditions when making loans instead of businesses' 2019 health, so they are reluctant to lend to the industries the pandemic hit hardest, Riedman said.

"That's why loans are not getting done," Riedman said. "They're very careful about this whole thing."

The company has several other loan offers on the table, but their high interest rates make them "much less attractive" than a Main Street loan, Riedman said. They also do not feature a key benefit of the Main Street program: a deferral of interest payments for one year and principal payments for two years.

Fed, Treasury officials looking at alternatives

Fed Chairman Jerome Powell and Treasury Secretary Steven Mnuchin told lawmakers at a June 30 hearing they are discussing potential workarounds, but the agencies have yet to lay out concrete changes.

In an Aug. 21 report, the Congressional Oversight Commission overseeing the program wrote that it "does not underestimate the complexity of the issues" involved.

For example, the report asked the agencies how the fall in commercial property prices would affect appraisals of borrowers' real estate collateral, along with whether the Fed would foreclose on assets if businesses are unable to pay back Main Street loans.

Another consideration is deciding whether changes would benefit private equity firms, hedge funds and real estate investment trusts, the report noted. Gwen Mills, of the UNITE HERE hospitality worker union, worried at an Aug. 7 hearing over a potential "bailout" of those companies, as they often are major investors in commercial real estate. While policymakers could loosen credit terms to boost participation, they would need to pair any changes with "air-tight requirements" to preserve jobs, she said.

Collateral damage

Asset-based borrowers that are able to tap into the Fed program, though, could face some reluctance from their existing lenders.

Those lenders would not be "all that excited" to agree to a borrower tacking on more debt to its totals, said Mindy Planer, an Atlanta-based lawyer at Arnall Golden Gregory LLP.

Lenders would also be hesitant to dilute any of their claims on a company's collateral, which protects them from losses if a company goes bankrupt.

Right now, those lenders are at the top of the priority list during a hypothetical bankruptcy proceeding. But under two of the three Main Street loan options, lenders would need to agree to elevate the Fed to at least an equal footing.

That is intended to prevent Main Street loans "from being subordinated or otherwise disadvantaged" compared to other debt that may otherwise be paid out first, with the exception of mortgage debt, according to the Fed's FAQ on the program.

That safeguard would limit any losses for the Treasury Department, which is backstopping the Fed program. But it also means that fewer Main Street loans will happen under the current structure, lawyers say.

"It's just hard to find that existing lender who's going to agree to subordinate or allow other debt to be out there," said Rebecca Moore, a Louisville, Ky.-based lawyer at the law firm Frost Brown Todd LLC.