The Federal Reserve last week put forward two credit facilities that will enable nearly $600 billion in loans to flow to small and medium-sized businesses under the Main Street Lending Program. But a number of rules that cap maximum leverage for firms that borrow under the program will bar large numbers of leveraged loan issuers from participating, an LCD review has found.

Together with a $75 billion equity investment from the Department of the Treasury, the Federal Reserve is committing up to $600 billion through the Main Street New Loan and Main Street Existing Loan Facilities. Under the new loan facility, a borrower can take a maximum of $25 million, and under the extension facility, an existing borrower can take a maximum of $150 million.

However, the new loan facility stipulates a borrower cannot take out any amount that would raise its debt/EBITDA ratio above 4:1, taken in combination with outstanding and committed but undrawn debt.

The same rules apply for the existing loan facility, which is targeted at existing loan issuers looking to upsize their deals, except the new debt/EBITDA ratio cannot be above 6:1.

These caveats on leverage will effectively cap many existing leveraged loan issuers from participating in either of the Main Street programs, based on a review of LCD data.

For example, the average pro forma debt/EBITDA ratio of 2019 M&A-related deals measured 5.9x as of year-end 2019, up slightly from 5.8x at year-end 2018. With synergies, the average leverage declined slightly, to 5.5x from 5.6x, but synergies and add-backs will not be taken into account for the terms of the Main Street programs.

Some 51% of M&A loans from 2019 had a pro forma debt/EBITDA ratio of 6x or higher, based on unadjusted numbers, while the share of M&A transactions levered at 7x or higher increased to 24%, based on unadjusted EBITDA.

Additionally, these EBITDA figures measure total debt on the issuer's balance sheet when the loan closes. Typically, that does not include revolving lines of credit that are usually undrawn at closing, which the Fed will include as part of the debt/EBITDA ratio measurement, likely pushing the ratio higher.

"From a borrower's perspective, there are a number of challenges in the way the program has been structured that makes it difficult for a typical American corporate to access it, especially in terms of leverage and how that is determined," said Sartaj Gill, finance partner at Davis Polk. "My sense is that many of the companies meant to benefit from the program are out of the box based on current program parameters."

Other terms of the program

While regulated banks will make the eligible loans, they will only retain a 5% share in them, selling the remaining 95% to the Fed's Main Street facility. Only depository institutions, bank holding companies, and savings and loan banks are designated as eligible lenders, meaning direct lenders would not be able to participate.

The unsecured loans under the programs will carry a four-year tenor, and despite the program's title, the loans are not designed exclusively for small companies. The terms allow for borrowers to have up to 10,000 employees and a maximum of $2.5 billion in 2019 annual revenues.

Based on 2019 M&A deals, an estimated 80% of leveraged loan issuers would qualify on the revenue basis alone, but a much smaller percentage may ultimately qualify for Main Street liquidity because of leverage requirements.

"The eligibility criteria are broad, so the program should pick up much of corporate America," said Gill of Davis Polk. "But when you get in the details, you realize unless you have met the myriad requirements for taking out a new loan, it is unlikely that many firms can access the facility."

The exclusion of some leveraged firms from the program is consistent with other concerns that private-equity-backed businesses will not receive public aid for the ongoing economic crisis. Recent news reports have highlighted how the private equity industry continues to lobby the U.S. government to amend the Coronavirus Aid Relief and Economic Security Act after it emerged that many portfolio companies will be unable to access the act's small-business Paycheck Protection Program.

Still, others comment that there ought to be a limit to government support of the economy, especially when highly levered investments are considered.

"Markets work best when participants have a healthy fear of loss," wrote Howard Marks, co-founder of Oaktree Capital Management, in an April 14 memo to clients. "It shouldn't be the role of the Fed or the government to eradicate it. Some people argue these days that there's no way those who took on leverage that turned out to be excessive could have been expected to anticipate a pandemic and the resultant damage to the economy. But unlikely (and even unforeseeable) things happen from time to time, and investors and businesspeople have to allow for that possibility and expect to bear the consequences."

The Federal Reserve is accepting comments on the Main Street Lending facility and other COVID-19 linked programs until April 16.

This analysis was written by Alexander Saeedy, who covers CLOs and leveraged finance for LCD.