SMEs need time for transition

Covid-19 has changed the world and the full effects on the UK economy are yet to be seen. The Government (HMG) has provided substantial support but the response from business and enterprise is still in its early stages. SMEs are the largest employers and the backbone of the economy and society. 1.2m smaller SMEs have benefited from ￡35bn of Bounce Back loans (BBLs) and 59,500 medium-sized SMEs have benefited from ￡13bn of Covid Business Interruption Loans (CBILs): source the British Business Bank.

The combination of schemes has been impressive but they are starting to wind-down and are scheduled to end in October. The horizon looks bleak for many as furloughing ends and loans, rents, business rates and taxes become due. All at a time when the economy is in recession and unemployment is soaring.

HMG needs to tailor its support for the economy and the stagnation caused by overleveraged balance sheets. They need to create time for the economy to transition from a pre-Covid world to a world that lives with pandemic risk. Some businesses will thrive, some need assistance, but others will not make it. Owners and their employees need time to manage this transition.

TheCityUK recently published a report with a detailed analysis of the impending problems. The report recommends a new framework for dealing with HMG’s Business Interruption Loan (BIL) exposure. In summary, they propose to set up a new government entity called the UK Recovery Corporation (RC) to take over the exposures and work them out.

This will be achieved by converting BBLs and CBILs up to ￡250,000 into a means tested tax obligation under a Business Repayment Plan (BRP). The remaining CBILs will be converted to preference shares (up to ￡1m) and subordinated loans (above ￡1m) called Business Recovery Capital (BRC). The BRP will be managed by the RC and administered through HMRC. If necessary, this obligation would remain in place in perpetuity until the obligation was repaid or the business closed.

HMRC would undergo an infrastructure assessment to determine what new technological enhancements were required to ensure it had the operational capability. They are no doubt concerned that large scale technological enhancements or innovations which have a tendency to go wrong e.g. TSB and HMG’S track and trace app.

Interestingly, the report claims the subordinated debt and preference shares “should be accounted for in a manner that does not create a new debt obligation and therefore businesses will be able to improve their balance sheets”. Creative accounting may be used by some big businesses but they are not appropriate for SMEs. It would be surprising if future investors, suppliers or credit rating agencies will ignore these obligations when assessing the risk of a SME.

A simpler solution would be to allow the banks and the entrepreneurs to manage the process with support from private debt funds. Trust the transition to the market. Debt funds have the skills but are still evolving and need to build resource. The banks already have the skill sets, infrastructure and decades of experience in doing this. Leaving the loans with the banks also addresses concerns regarding the administration of transferring the loans, KYC requirements and valuations.

HMG is already present in the SME market through its ownership of NatWest, the British Business Bank (BBB), British Patient Capital, Innovate UK, Big Society Capital, UK Government Investments and Local Enterprise Partnerships. TheCityUK recommended body, RC, will move quickly from being ‘Virtual/Hybrid’ to a ‘Full Stack’ all service provider. However, another government body is not required.

What is needed is: firstly, time to transition; secondly, the right incentives; thirdly, increased support for existing routes to market; and fourthly, access to real equity to reduce debt. The best people to understand whether they can repay the BILs are the entrepreneurs and lenders. The best people to understand whether they need equity or subordinated debt to repay the BILs are the entrepreneurs and their investors. The best people to understand whether their businesses are no longer viable in a post-Covid world are the entrepreneurs and their teams. The entrepreneurs should be trusted to work with their colleagues and capital providers to optimise outcomes – the ‘invisible hand’ of the market.

Firstly, time. HMG can provide time by extending the BIL schemes. The additional time will enable banks, funds and entrepreneurs to provide tailored solutions to SMEs’ funding requirements. This has the additional benefit of supporting good quality businesses that have survived with their own resources but now need support. It avoids the moral hazard in providing incentives only to those who have borrowed and provides a buffer when ending other schemes. At the same time, HMG should extend the Corporate Insolvency and Governance Act beyond September 2020. This will give company directors more breathing space before they are required to file for administration or insolvency.

Secondly, the market is the best source of information to allocate resources. A simple incentive programme should be put in place e.g. loans which are 80% repaid within 3 years and those 90% repaid in 4 years will have the balance cancelled (funded by HMG). This will leave the balance that have not yet gone into administration or insolvency that need to be dealt with (see below). At an affordable cost, HMG will see its exposure reduce significantly and provide liquidity for extending the scheme.

Thirdly, the report points to the ￡35bn of capital raised by private debt funds which could be used. But over 95% of this is to be deployed to the mid-market and specifically not to SMEs as defined by the Department for Business, Energy & Industrial Strategy. For example, Ares are raising a €9bn European credit fund but little will go to SMEs. The average loan size will be nearer ￡100m than ￡1m.

If HMG wanted to speed up the provision of debt by private debt funds then they should also provide working capital to build resource and regional networks. Following the consolidation and increased regulation of the banking industry, there is now a shortage of lenders, not just capital. The alternative lenders should be backed further by the BBB.

Whilst the UK seems set on leaving the EU, the Government should maintain its shareholding in the European Investment Bank (EIB), and benefit from the European Investment Fund (EIF). The EIF probably does more to facilitate the provision of equity to UK SMEs through private sector managers than any other institution. They have the resource, culture, networks and processes in place but are all on hold pending the withdrawal negotiation. A simple announcement that the UK intends to keep its EIB stake would immediately release significant funds to UK SMEs.

Fourthly, many SMEs are simply overleveraged and need to reduce debt. Even good quality businesses that are preparing for a post-Covid world will have too much debt. They will need to convert part or all of their debt to equity. Borrowers may take this option early to benefit from the incentives proposed above, or after the market has completed its information gathering. TheCityUK report seems to prefer converting debt into subordinated debt. This will be the wrong solution for the vast majority of SMEs. Many businesses need true equity and not subordinated loans or prefs.

Equity providers come in many forms: staff (e.g. Employee Ownership Trusts), friends and family, business angels, funds and institutions. Equity can bring advantages of networks, corporate governance, financial reporting, and balance sheet restructuring knowhow, all of which will add value to the SME, more than just the capital. Entrepreneurs and their corporate finance advisers will know best their equity requirements and the cost they are willing to pay. To encourage more equity into the SME space, they should also reduce tax on capital gains and dividends. As Charlie Munger said, “Show me the incentive and I’ll show you the outcome”. By reducing tax on equity, the supply of equity will increase.

SMEs need time to breathe, adjust their business models and prepare for a Covid and post-Covid world. The resources of businesses that won’t survive need to be reallocated. Entrepreneurs need time and options to manage their balance sheets so they are aligned with their markets and business plans. HMG has the ability to create time through extending the BILs and change laws to incentivise equity.

The usual corporatist response is to encourage HMG to set up a body to buck the market. Setting up a new government entity to administer 100,000s of loans would be unnecessary, disruptive and costly. The infrastructure is already in place to support enterprise. Banks already have the systems, relationships and experience to manage these loans. The private debt funds can assist with the restructuring of balance sheets that require tailored solutions. HMG should create time for this transition and ensure a resilient recovery.