Doing Business – and Doing Deals – in the PPP Era
PPP Change of Control Restrictions Add a Wrinkle
At this point, many of the first-order effects of COVID-19 on private equity are well known. The pandemic has disrupted portfolio company business models and increased the complexity of new-deal logistics. Unfortunately, some political responses to the crisis, including the CARES Act, have introduced additional complexities. While many PE-backed firms were not eligible for pandemic-related government aid, other businesses that availed themselves of the assistance are coming to market as potential acquisition targets for private equity. Amid a growing pipeline of sell-side situations involving businesses that have received relief from Washington, deal professionals are learning real-time about the mandates and restrictions of the Payroll Protection Program.
Generally speaking, companies that sought PPP assistance were required to apply to an SBA-authorized lender to secure a loan and be eligible for certain beneficial provisions, including potential cancellation of some portion – or all – of the obligation. They had to make good faith certifications about their business and economic need and the use of proceeds, among others. To receive loan forgiveness, PPP recipients needed to submit an application with supporting documentation to the lender, which has up to 60 days to review it. Assuming the application is complete, it is then forwarded to the SBA, which has up to 90 days to approve it. Handing in a forgiveness application is not necessarily the final step in the process of reducing what was owed, however. Mistakes in processing or modification requests could leave the application in limbo for some time.
M&A in the PPP-Era
In the context of M&A activity, PPP borrowers are required to obtain consent from their lender or the SBA, depending on the circumstances, in the event of a sale or transfer of assets or a change in ownership. If consent is granted, there are further conditions. In cases where a PPP loan remains outstanding following an M&A transaction, obligations pertaining to the original agreement continue in force. These include mandates that loan proceeds only be used for permitted purposes, loans for $2 million or more are subject to audits over a six-year period, and lender or SBA consent was required for certain corporate actions.
These restrictions have introduced additional complexity in the diligence and negotiation of a potential transaction where the target business has an outstanding PPP loan. In most instances, PPP-specific due diligence must be conducted by the acquiring PE firm as well as the lender(s) providing financing for the deal. This diligence is made more difficult by the fact that certain questions have not yet been fully addressed. For example, how will these standards apply to transactions that involve insolvent or liquidity-challenged PPP beneficiaries? In certain of these instances, prospects for a viable deal could be undermined by SBA-mandated escrow provisions.
In addition, while a PPP loan is ostensibly an unsecured obligation, the SBA guarantee and the high-profile nature of the program have potentially made the financial, legal and reputational risks associated with consummating a deal more consequential than might otherwise be the case. For instance, should it be determined at some point that a target’s original loan application or documentation contained false or misleading information, the borrower could be subject to criminal or civil penalties – even if the loan had been paid off. Some lawyers have suggested that fraud could even lead to a piercing of the corporate veil.
Concern Among Lenders
While most of the risk resides with PPP borrowers, there is also a concern among lenders, whether real or imagined, that the SBA might refuse to honor its guarantee if a PPP lender errs in authorizing transactions that are below change-of-control thresholds requiring SBA consent. This somewhat amorphous concern has led to a heightened level of lender scrutiny across the board, introducing delays to the consent process.
On October 2, 2020, the SBA issued a Procedural Notice aimed at addressing uncertainties associated with the program’s change-of-ownership and asset-sale provisions. The guidance established terms under which transactions could proceed, including relevant thresholds, loan-payoff requirements, and SBA loan forgiveness and reimbursement processes, among others. While this helped clarify some issues, it did not alleviate burdens specific to the program, including the presumed de facto seniority of PPP debt and the fact that loan proceeds must continue to be used in accordance with the original agreement.
What’s Next?
Going forward, odds are that we will continue to encounter these and other issues, as it is likely that companies that received PPP loans during the program’s initial round – as well as others that have been hurt by the crisis – will also secure financing in the second round, which was authorized by the $900 billion COVID-19 stimulus bill enacted in late-2020. While many of the program’s provisions remain the same, there are some differences, including lower maximum-loan and employee-headcount limits, as well as a provision limiting eligibility to companies that had seen a 25% quarterly revenue decline during the period. The measure also expanded the types of expenses that could be funded with PPP loan proceeds, allowing for easier forgiveness.
There is little doubt that PPP has been a critical lifeline to many firms impacted by the pandemic. The fact that more than five million businesses received PPP loans during the initial phase and that more will join the ranks in round two – and subsequent rounds, if media reports are accurate – means that familiarity with the program’s change-of-control procedures will be increasingly important when it comes to the M&A space. To date, the market has not really been tested at scale for deals involving PPP loan recipients, so the specifics of “PPP diligence” have not been fully developed by PE buyers or the lenders that finance such transactions.
The issue of how sponsors and lenders underwrite and accommodate a post-pandemic recovery in businesses that have received PPP assistance will become a major consideration in 2021. Aside from accounting for the demands of certain players — the SBA and PPP lenders, in particular — all sides will need to allow for PPP-specific due diligence and the potential resulting delays. Over time, the SBA will likely issue additional procedural clarifications and the M&A ecosystem will develop precedents that guide subsequent deal-making. Meanwhile, we will all be forced to contend with a heightened measure of uncertainty.