What strings to attach to governments’ equity support?

By Aleksandar Simić and Rens van Tilburg

The European Commission is working on a framework for equity support, the next generation of government support measures for companies. This blog discusses the US experience with equity support for car manufacturers in 2008, the current developments with the airline industry, as well as current different proposals of this nature from the leading think tanks.

The recent IMF predictions of the economic damage done by Covid-19 have buried the last hopes for a V-shaped recovery. The losses incurred by companies will be heavy and the current support measures of loans to companies, next to income support, will not suffice. Companies will need grants and loss-absorbing funding like equity.

The European Commission is working on a framework for this kind of support. The Guardian reported that it examines how governments might support ailing companies by taking equity stakes as part of rescue schemes. The EC proposes several strings attached to this kind of support: companies will be barred from “aggressive commercial expansion”, nor will they be allowed to buy competitors or other operators in their line of business. Executives will be limited to their base salaries. Large companies benefiting from a government stake of more than 20% would be obliged to set out “exit strategies” within six months.

The US airline rescue package

In the US the first rescue packages for the airlines that include equity-like elements have already been agreed. As a part of the $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act of March 27, $25 billion is dedicated to assisting the airline sector. This comes in the shape of grants and low-interest loans with warrants. The inclusion of loans in the package is the result of the negotiations between the Treasury and the industry, that initially required the assistance to consist fully of grants. The recipients of the aid will be the heavyweights of the industry: American, Delta, and Southwest Airlines, as well as numerous minor companies. 

Of the total sum, Southwest will receive $3.2 billion, of which $2.3 billion as a grant and $0.9 billion as a 10-year loan, which includes the warrants for the state to buy 2.6 million of the company’s shares. American Airlines will receive $4.8 billion in loans, in return for warrants for 38 million shares (at $12.51 each, amounting to 3% stake), while Delta will receive $5.4 billion of assistance (of which $1.6 billion in the form of a loan) in return for warrants equivalent to 1% stake at $24.39 per share over five years.

The government put the following conditions on these loans. Firstly, airlines will be forbidden from sending staff on forced leave or cutting employee pay until September 30. Secondly, share repurchases and dividend payment will be banned until September 2021. Lastly, executive compensation will be limited until March 2022. More concretely, this means that executives with total yearly compensation (salary, bonuses, stock options, etc.) higher than $425.000 in 2019 will have their salaries frozen until March 2020. They will also not have a possibility of a severance package larger than twice their yearly compensation in 2019. The executives with total compensation higher than $3 million will not be allowed a higher compensation than $3 million and 50 percent of the excess over $3.000.000 of total compensation from 2019, all until March 2020.

The green support for the US car manufacturers

In 2008 the US auto makers were bailed out through the government’s 700 billion dollar Troubled Asset Relief Program (TARP). Most prominently, it was the General Motors that got bailed-out with more than $50 billion  in total, and Chrysler with $12.5 billion. In return for loans in these companies, and on top of the equity acquired in them, the government received warrants: rights to buy shares of the companies at an agreed price [PDF link] equal to the 15-day average as of December 2, 2008. In total, the government acquired a 61% of common equity stake in General Motors. Similarly, the government acquired a 9.9% equity stake in Chrysler. Several European countries have also provided loans and guarantees to large players [PDF link] in its auto sector, such as Opel, Peugeot, and Renault.

This assistance came with strings attached. President Obama conditioned the bail-out with the requirement that GM enforce more rigorous efficiency standards  and restructure. This conditionality seems to have paid off. As a result, the American auto industry has thrived, with a bustling auto tech community clustered in Detroit right now.

Ford, the third largest US auto maker, was not covered by TARP, but by the separate program by the Department of Energy called Advanced Technology Vehicles Manufacturing (ATVM) Loan Program. The conditionality of this program required Ford to improve on its energy efficiency production. As a result, it started producing more fuel-efficient small cars and hybrid cars. Furthermore, the government funds enabled Ford to create its EcoBoost engines, as well as a new strand of lightweight, more durable aluminium. Lastly, it promised to invest $4.5 billion in electrified vehicles.

Proposals for equity support

Several think tanks have already proposed ways to support companies with loss absorbing capital. For instance, David Wilcox of the Peterson Institute in Washington DC proposed that if loans are not viable or desirable, the first thing to do is to take companies to bankruptcy court. There, companies should be given strict conditions under which they would receive government support. For instance, they could be requested to keep a certain percentage of employees on the payroll with a certain percentage of their previous salary as long as the state has stake in the company. Other criteria could be included, like forbidding bonuses for CEOs and forbidding share-buybacks. Similarly, broader environmental considerations could be taken into account, so energy efficiency conditions (‘green-strings’) could be attached, like in the case of GM. Lastly, an appointee of the state could be established in order to supervise that the interests of the state are respected.

Eric Lonergan and Mark Blyth for the UK think tank IPPR propose a combination of debt-based (refinancing existing credit facilities and offering new credit facilities, both at zero percent interest for six months) and equity positions of up to 30 per cent, at a share price averaging prior 30 days. In return for the loans the government could receive a five year warrant. This would allow it to purchase up to extra 10 per cent of equity in the next five years at the original price. The two conditions established under this model is that all dividends, buybacks and executive bonuses be suspended until the loans are repaid, as well as that the company guarantee that all the employees remain on the payroll.

Lonergan and Blyth propose that the government does not re-sell its stake in the private companies it assisted. Instead, it should, they claim, keep them as a base for funding a National Wealth Fund. This would, according to them, enable the states to become true stakeholders in large companies, and enforce Environmental Social and Governance standards in them all the time, and not only in the crisis situations. Furthermore, it could give more stake in the economy to the groups that are marginalized and otherwise economically excluded.

A sovereign wealth fund is also where a group of European academics arrive at in their paper for the German institute SAFE. They propose a European Pandemic Equity Fund (EPEF). A ‘pan-European sovereign wealth fund’, where all European citizens could reap benefits and share risks from state equity financing. They differ with the proposals discussed so far in that no strings are attached to the assistance. For large corporations equity takes the form of non-voting stocks.

Their ideas are especially interesting as they also make it possible for smaller companies to be supported. As these companies usually do not have access to capital markets, or their owners are weary of ownership dilution, any kind of equity scheme is difficult to reach them.

This can be done with an instrument that carries no direct repayment obligation. Although they are not outright transfers either as future profits are also shared by the EPEF, with repayments to the fund being conditional on positive firm performance.

Authors also propose that these firms could be invested in by EPEF, and reached by through the channels such as development banks or tax authorities. In exchange, these companies would then pay extra taxes after the crisis on their profits, if any, so that EPEF would get a return on its investment.

Attach strings

Now that we leave hopes for a V-shaped recession behind us, and prepare for a U-or even L-shaped one, it is clear that loans will not suffice as instruments of support for companies. Equity support in the previous crisis at times paid off. For instance, the Dutch government earned almost 5 billion euro from its assistance to the ING. Similarly, the US Treasury gained 8.4 billion dollars on TARP. The Fed and Federal Deposit Insurance Corp. (FDIC) have also turned a profit from their operations.

Whether that will be possible in this crisis is questionable. The economic impact seems to be even higher. However, what is clear is that without equity support also healthy firms will fall apart. 

The challenge is to decide which sectors and firms to support and what strings to attach to the support. Whereas for small firms a no-strings-attached approach seems the most feasible, for the larger ones we see that conditions have been included in 2008 and most proposals now include them as well. These measures range from keeping capital in the company and preventing the supported company to take over other companies, to social and environmental demands. In the US these conditional measures paid off in the case of car companies in the last financial crisis. It seems like a missed opportunity that no green strings have been attached to the aid for the airlines in this crisis as well.