A budget idea for Minister Flaherty

The interconnection between politics and business is as tight as I can recall, with every sector of the economy trying to determine what the federal and provincial governments can do to help in these difficult economic times. I have an idea to add to the mix, and it has the benefit of:

– being immediate;
– helping every corner of the small-and-medium business (SME) sector of the economy; and
– involves the private sector making decisions about capital allocation.

For lack of a better title, let’s call it the Credit Enhancement Program.

Here’s the problem. Representatives of the Canadian Bankers Association (the “CBA”) claim they are doing what they can to help “credit worthy” clients. A subjective description if there ever was one, but that’s their right as banks are owned by their shareholders, after all. Not the government.

Yet, during his budget consultations, our Finance Minister has heard in no uncertain terms that credit worthy Canadian businesses are unable to raise sufficient debt capital. There appears to be an obvious disconnect between what Minister Flaherty is hearing from the CBA and what he has seen in the marketplace. CBA members assure him that they are making capital available to “credit worthy” Canadian borrowers; that their SME loan books are “growing” (at least between 2004 and 2008). But legions of Canadian entrepreneurs are saying that they can’t retain their current loans, let alone raise new debt capital in many cases (see prior post “Could it be that the Banks and Flaherty are both right?” January 6-09).

Our firm is one of Canada’s leading specialty finance companies, and I believe that our industry can play a constructive role in increasing capital access in the Canadian SME market.

My suggestion is a simple one: a federally-sponsored credit enhancement program (loan guarantee) for established and recognized lenders to utilize when they advance new loans.

An example of a such a program is the one provided to Quebec-based borrowers by Investissement Québec (“IQ”). In a nutshell, IQ guarantees the loan (for a fee) that a private sector lender provides to a Quebec-based SME borrower.

The federal Small Business Loans Act (“SBLA”) program of the early 1990s is another concept that comes to mind.

Whichever template you were to look at, the essential concept is the same: the private sector finds the client, adjudicates the loan, manages the relationship with the borrower, and monitors the credit over the life of the lending relationship. The role of the government in question takes different forms under different programs, but the thrust is similar. The government assists with the risk mitigation and is compensated for this role by receiving some of the revenue that is generated by the loan in question. The economy benefits from the increased capital that flows into the SME sector, and firms that take advantage of business opportunities during difficult economic times should be rewarded when the economy begins to grow again over the coming quarters (or years as the case may be).

According to the media, Minister Flaherty has been told by many Canadians that it is extremely difficult to raise debt capital for good business opportunities, whether it be working capital, capital goods, or research & development. The Feds have also been assured by these Canadian entrepreneurs that their firms are “credit worthy”, and that the “use of funds” of this needed capital would help stimulate the economy, whether it be through new employment or equipment purchases to name but two obvious examples.

I would be pleased to team up with the federal government in these situations. A firm such as ours would find the clients and perform traditional due diligence. We’d provide 100% of the actual loan capital to the borrower in question, and the federal government would come to the table with a “loan guarantee” that could take the form of “first loss protection”.

The government would charge us a fee for this guarantee, just as Export Development Canada would charge a borrower (or lender) for country risk or accounts receivable insurance under their existing programs.

By sharing the risk with the private sector lender on a particular loan, the government would be enhacing the credit quality of the borrower in question, without having to provide capital directly to the client. The government fee for this guarantee could take the form of a percentage of the “yield profit” that the lender is receiving on the portion of the loan that is receiving the guarantee. The Feds would also be putting it’s money where it’s mouth is: if there are many credit worthy Canadian companies that can’t access the debt markets, then the government shouldn’t mind putting itself into the “first loss” position.

If the federal government is confident that there are unsatiated credit-worthy borrowers, let’s work together to get them the capital they need in these difficult economic times. Our firm is ready and willing to continue to assist the SME market, on market terms, and to share with the government an appropriate portion of the revenue that would be generated from these incremental loans.

The mechanics would have to be targeted to the SME sector, so here is a shot at the details of the First Loss Protection Guarantee program:

– Government would provide first loss protection / loan guarantee, but it could cover no more than one-third of the loan tranche being insured. This way the private sector has more on the line than the government, and it also ensures that for every one federal dollar involved, the private sector is putting up at least $2 (a far better approach than just throwing the same capital at the Business Development Bank of Canada, for example, where every federal dollar generates just one dollar of loan capital);

– The private sector capital providers eligible to participate would be the domestic and foreign banks, as well as established specialty finance firms such as ours (ones with an institutional equity share capital or equity commitments of at least $100 million) that were in business prior to January 1, 2008 and have advanced capital in the prior 12 month period;

– to ensure this is targeted solely at the SME market, the loan tranche that involves the First Loss Protection Guarantee would not exceed, say, $25 million (Feds guarantee the first $8.33MM, while the private sector is on the hook for the remaining $16.66M). Perhaps $35MM is a better ceiling, but anything larger starts to get into corporate lending territory;

– only new loans or loans up for scheduled renewal are eligible for a First Loss Protection Guarantee, and perhaps not renewing loans that have been in default during the previous 12 months?;

– the business in question should have no more than, say 500 employees (the federal government’s SME definition; in Europe it’s 250 employees)

– maximum borrower revenue of $200 million, perhaps?

– the private sector lender would share the revenue for the portion of the loan that is being guaranteed. If we advanced a $3 million loan and $1 million of that loan was subject to the guarantee, our firm would split the revenue from that $1 million with the government, above some implied “cost of capital” that would have to be used by ever participating lender (say 6%?); So, the revenue from a 9% term loan would be allocated along the following lines: the first 6% would go to cover the cost of capital, and then half of the “upside” (9% minus 6%) would be split between the Federal Government and the lender. If there were warrants or bonus interest, the Feds would also participate in proportion to the size of the guarantee relative to the loan tranche.

When you compare this to the guts of the 1990s “SBLA” loans, the government took far more risk there, by guaranteeing 85% of the entire loan. The SBLA program was derided by many in the credit markets as being a “make work” program for the banks, and a subsidization program for their shareholders.

Under my proposal, the government can never lose more than one third of the loan being advanced by the private sector, but by making it a “first loss” vehicle, the structure will help to put new loan capital into the market immediately. If the loan goes very badly, the private sector lender loses capital as well. Appropriately so.

Our firm just increased our capital base (see prior post “Wellington Financial increases Fund III to $150 million” January 9-09), and are happy to do good business. Lending into the teeth of a global recession is also a great way to have your head handed to you if you aren’t prudent.

This idea taps rewards the entrepreneurial spirit, and gets the Feds at least two incremental dollars for every one at risk. I wrote to the Minister last week, and have already received some support from a few companies and industry associations.

If you like the concept, feel free to help push this along by emailing him at jflaherty@fin.gc.ca, and send me a copy.

MRM