Capital Access Program

A Primer on the Small Business Capital Access Program

• Background
• Executive Summary
• History and Introduction
• Basic Concept of Program
• Eligible Loans and Borrowers
• Collection and Claims
• Maintenance of the Reserve Fund
• Reliance on Participating Lenders to be Responsible

Background

As part of the 21st Century Jobs Fund, PA 225 directed the Michigan Strategic Fund Board to reestablish the Capital Access Program.  Specifically, section 88d (3) of PA 225 of 2005 states, “as a separate and distinct part of the loan enhancement program, the fund (MSF Board) shall reestablish the small business capital access program that was previously operated by the fund for small business in a manner similar to how that program was operated….”

The Act also directed the fund to make an initial commitment of $3.5 million to implement the Capital Access Program (CAP) separate and above the up to 25% allocation made to the loan enhancement program, though CAP can be augmented with loan enhancement program funds in the future.

Executive Summary

The Capital Access Program was originally adopted by the MSF in 1986 and ran until September 2002 and was reinstituted in April 2006.  The program, at its peak, participated in over 1,000 loans a year and cost the MSF about $2 million a year to operate.  Unlike other government loan guarantee programs, CAP does not insure each loan separately.  Rather, it works on a pooled reserve concept where each loan enrolled by a specific financial institution is protected by a reserve account in that institution’s name.  The reserve is funded through one-time premium charges paid into the reserve in equal parts by the borrower and the lender.  The MSF then matches the combined one-time charge.  This payment as well as all other similar payments into the lender’s reserve, backs each and every loan enrolled by the lender.  The lender can pick a premium, from 1.5% to 3.5% of the loan amount and based on their assessment of the risk of the loan, that they and the borrower will both be charged with the MSF matching the total of the lender and borrower premiums.  That, in essence, is the program.  The enrollment process is extremely easy and the MSF staff’s role is simply to ensure that the borrower does not fall into a few of the excluded business/use areas. 

History and Introduction

The Capital Access Program (CAP), launched in June 1986 and operated through September 30, 2002, provided lenders with a flexible and non-bureaucratic tool to make business loans, which were somewhat riskier than conventional loans, in a manner consistent with safe and sound financial regulations.  The Capital Access Program thus assisted lenders in expanding their markets and better serving their customer base, and had an important positive impact on the creation of jobs and improving the effectiveness of Michigan’s economy by supporting the growth and success of Michigan small businesses.

The program assisted lenders in financing over 10,000 companies.  Loans made under the program were as small as $400 and as large as $2.4 million.  The average loan was about $52,000.  Historical data also shows that over one-third of the loans made under the program were under $25,000 in size, with three-quarters of the loans being under $75,000.  In addition, nearly one-fifth of the loans went to start-up firms; over one-quarter were to retail establishments,   one-third to service firms, and one-eighth to manufacturing firms.  At the height  of its popularity, the program enrolled about 1,100 loans a year and cost about $2 million in reserve deposit contributions.

From the lender’s perspective, a central feature of the program was the flexibility of the program and its extremely non-bureaucratic administration.  The lender had sole responsibility for deciding whether or not and under what terms and conditions to make the loan.  To enroll a loan in the program, a one-page form was sent to the Michigan Strategic Fund (MSF) within ten days after the loan was made.

From the borrower’s perspective, the key feature of the program was that it provided access to financing that might otherwise not be available.  Access to affordable financing is often a crucial ingredient in enabling a business to prosper and grow.

From the MSF’s viewpoint, a key feature of the program was the high degree of leverage of public resources – a relatively small amount of MSF funds generated a large amount of private lending.  The leveraging ratio of private to MSF resources being achieved by the program was 24 to 1.

The new Small Business Capital Access Program will operate, in nearly all regards, as the original did.

While this primer describes and discusses the program in some detail, and is intended to be helpful for descriptive purposes, the official legal document specifying program parameters is the Agreement entered into between the MSF and each participating financial institution.

Basic Concept of Program

Although the Capital Access Program, and the new Small Business Capital Access Program, are based on an insuring concept, it is fundamentally different from the traditional type of insurance or guarantee program, such as the SBA 7(a) program, which guarantees some percentage of a loan on a loan-by-loan basis.  Instead, Capital Access is based on a portfolio concept.  When a lender participates in the Capital Access Program, a special reserve fund is set up to cover future losses from a portfolio of loans that the lender makes under the program.  The special reserve is owned and controlled by the MSF, but it is earmarked in that lender’s name.  Thus, each financial institution participating in the program has its own earmarked reserve.  A lender can withdraw funds from its earmarked reserve only to cover losses on loans made under the program. 

Payments Made Into the Reserve.  Payments are made into a lender’s earmarked reserve each time the lender makes a loan under the program.  The borrower makes a premium payment, the lender matches that payment, and the MSF matches the combined total of the borrower’s payment and the lender’s payment.  The lender is allowed to recover the cost of its payment from the borrower, through a higher interest rate, up-front fees, or some combination of these or other methods.  Up-front premium payments and fees can be financed as part of the loan.

The actual level of payments to be made into the reserve at the time of making any loan is determined by the lender, within certain parameters.  At the minimum, the borrower pays an amount equal to 1.5% of the enrolled loan amount, the lender would match that with another 1.5%, and then the MSF would contribute 3%, for a total of 6%.  At the maximum, the borrower contributes 3.5%, the lender another 3.5%, and the MSF 7%, for a total of 14%.

Thus, for any loan made under the program, an amount equal to anywhere from 6% to 14% of the enrolled loan amount is paid into the lender’s earmarked reserve.  After a lender has made a portfolio of loans under the program, it might have a reserve equal to, perhaps, 10% of the total amount of that portfolio.  In such a situation, the lender could absorb a dollar loss rate of up to 10% on that portfolio and still be completely covered against loss.  A key feature of the program is that the full amount in the lender’s total reserve is available as needed to cover any loss from any of the loans made under the program.  When loans are paid off without loss, the reserve fund is not reduced.

The earmarked reserve enables a lender to be more aggressive in making loans and expanding its market.  However, if a lender’s loss rate exceeds the coverage provided by the reserve, the lender is at risk for that excess loss.  Thus, there is a built-in incentive for a lender to be prudent.  Based on historical information and analysis of the CAP portfolios, loss rates for loans enrolled under the program were 6-8 times higher than those in the lender’s conventional loan portfolio.   This seems to indicate that lenders were, indeed, making somewhat more risky loans due to the CAP program.

Nevertheless, since the reserve would enable a lender to withstand a substantially higher loss rate than it could tolerate under its conventional loan portfolio, the program enables a lender to prudently make riskier loans.  For example, these loans might be loans to companies with good management and a good direction, but for one reason or another, such as lack of adequate collateral, lack of sufficient track records, lack of sufficient net worth, or other reasons, can’t quite qualify for a conventional loan.

No MSF Involvement in Lending Decisions.  Because the program is structured to provide a built-in incentive for the lender to be prudent, there is no need for the MSF to be involved in reviewing the lender’s decision on the loan.  The reserve is there for the lender to protect and use.  The lender makes the loan and simply files a one-page Loan Filing Form with the MSF within 10 days after the loan is made.  Enrolling loans under the program is thus designed to work as essentially an automatic process.  There is no processing delay, and virtually no paperwork.

Lender Flexibility.  Flexibility is a key characteristic of the program. It is completely up to the lender to determine how it wants to use the program.  The lender sets its own criteria for determining whether to make the loan, determining what types of loans it wants to make under the program, and deciding the interest rate, fees, term of maturity, collateral requirements (if any), and other conditions of the loan.  Thus, the market is allowed to work, and intelligent private sector decision making is facilitated.  The loan can be short-term or long-term, fixed or variable rate, secured or unsecured, amortizing or balloon, term loan or line of credit, etc.

When filing a loan for enrollment under the program, the lender has the option of covering an amount under the program, which is less than the full amount of the loan.  This provides added flexibility, since borrower and lender premium payments would then be based on this smaller amount.  For example, a lender makes a $100,000 loan under the program, but is convinced that under a worst case scenario, the maximum possible loss on the loan would be $60,000.  The lender could specify a covered amount of $60,000 on the loan.  In such an event, the funds in the reserve could be used to cover the first $60,000 in principal loss on the loan, plus up to 90 days accrued interest.

A key feature of the program is the flexibility it provides to enable a lender to work with a borrower after the lender has made a loan to the borrower under the program.  After a loan has been made under the program, the lender can subsequently recast it as often as may be desirable.  The lender can extend the term of the loan, amend covenants, release collateral, etc., without having to obtain approval from the MSF, or even report the change to the MSF.

Refinancing Loans.  The lender also has the flexibility to refinance the loan, adding funds.  Indeed, if the total amount of the refinanced loan does not exceed the covered amount of the loan as previously enrolled, no new borrower or lender premium payments need to be made into the reserve, and the refinancing does not even need to be reported.  (Once a year, the lender will be asked to file a simple report with the MSF containing a list of the outstanding balance for each loan enrolled under the program).  For example, if a $100,000 loan covered under the program has been paid down to $30,000, and then is refinanced up to $100,000, no new premium payments are owed.  However, if the loan were instead refinanced up to $150,000, premium payments would be owed on the incremental $50,000 above the $100,000, but only if the lender wanted to cover that additional $50,000 under the program.

Lines of credit.  Lines of credit are also treated with similar flexibility.  In establishing a line of credit and filing it for enrollment, the amount of the loan, for the purposes of determining premium payments and the maximum covered amount shall be the maximum amount that can be drawn against the line of credit.  Lenders could use their normal approach, including informal arrangements as applicable, in establishing a line of credit.  A line of credit, once established, could then be renewed each year, staying covered under the program, without new premium payments being required (unless the covered amount under the program is to be increased).

The collection and claims process is also designed to work in a routine, non-bureaucratic way.  The lender simply uses its normal method for determining when and how much to charge off on a loan.  At the same time a lender charges off all or part of a loan, the lender files a one-page Claim Form with the MSF, with payment to be handled in a prompt and routine fashion.

CAP Vs. Conventional Loans.  Because of the payments made into the reserve, a loan under the Capital Access Program will be more expensive to the borrower than a conventional loan.  Premium payments into the reserve are one-time, up-front payments, the costs of which can be financed.  Thus, the longer the financing stays on the books, the smaller the increase in the borrower’s effective cost.  However, the transaction will be more expensive than a conventional loan.  Borrowers who can obtain conventional financing are better off with such financing, and competition within the primary lending environment will work to steer such borrowers to conventional financing.  From the perspective of borrowers, the Capital Access Program can provide access to financing for many companies that otherwise might not be able to obtain financing to meet their needs.  Moreover, financing under the Capital Access Program is likely to be much less expensive for a company than alternative sources of financing, if any are available.

Prospective borrowers must understand that a loan under the program is a private transaction between the lender and the borrower.  While the program may assist a lender in taking more risk than normal, it is still the lender that is bearing the risk of the loan, and is responsible for the decision to make a loan.

Eligible Loans and Borrowers

The goal of the program is to make eligibility as broad-based as possible to maximize the impact on Michigan’s economy and to avoid second guessing private market decisions.  The borrower can be a corporation, partnership, joint venture, sole proprietorship, cooperative or other entity which is authorized to conduct business in the State of Michigan. 

Flexibility is key so that each Financial Institution can use the program in a manner which best suits the needs of the lender and its customers.  Keeping the program broad-based also assists lenders in building a portfolio to take maximum advantage of the portfolio insurance effect, thereby making the program more attractive and effective.  Moreover, the high degree of leveraging of public resources increases the effectiveness of the program.

Loan Restrictions.  There are, however, a few restrictions that are mandated by PA 225 of 2005 to protect the integrity and purpose of the program.  These restrictions are described below:

1. Business Purpose in Michigan – The proceeds of the loan must be used for a business purpose within the State of Michigan.  Generally, therefore, the program is geared to Michigan businesses.  In the case of a company with multi-state operations, the key test is that the primary economic impact of the endeavor financed by the proceeds of the loan be in Michigan.
2. Exclusion of Housing – The MSF statute prevents the financing of “that portion of an endeavor devoted to housing.”  Thus, the proceeds of the loan cannot be used for the construction or purchase of residential housing.  However, this is interpreted to mean permanent housing.  Thus, loans to motels or hotels or for the construction of motels or hotels, are eligible.
3. Passive Real Estate Ownership – The loan cannot be used to finance passive real estate ownership.  Passive real estate ownership would occur if a company were to buy land or buildings simply as an investment, without developing or improving the real estate in any way, and without intending to use it for its own business operations.  It is important to stress that, except for the restrictions against passive real estate ownership and housing discussed above, the program can be used for real estate financing.  For example, the program can be used to assist a company to finance the acquisition of land or buildings intended to be used in the business operations of the company.  In addition, the program can be used to finance the activities of a developer or builder in acquiring real estate for developing or in constructing or renovating a building.  In the case of a loan to a developer for construction or renovation financing, the loan under the program is intended to cover only the period through the construction or renovation phase.  Permanent financing can also be included, if the borrower will be the company that will use the real estate for its own business operations.
4. Refinancing Prior Debt Which is Not in Program – A lender is not permitted to take an existing loan on its books (or on the books of an affiliate) which is not in the program and simply refinance it, without adding new money, and put the refinanced loan under the program.  However, if a lender refinances an existing loan and adds new money by increasing the outstanding balance, it is permissible to cover under the program, an amount not exceeding the amount of the new money.  For example, if an existing loan, not under the program, has an outstanding balance of $100,000, and that loan is refinanced with a new balance of $150,000, the refinanced loan can be enrolled under the program, but the covered amount could not exceed $50,000.
5. Conflicts of Interest – A lender is not permitted to use the program for “insider” transactions.  Insider transactions are defined as a loan to an executive officer, director or principal shareholder of the financial institution, a member of the immediate family of such an executive officer, director or principal shareholder, or to a company controlled by any of these people.  The basic definitions used in this conflict of interest prohibition tie into basic terms used in the Federal Reserve’s Regulation 0, which the lender has to be familiar with in any event for its normal operations.
6. Size of Business – A new restriction has been added to the program by PA 225, which was not in the program as previously operated.  The program is now restricted to firms which are independently owned and operated and employ (at the time of the loan) fewer than 250 full-time employees, or have gross annual sales of less than $6 million.
7. Other Restrictions   -- PA 225 further states that no CAP loans should be made to 1) persons convicted of a criminal offense related to a state contract or subcontract; 2) persons convicted of a criminal offense, or held liable in a civil proceeding, that negatively reflects on a person’s business integrity, based on a finding of embezzlement, theft, forgery, bribery, falsification or destruction of records, receiving stolen property or violation of state or federal anti-trust laws; 3) a business enterprise to induce businesses to leave the state; 4) a business that would violate internationally recognized workers’ rights of workers in a country other than the United States; 5) a business which is incorporated in a tax haven country after September 11, 2001.
8. For Profits Only – While not statutory, the reestablished program, excludes not-for-profit firms as the main purpose of CAP is job creation.

Collection and Claims

Reimbursement for losses is intended to be as routine and non-bureaucratic as the process for enrolling loans under the program.  The MSF relies on the lender to exercise reasonable care and diligence in its collection activities.  If a loan gets into trouble, the program calls for the lender to determine when and how much to charge off on an enrolled loan in a manner consistent with the lender’s normal method for making such determinations on its conventional business loans.  A lender would file a claim under the program at the time it charges off all or part of a loan.  The claim may include the full amount of principal charged off, plus up to 90 days accrued interest.  (If the amount of the loan that the lender covered under the program is less than the amount of principal charged off, the amount of principal and accrued interest included in the claim shall not exceed the principal amount covered under the program, plus up to 90 days accrued interest attributable to that covered principal amount).

In keeping with the extremely non-bureaucratic nature of the program, the Claim Form submitted by the lender to the MSF is only a half-page form.  The program provides for prompt and routine payment.

Lender Representations and Warranties.  The program is structured so that when the lender makes a loan and then enrolls it in the program, the lender is automatically making a small number of representations and warranties to the MSF that the loan complies with program requirements.  If the lender later suffers a loss on that loan and properly files the claim form, the only grounds for denial of the claim would be if the representations and warranties made by the lender at the time of enrollment of the loan were known by the lender to be false at the time the loan was filed for enrollment.

The claim process allows a lender to recover its loss at the time it recognizes the loss, prior to having to exercise its collateral rights or other legal remedies in connection with the loan.  However, the lender is expected to continue to exercise its collateral or other rights in a manner such as it would do for a conventional loan.  If there is a subsequent recovery from the exercise of such rights, so that the amount of loss ultimately is less than the amount for which the lender has been reimbursed from its reserve, the lender will be required to deposit the relevant amount of the recovery, net of out-of-pocket expenses, back into the reserve.  This is similar to the process that a lender follows in putting recoveries on conventional loans back into the lender’s internal loan loss reserve. 

MSF Right of Subrogation.  As described above, the intent of the program is for the lender to be fully responsible for collection activities and for the MSF to stay out of the lender’s way.  However, as a safeguard against the extreme situation where a lender is abusing the intent of the program by ignoring its obligation to exercise reasonable care and diligence in its collection activities, the MSF will reserve for itself, in limited circumstances and as a last resort, the right to be subrogated to the rights of the lender.  The subrogation would apply to any collateral, security or other right of recovery, in connection with a loan, which has not been realized upon by the lender.  This provision could only take effect after the lender has filed a claim and has had its loss fully covered.  It is hoped that the MSF will never have to exercise this right of subrogation.

Maintenance of the Reserve Fund

A central concept of the program is that while the MSF owns the funds in the lender’s earmarked reserve, these funds are dedicated, by legal agreement, to cover only losses on loans made by the lender and enrolled in the program. 

For administrative convenience for both the MSF and the lender, and to provide an extra benefit to the participating lender, the MSF plans to open an interest bearing deposit account in the MSF’s name at each of the participating lenders and deposit the reserve monies into those accounts.

It should be pointed out that although the above procedure is consistent with the full intent of the MSF, and there are no plans to do otherwise, the legal Agreement between the Financial Institution and the MSF does not bind the MSF to maintain the funds in a deposit account at that Institution.  Thus, for example, if a lender abuses the intent of the program, the MSF will have the flexibility to close that deposit account and deposit the monies in the reserve elsewhere.  However, this wouldn’t change the legal status of the reserve as dedicated solely to cover losses from loans that the lender makes under the program.  Moreover, in the event that the MSF does not deposit the funds in an account at that Institution, the funds may be invested or deposited only in:

1. Direct obligations of the United States government or the State of Michigan, or in obligations the principal and interest of which are unconditionally guaranteed by the United States or the State of Michigan, or
2. a deposit account at a federally insured depository institution.

Half of the interest earned on the funds in the lender’s earmarked reserve will stay in the reserve, to increase the account.  The MSF is authorized to withdraw the other half of the interest for use by the MSF for whatever use the MSF Board determines.

Proprietary Interest of Reserve Accounts.  Although the MSF technically owns the funds in the reserve, it is intended and expected that lenders will develop a proprietary interest in the reserve.  The reserve earmarked for a lender takes on the character of an off balance sheet asset of the lender, which enables it to be more aggressive in its lending activities.  The lender controls the amount of payments going into the reserve and the reserve is reduced only when the lender suffers a loss on a loan made under the program.  The program rewards good performance.  As loans are successfully paid off, funds stay in the reserve, and the reserve fund continues to grow through interest earnings.  However, if at some point in the future the lender was to completely drop out of the program, and after all enrolled loans had been paid off, the MSF would have the right to withdraw the funds and one half the interest earnings from the reserve.

Lenders sometimes ask why they wouldn’t be able to get back some or all of the funds from the reserve in the event that they have dropped out of the program, and the loans have been paid off.  To maintain the integrity of the program, the lender can only gain access to the funds in its reserve to cover losses on loans made under the program.  If a lender could withdraw funds from the reserve after dropping out of the program, there might be incentive for the lender to put conventionally approvable loans under the program, because the lender could ultimately get the reserve funds back.  By contrast, if the only way that a lender can access reserve funds is to cover losses from its program loans, than the only way a lender can gain any advantage from the program is to use it for its intended purpose, as a flexible tool to enable the lender to expand its markets and continue to assist companies that may not otherwise be eligible for conventional financing.

The program contains a formula for addressing the effective dropping out of the program by the lender.  If for a consecutive 24 month period the amount in the reserve fund continuously exceeds the outstanding balance of all of the lender’s enrolled loans made since the beginning of the program, the MSF is authorized to withdraw any such excess to bring the reserve down to an amount equal to 100% of the outstanding balance.  As a practical matter, this formula would only come into play for a lender that has dropped out of the program.  Even if a lender has been inactive for a long period, if it begins making loans during the 24 month period, the aggregate outstanding balance would generally quickly exceed the reserve.  The formula is intended to give the MSF the ability to withdraw funds from the reserves earmarked for lenders that have dropped out of the program, but to do it in a manner that in no way jeopardizes the protection that the reserve provides for any loans still outstanding.

Reliance on Participating Lenders to be Responsible

The Capital Access Program has been structured to give lenders maximum freedom to make intelligent private sector lending decisions.  Structural incentives are built into the program to promote program goals.  Nevertheless, it is also important to emphasize that the MSF is relying on the participating lenders to be responsible.  The ability of the MSF to keep the program simple and effective will be sustained if the participating lenders adhere not only to the program requirements, but also to the spirit and intent of the program – to improve small businesses’ access to capital.

In order to implement the program in a non-bureaucratic manner, the MSF must prevent the program from being abused.  So that the MSF can move quickly to stop abuses, the MSF retains, in the legal Agreement entered into with each participating lender, the absolute discretion to terminate a lender’s right to make new loans under the program.  (This wouldn’t affect the status of loans already made under the program).  Obviously, the MSF’s objective is to have as many lenders as possible use the program successfully.  It is the MSF’s intention to enforce this provision against a particular lender only if such lender has violated its agreement with the MSF or has exhibited a pattern of abuse of the intent of the program.  It is hoped that this authority will never have to be used.

As a lender begins to use or resume using the program, it will be helpful for their staff to seek informal clarifications regarding the objectives and intent of the program.  The MSF staff will provide quick responses.  The MSF continues to be committed to this program as a model for government responsiveness and effectiveness, and so that the program can have maximum benefit for lenders, Michigan businesses, and the State.