Release Date: June 1, 2020
BUFFALO, N.Y. — When the government bails out businesses during the coronavirus pandemic, it should acquire stakes in the firms—not just hand out loans, according to a University at Buffalo School of Management expert.
In a policy paper recently published on SSRN, Veljko Fotak, PhD, associate professor of finance in the UB School of Management, says equity injection is the best option because firms are struggling and don’t need the added burden of interest payments and debt that could push them into bankruptcy.
“This crisis is different than what we’ve seen before,” says Fotak. “It’s widespread and affects every sector of the economy, so it can’t be solved by doing what the government did during the Great Recession of 2007-09—because every business needs help.”
Equity injections are beneficial for a number of reasons, according to Fotak. He says they discourage abuse of the system because they are self-disciplining, since healthy firms don’t want to give up equity.
The paper draws on history, including previous bailouts of Chrysler and General Motors, citing them as examples of government overreach.
“With bailouts like the ones that happened during the Great Recession, the government tends to linger too long,” says Fotak. “After taking shares in Chrysler and GM, the government imposed a green agenda, for example. The temptation to interfere and apply political pressure increases over time.”
To avoid such situations, Fotak recommends using preferred stock, which would allow the government to take on equity with shares that don’t carry voting rights and come with a set dividend payment.
“Government and businesses should negotiate in advance to set coupon dividend payments high enough that the cost incentivizes companies to repurchase them as soon as possible,” says Fotak.
The challenge, according to the paper, is scaling the bailouts up to the large number of companies that need it amid COVID-19. Here, Fotak suggests speed is the critical factor.
“Some mistakes will be made, but acting fast is more important than getting it 100% right,” he says. “Government should take a staggered approach and learn along the way. Right now, when so many businesses need help, don’t let perfection be the enemy of the good.”
Fotak collaborated on the paper with William Megginson, PhD, professor and Price Chair in Finance at the University of Oklahoma Price College of Business.