Note: We have retracted a previous version of this Research Report. This is a republished version with a correction and clarification in the discussion of how financial subsidy should be calculated for equity investments.
Right now, the Federal Government is rolling out the largest suite of industrial policy projects in our nation’s history, with investments ranging from strategic semiconductors, to energy, to critical infrastructure. The problem is, a misguided accounting rule rule related to the budgetary treatment of government investments is preventing the appropriations that Congress has made from providing the kind of patient capital that innovative businesses need. Absent changes to these accounting rules, US companies will continue to lose ground to foreign competitors that are backed by national governments with enhanced flexibility to provide favorable debt and equity investments.
For the government’s ambitious industrial policy projects to be successful, the federal government must be able to meet the private sector halfway and have access to a flexible financial toolkit to act and react in a global market context. As it stands, the Development Finance Corporation — a strategic, global investment arm of the US Government — was granted the authority to make equity investments in pursuit of development and national security goals. However, current budgetary rules do not treat investments in equity as investments — instead, the investment is treated like a grant, as if there’s no possibility of a return to the federal government.
This artificially and unintentionally limits the success of our industrial policy and national security goals while making investment programs more expensive and barring US taxpayers from making healthy returns on their government’s investment activities. It impedes the government’s ability to invest in innovative companies that need patient capital. In the context of the DFC, it also cuts against our national security goals — since other countries, unencumbered by similar difficulties in accounting, can engage their domestic markets more flexibly. Worst of all, the government takes on the risk of loss in the form of non-performing loans while cutting out taxpayers’ ability to benefit from the investments made on their behalf.
Why Equity Investments Matter
In the context of targeted industrial policy, equity investments can be used to achieve objectives where traditional lending often falls short for both businesses and governments. On the business side, government equity investments can provide the necessary support to critical industries without worsening a firm’s debt burden. For taxpayers, providing equity to businesses — and capturing the upside when the business recovers — is a much better deal than simple direct grants. Taxpayers are taking a risk — and deserve the rewards that come with it.
Equity Investments Are Better For The Taxpayer
In fact, this exact reasoning has already been the basis for successful economic policy. Consider the 1979 loan guarantee for Chrysler, which included an equity kicker of 14.4 million stock warrants. Republican Representative William Green commented at the time that “the equity ‘kicker’ that Congress insisted on is entirely consistent with the high risk; there is no reason for surrendering a penny of it… when a private entity provides a service and takes an economic risk, it demands and receives financial benefits. Why should the taxpayers, who provided a vital service and took a great gamble, be denied the same right?”
The result? Chrysler repaid the $1.2 billion in guaranteed loans seven years ahead of schedule, and the government made nearly $300 million in profits from the equity kicker. The government didn’t just save up to hundreds of thousands of jobs — it made good money for the taxpayer doing it.
Equity investments are even more important with the goal of a broader government portfolio in view. The returns from this equity can play a unique role for a government corporation like the Development Finance Corporation, which is given other authorities, including lending. By making or guaranteeing a loan, the government is essentially — if implicitly — selling off the rewards from making these sometimes-risky investments. The most the Federal Government can make from a loan or a loan guarantee is principal plus interest, but the downside risk is unlimited. An equity authority can change that calculus.
The case of Tesla illustrates well how the existing restrictions have forced taxpayers to miss out on the substantial upside of supporting the commercialization of new technologies. When the fledgling company could not raise capital in the private markets, the Department of Energy’s Loan Programs Office stepped in to provide capital. But if the DOE had also included an equity kicker — guarantees of stock that will be valuable if the loan is successful — the return on that investment alone would have paid for a considerable portion of the entire program. The case of Solyndra is often trotted out to show that government investments aren’t always successful, but proper program design can ensure that unsuccessful government investments aren’t costly. As it stands, the LPO holds all the downside risk and none of the upside.
This is why lending, at least in the context of government lending to businesses (rather than areas with other policy goals like affordable housing or disaster assistance), agencies will typically favor less risky, more established companies. Because interest payments typically begin within one to two years, there needs to be a reasonable expectation of revenue to make those interest payments. But companies we’d like to support don’t often have that reasonable expectation.
Equity Investments Give Businesses Breathing Room
Equity investments can be a much more patient form of capital than lending. Innovative companies working at the technological frontier are often smaller, with less established relationships to capital markets. While these companies often have considerable potential, timelines for profitability are uncertain. Critical sectors like hard tech manufacturing and energy production with high upfront capital costs may prove even more challenging. Long-term success and profitability in these industries rely on incremental improvements and iteratively refined techniques to capture process efficiencies. In plain language, we call this “learning by doing.”
But that learning by doing takes time, and securing that time takes capital. For this reason, the patient capital approach can make the DFC into strategic partners for firms whose success strengthens our national security. To see how this all works in practice, consider the case of NuScale, a company at the forefront of the nuclear power industry with deep ties to our nation’s academic and research community. On the commercial side, it is the first company to receive certification from the Nuclear Regulatory Commission for the design of a Small Modular Reactor (SMR), one of only seven approved designs in the entire country.
Equity Investments Will Help Us Compete Internationally
As the world looks to meet rising energy demands with clean firm technology, China, Russia, and other nations are looking to fill that gap through “build, own, and operate” models, but NuScale, GEH, Westinghouse and Holtec are among the US companies that have an opportunity to lead. NuScale, as one example, has entered into a number of agreements to deploy SMRs to customers in countries like Romania, Ghana, Indonesia and Poland. But these are not firm agreements with 100% certainty of reaching deployment. They are contingent on NuScale successfully commercializing its SMRs domestically — which will take time and capital — and learning by doing via customers deploying first in the US. The potential for cost overruns evidenced by legacy nuclear plants is well-documented and the fear of such is moreso overseas. The rigor associated with procurement, quality assurance, and handling can be quite costly, not to mention navigating different legal and regulatory barriers. China and Russia can overcome this by providing 100% of the equity and debt financing and operating through the “build, own, and operate” model. With purely debt support at the moment, the US simply can’t compete. Ultimately, it’s a race between our competitors to who can develop the commercial technology first. The fuel for that race is capital — and without full utilization of the equity authority, we might not win.
For now, NuScale’s Romanian customer has cobbled together loans from a range of partners (including the USG), but there is a limit to how much debt a single deal can take on. This is even more pronounced in emerging markets. An equity investment from the DFC could bridge the gap significantly, catalyze further capital investment, and put NuScale in a strong position to lead the commercial deployment of SMRs globally — a significant national security boon with competitors like China and Russia. Unfortunately, even though DFC has appropriated funds for equity investments, it has only used that authority sparingly.
The Problem of Budget “Scoring”
Right now, the DFC cannot use the money appropriated to them to make an equity investment in innovative companies like NuScale. But why? The answer is simple, but bewildering: equity investments are treated as if they are grants. The DFC would have to use a large percentage of its appropriations to cover the equity investment. To understand why this is the case, we have to dig into the process by which Congress allocates and records appropriations during the executive branch’s budgetary process.
It begins with the appropriations process — Congress appropriates funds to agencies to undertake operations aligned with their missions. Appropriations can be used to fund many kinds of authorized activities, including (but not limited to) the acquisition of goods, operating expenses for agencies, construction, or grants and loans for various purposes like research or disaster relief. The use of appropriations must comport with the requirements of the Anti-Deficiency Act (ADA), which prohibits agencies from spending for unauthorized activities or in advance or in excess of the availability of appropriations (among other things).
For most of these kinds of spending, it’s relatively easy to keep on the right side of the ADA, particularly the requirement that spending does not occur in excess of available appropriations. For example, if Congress appropriates $10,000,000 for research grants at the NSF for a single fiscal year, it’s clear how much the NSF can spend in that year on research grants: $10,000,000. Of course, real life appropriations have extra complications and might be spread over years of spending, but the underlying truth of appropriations spending is that it’s a cash flow system and once the money has been disbursed, its budgetary effect has concluded. However, there is one important exception: credit programs like loans and loan guarantees.
Loans have a very different financial character from grants — namely that there is an expectation of direct returns to the government in the future in the form of interest and principal payments. This makes accounting for appropriations that include credit activities a bit more tricky. Those returns may be directly returned to the Treasury or may be recycled for future lending, but either way it’s not a simple cash-in, cash-out transaction like a grant.
This is especially true for a lending program, which will often have an entire portfolio of borrowers with different maturities and risk profiles. This complexity is even more challenging in the context of typical appropriations cycles — without accounting for these differences, it would be considerably difficult for Congress to assess the cost of Federal credit programs and appropriate less or more accordingly. To better account for this, it passed the Federal Credit Reform Act (FCRA) in 1990. FCRA introduced the concept of assessing the “net present value” (NPV) of loans and loan guarantees and accounting on that basis.
Under FCRA, appropriations cover what’s statutorily defined as the “cost” of a loan — the NPV of the disbursements out, the payments back in, and any estimated costs for defaults, prepayments, or other outlays or inlays arising from the loan. FCRA vests the ultimate authority to determine costs for credit programs with OMB, but also requires OMB to coordinate with the CBO and other agencies. Costs and the assumptions underlying them to calculate the NPV must be re-estimated on a yearly basis. FCRA also provides an unlimited, indefinite budget authority in the event that re-estimates of subsidy costs are adjusted upwards. This complex approach has drawbacks, but overall, drastically alters how appropriations can cover the cost of credit programs. Moreso, it is a more accurate form of accounting for the true cost of credit programs when compared to alternative approaches.
Equity Investments Aren’t Giveaways
Where do equity investments fit into this Federal accounting process? When Congress established the equity authority in the DFC, it didn’t provide a method of accounting. Therefore, the default cash flow method used for most funding currently applies to equity investments. And that’s why the DFC hasn’t utilized its equity authority yet for projects like NuScale’s — if the equity is evaluated as a grant, the cost is simply too high.
This is bonkers. It’s simply not appropriate to use a cash accounting method for equity investments. Like loans, the cash flows do not end once the appropriated money is disbursed — the DFC can expect to resell the equity stake at a later date, receive dividends, or other cash flows arising from various contingencies. Accordingly, Congress should treat equity investments similar to credit programs under FCRA, using an NPV method. Not only would it treat equity investments more appropriately, it would unlock more investment.
To understand this, we can look to the FCRA loan accounting method. There, we calculate the credit subsidy rate divided by the amount disbursed. In the context of the SBA’s disaster loan program in FY2020, the loan credit subsidy rate was 13.62%, meaning that a dollar of appropriations is needed to backstop $7.34 in disaster loans. The credit subsidy in this case is functioning as a cushion against some additional risk of loss that the taxpayer bears, and is presumed to be additional because the private sector is unwilling to underwrite it unilaterally.
Equity investments come with different risks, but the reasoning should at least be consistent. The subsidy rate should reflect some probabilistic judgment about the expected value of the acquired equity instruments over time. NuScale is a publicly traded company; while the share price is volatile, the expected value of the share price over time is not zero across all probability-weighted scenarios, even if some further risk-adjustment is applied to the expected value. If equity subsidy and credit subsidy are to be applied with consistency, the equity subsidy rate should protect against some probability of depreciation in the equity value of the enterprise, but the status quo DFC approach implicitly assumes that subsidy rate to be 100%. With a more reasonable translation between a dollar of appropriations and dollars available for equity investments, there’s a more powerful multiplier available for patient-capital long-term investments. As a result, the DFC could much more easily use its appropriations to deploy the equity investment into projects like the NuScale SMR in Romania.
One key lesson should also be clear: by fixing the scoring problem, Congress would need to appropriate much less money to cover equity investments. Consider that DFC’s total authorized portfolio is $60bn, 35% of which can be equity investments ($21B). Therefore, to provide full use of its authorized equity power, Congress would not have to appropriate a full $21B, but rather a fraction of that which appropriately reflects the risks (and rewards) associated with an equity investment. This isn’t a trick of accounting — it’s an explicit operationalization of the basic fact that over time, some government investments retain market value and earn market returns.
Congress Has an Opportunity To Fix This
This year’s National Defense Authorization Act (NDAA) is currently being finalized in the Senate. A few weeks ago, Senators Chris Coons and John Cornyn introduced a bill that would fix the budgetary treatment of equity investments, which has now been offered as an NDAA amendment. It is nearly identical to FCRA in the process and procedures it lays out for treating equity investments — OMB would have ultimate authority but coordinate with agencies and CBO to ensure proper estimates.
The success of industrial policy is critical — the government needs to know how to steer the economy towards different specific outcomes, whether in national security, hard tech manufacturing, or elsewhere — and mending the accounting rules around equity investment would be a major contributor to this success. Grants are grants, loans are loans, and equity investments are equity investments. Government accounting treatment should match industry standard accounting approaches rather than account for everything on a cash basis.
Treating equity investments by the Federal Government like federal credit programs is a no-brainer — it pays off for the taxpayer, ensures more efficient allocation of resources, and strengthens our national security. Senator Cornyn and Coons’ bill is going to be introduced as an amendment to the NDAA. Congress should ensure it’s in the final bill.