The early view of 2004 is that the venture capital investment markets are stabilizing with the fourth quarter of 2003 producing the highest level of activity since the second quarter of 2002. Likewise, prognosticators see an active fund raising cycle starting in early 2004. One study predicts 53% of venture funds will commence fund raising activity in 2004. Despite the good news, the recent financial performance of venture capital funds ensures that the fund raising environment will be a challenging one. One non-traditional source of investment capital that is often overlooked, the Small Business Investment Company (SBIC) program, has provided an attractive option in this environment. SBICs are privately owned and operated investment companies that are licensed and regulated by the U.S. Small Business Administration (SBA).
Most SBICs obtain funding (“Leverage”) provided by SBA. The use of Leverage generally has allowed the managers of SBICs to boost their IRRs, and because of this and an increased sensitivity by SBA to the needs of the investment marketplace, SBICs have become more attractive investments for institutional investors who have the opportunity to have their capital matched by the SBA on a two or three-to-one basis.
The SBIC program was established in 1958. Its statutory mandate is to stimulate long-term debt and equity investment in American small business. Over the subsequent years since the program was authorized, SBICs have provided funding to over 90,000 small businesses to assist in their development, including several well-known companies such as Apple Computer, Federal Express, Cray Computers, Callaway Golf, Intel, Staples and Outback Steakhouse.
Legislation enacted in 1992 and fully implemented in 1994 significantly revised the SBIC program and made it more attractive to institutional investors. That legislation created a new form of SBA Leverage instrument known as the “Participating Security”. It also increased the amount of Leverage which may be outstanding to an SBIC, or group of SBICs under common control, to an amount, indexed to inflation, which is now $116 million; increased minimum private capital required for SBICs using Leverage; provided for stricter SBA licensing standards; and provided other changes which were intended to make the program more consistent with the private venture capital industry.
The result has been a dramatic increase in the number of licensed SBICs and the amount of private investment in them. From the summer of 1994 through Sept. 30, 2003, 376 SBICs were licensed. As of Oct. 1, 2003, there were 198 SBICs using Participating Securities with aggregate private capital of $4.72 billion (a good portion of which has come from institutional investors) and 131 SBICs using the old form of Leverage instrument (Debentures) with aggregate private capital of $2.12 billion. As of Oct. 1, 2003, the private capital and outstanding and committed Leverage for the 411 active SBICs totaled $21.45 billion.
SBA provides Leverage to SBICs on a formulaic basis established in the authorizing legislation which generally works out to two or three dollars of Leverage for one dollar of Private Capital. SBICs obtain Leverage by issuing one of two types of instruments: “Debentures” or “Participating Securities,” which are guaranteed, pooled and sold in the marketplace by SBA. The proceeds of these sales are remitted to the issuing SBICs pro rata,and may be used for investing or to pay approved costs of operations. The instrument issued by the SBIC is normally a function of its business plan and whether the SBIC has investors that are tax-exempt entities. Debenture Leverage is normally used by SBICs that plan to make debt or mezzanine investments. Participating Securities are used by SBICs that plan to make equity investments in seed, early, and mid-stage businesses or businesses which generally do not have the capacity to service debt. Use of Debenture Leverage by an SBIC that is a limited partnership or limited liability company may cause unrelated business taxable income for tax exempt investors. Because Participating Securities do not have the same debt features as Debentures, their use by an SBIC to obtain Leverage does not create unrelated business taxable income for investors in the SBIC. This has proved to be an extremely significant consideration for our tax-exempt institutional investor clients.
Under SBA’s regulations, SBICs issuing Participating Securities must be formed as limited partnerships. Participating Securities are preferred limited partnership interests that are redeemable after 10 years and which provide SBA with both (i) a current return or a “Prioritized Payment” which is approximately 200-220 basis points over the 10 year Treasury Bond Rate prevailing at the time the instrument is issued, and is contingent upon and payable only from cumulative realized partnership profits, and (ii)a disproportionately small share of the Partnership’s profits, generally about 10 percent.
It should be noted that SBA has recently proposed some changes in the variables that determine the impact Leverage can have on an SBIC’s IRR. Accomplishment of these changes will likely require legislation. We are carefully monitoring thesituation and will be in a position to advise investors and fund managers alike of any new developments. As mentioned above however, the use of Leverage, and Participating Securities in particular as presently structured, can create a significant boost in the IRR of the issuing SBIC.
The present impact Leverage can have upon the IRR of an SBIC is demonstrated by the comparison below. The comparison, based on certain assumptions summarized in the accompanying notes, illustrates the effect on a private investor’s rate of return, net of the managers’ fees and carried interest, resulting from the use of Participating Securities Leverage. For example, based on the assumptions noted below and assuming a portfolio return of 20%, the Participating Securities Leverage results in a rate of return to a private investor of more than one and one-half times the investor’s rate of return for an unleveraged fund (19.5% IRR versus 12.5% IRR). But if a portfolio return of 10% is assumed, the Leverage has a negative effect on a private investor’s rate of return.
(a) Source: National Association of Small Business Investment Companies.
(b) All returns refer to compound annual returns.
(c) Returns are net of 2.5% annual management expenses, organizational and other costs, and 20% management carried interest, and assume a 4-year investment period and 4-year holding period.
(d) Leveraged returns assume 2:1 Leverage in the form of Participating Securities (2 times private paid-in capital), 7.75% combined Prioritized Payments and annual fee, and 9% Profit Participation rate.
In addition to the potential boost to IRR which the use of Leverage can provide, our clients have found other attractive features to investing in SBICs. Our fund manager clients have found the availability of Leverage an attractive supplement to private capital in the tough fundraising market of the last few years. In this regard, SBA has been authorized to fund $4 billion of Participating Securities and $3 billion of Debentures in Fiscal Year 2004. The availability of these amounts of Government funding should be a significant inducement to the flow of increased Private Capital into the SBIC Program.
Further, now that the capital market seems to be turning around, SBICs should remain an attractive source of funds for VCs because the interest-rate sensitive nature of the repayment obligation to the Government will keep the costs of leverage low, although the potential legislative changes mentioned above could have some implications in this regard if they are enacted.
Also, SBA as a regulator has shown increased sensitivity to investor concerns in its approval of the terms contained in the underlying Partnership and LLC Agreements of SBICs. Agreement by SBA to investor-inspired conditions such as reduced management fees and caps on cross-fund investments and organizational expenses; and the possible future inclusion of “no fault divorce” and “key man” provisions in SBIC operating documents at the behest of institutional investors with the concurrence of SBA, are added inducements to institutional investment in SBICs. In addition, SBA has pledged to continue to make the program as market acceptable as possible and likely will be open to further investor-oriented issues of this nature in its program governance.
Finally, our bank clients have been able to derive Community Reinvestment Act credit for investment in SBICs which, in turn, invest in their investment areas. In this regard, under applicable regulation, an investment in an SBIC is a “qualified investment” for CRA purposes. This has induced many of the nation’s largest banks to consider the SBIC program as an attractive investment consideration.
The very beneficial result of all of these improvements has been to attract extremely qualified managers to the SBIC program such as Whitney & Co., with which we have recently been working to form and license an SBIC. In this regard, Mike Cowan of Whitney recently observed: “The SBA has created a powerful program to encourage firms like Whitney to focus on partnering with deserving American small businesses. Our recently launched SBIC fund, JHW Greentree Capital, will utilize private investor capital and up to two times that amount in SBA Leverage to provide equity capital to fund U.S. entrepreneurs’ growth plans.”
This article was authored by Martin D. Teckler, a partner in the Washington, D.C. office of Kirkpatrick & Lockhart, LLP firstname.lastname@example.org, (202) 778-9890 and James P. O’Hare, of Counsel in the Boston office of Kirkpatrick & Lockhart, LLP, email@example.com, (617) 261-3219.