WASHINGTON, D.C. – Thanks to legislative initiatives implemented in 1994, the Small Business Investment Company program has been revived, with the number of new SBIC licenses being issued having more than doubled to 53 in 1999 from 22 in 1996, said Don Christensen, associate administrator for investments at the Small Business Administration.
The turn around is due in part to the SBA’s participating securities program, which has made applying for an SBIC more attractive, venture capitalists said. Prior to 1994, under the SBA’s debenture program, an SBIC had to make two annual interest payments on the money it received from the SBA. Christensen said that SBICs found this burdensome because they had to make interest payments before they realized any profits.
Under the participating securities program, the SBA makes interest payments on behalf of the SBIC to the point when the SBIC starts to realize a profit from its investments, at which time the SBIC repays the SBA with interest for those interest payments. Of the 53 newly licensed SBIC’s last year, over half were participating securities licensees. To date, the SBA has received $189 million in profits from this program, he added.
VCs praised the program for making fund raising easier because of its two-to-one leverage, while also enhancing the potential returns for traditional limited partners. The SBA does not participate in a vehicle’s profits to the degree in which it invests capital since the SBA is potentially providing a fund with 66% of its capital, but only participating in 10% of the profits. “In one shot you get two-thirds of your capital – and this enhances the returns for other LPs because it gives you more to invest,” said Robert Finkel, president of Prism Capital and managing partner of the Prism Opportunity Fund. Finkel expects the fund to tap around $40 million of SBIC funds after it holds a second close on $20 million in mid-May.
The program gives a particular boost to those VCs raising first time funds, said Janet Paroo, managing director of the $90 million-targeted NewSpring Ventures LP, which is expecting to supplement the $30 million its raises with $60 million in SBIC capital. Even though the managers of new vehicles might have ample personal experience in the private equity arena, the funds themselves do not posses a track record as vehicles in their own right, so SBIC capital can help ramp-up a first time fund, allowing its managers to build credibility, which should make raising capital easier the next time, she noted.
“We are kind of an entry-level way into the VC industry,” Christensen said. A successful vehicle needs at least $30 million, he noted, adding this means a fund can raise $10 million by themselves, get $20 million from the SBA and become what he termed “an economic reality.”
SBIC’s are restricted to investing in small businesses that have after tax profits of less than $6 million and a net worth of less than $18 million, Christensen said. The companies they invest in must be based in the United States, and they cannot invest in the real estate or natural resource industries or in an entity that could redistribute any SBIC capital. SBIC’s also cannot take control of companies in which they invest, unless the company is failing or is a start-up. “We want to build small companies in the U.S. that can build wealth and employment opportunities,” Christensen explained.
Finkel said the restrictions were not a problem for Prism, which focuses on early-to-mid stage companies in the information technology, publishing, business services and specialty manufacturing industries. The fund’s average deal size is $500,000 to $5 million, he added. Thomas Porter, a general partner at Enterprise Development Fund in Ann Arbor, Mich., said the restrictions have not really impacted his firm’s EDF Ventures LP, which is expecting to close on slightly over $80 million, including SBIC funds, when it wraps at the end of April. “We might have made some investments in Canada given our location, but we can’t because of the location restriction,” he said. “But there is not too much we cannot do.”
Finkel, Porter and Thomas all said the program probably works best for a small or first time fund looking for a few additional dollars to make a real difference in the returns it generates. A bigger fund might also be more limited by the restrictions than a smaller fund, Finkel noted. “For bigger funds, the leverage would be inconsequential,” Paroo added, noting that the maximum amount of leverage a fund can receive is $105 million.
Applying for an SBIC is a detailed process that includes an interview, written application and a background check by Federal Bureau of Investigation on a fund’s partners, Christensen said. As the program has caught on in popularity, the SBA has built a back log of applications, which means that successfully applying for an SBIC license currently takes about a year. “We are working on trying to get some staff to speed this up,” he said.