The Questions
- Why, since 1994, have more than 150 investment firms (venture capitalists, merchant banks, investment banks, private investors, mezzanine lenders) applied for licenses to become small business investment companies ("SBICs")?
- Why have more SBIC licenses (46 during fiscal 1999) been issued since 1994 than in the prior 15 years combined?
- Why have SBICs been able to raise more private capital from endowments, pension funds, wealthy families and individuals since 1994 than in the prior 15 years combined?
The Answers
In an effort to promote the growth, modernization and expansion of American Business and to create jobs, expand the tax base and promote exports, the federal government - with highly unusual bi-partisan support - has given those who qualify (experienced investors,) in excess of $2 billion dollars, since 1995, for the purpose of investing in U.S.-based companies that do not exceed a certain size ($18 million net worth and $6 million after-tax net income.)
The funding mechanism for equity SBICs is a financial instrument called a "participating security" -- a 10-year, interest-only, non-recourse instrument akin to a preferred stock or income bond. The coupon accrues and is payable only as, if and when, the SBIC is profitable. The principal of this security is guaranteed by the U.S. Small Business Administration ("SBA"), which is then packaged and pooled with participating securities issued by all other SBICs seeking funding. Participating interests in the pool are then sold to the public in the government bond market, by Goldman Sachs, First Boston and Chase Securities.
The public purchases these securities because of the government guarantee, which makes the participating security have a below-market interest rate (ranging from approximately 175-215 basis points above 10-year treasuries) that is fixed for 10 years. The interest payments accrue and are only paid by the SBIC when it, as an entity, not any particular investment, is profitable. SBA anticipates payments will not start until year five or six of the life of the SBIC, when investments are sold.
If interest accrues, but is not paid until profitability, who pays the public purchasers every six months? Answer -- Uncle Sam does -- the money is taken from SBA's budget in exchange for which SBA becomes a preferred limited partner in the SBIC partnership and receives a share of the SBIC's profits tied to 10-year treasuries. For example, if 10-year treasuries are at six percent, SBA's profit is nine percent.
From its inception in February 1995, the sale of participating securities occurred every quarter in the months of February, May, August and November. In May of 1998, the SBA implemented so-called "Just-in-Time" financing that allows SBICs to receive a five-year commitment for the amount of participating securities ("Leverage") (and thus bypass the annual government budget process) that can be drawn down upon 10 days' notice. This financing has been effected through a short-term arrangement with the Federal Home Loan Bank of Chicago. Each recipient of Leverage accrues a short-term rate on this financing until it is rolled into a long-term accruing rate, as a result of the public sale of participating interests in the above-described pool every six months.
Leverage issuable by any one SBIC is twice the amount of its private capital commitments, with a maximum of approximately $100 million allocable to any one licensee, with a minimum of $10 million of private capital required for the issuance of a SBIC license. In other words, $10 million of private capital commitments from qualified investors ($2 million net worth for individuals) creates a $30 million fund, and $50 million creates a $150 million dollar fund. Thus, assuming six percent 10-year treasuries, SBA arranges for 66 percent of an SBIC's capital, and receives nine percent of its profits as a preferred limited partner.
With the use of this SBA capital, internal rates of return can be increased significantly (many millions of dollars. Assuming equal investment performance, the "cheap capital" becomes a competitive advantage in securing investment opportunities. Because the SBIC can price its investment at a lower cost, the Leverage enables a fund to be launched with much less capital than is required by a traditional fund, and 66 percent of salaries and overhead are paid with government money.
In order to incentivise the managers of an SBIC fund, SBA permits annual management fees of up to 2.5 percent of the private capital commitments plus, during the first five years of the life of the partnership, 2.5 percent of an assumed 200 percent Leverage (i.e., before the Leverage is received), based on such private capital commitments, for example a minimum of 2.5 percent of $30 million (assuming $10 million of private capital), or $750,000 per annum, to a maximum of 2.5 percent of $150 million (assuming $50 million of private capital), or $3,750,000 per annum. After year five, the 2.5 percent is based on Leverage actually drawn down.
SBIC Leverage also is available to lenders and mezzanine investors. It takes the form of a 10-year, interest-only non-recourse debenture, also guaranteed by SBA, packaged and pooled as described above and sold to the public. The major difference between the two forms of Leverage is that an SBIC using debentures must make interest payments directly every six months (whereas SBA makes the payments for the equity SBIC using participating securities). A lender may only make loans and debt investments (loans with equity features) with its capital, but SBA does not share in its profits. An equity SBIC must make equity investments in the amount of the Leverage it receives, but has the flexibility to use the balance of its capital for loans or debt investments if it chooses.
Debenture Leverage is available on a 3-1 basis for the first $15 million of private capital, 2-1 on the second $15 million and 1-1 on the third $15 million.
Managers of existing funds need not wait until their fund is fully invested to invest in an SBIC. The SBA permits an existing fund to "drop-down" a portion of its commitments and funds to an SBIC limited partnership, where the "parent" fund becomes a private limited partner of the SBIC partnership, once the consent of the existing limited partners is obtained.
Illustrative of the quality of existing Licensees are SBICs created by the following firms:
- Wasserstein Parella,
- Furman Selz,
- Piper Jaffray,
- J.H. Whitney,
- RFE,
- Canaan Partners,
- DFW and
- Wexford Management.
SBA's budget for FYE September 30, 1999, was $850 million for participating securities, $550 million for debentures. Discussions are ongoing regarding a combined $2 billion budget for this year.
In addition, investments in SBICs by banks and financial institutions subject to the Community Reinvestment Act are now presumed to be eligible investments under that act and the returns are expected to be higher than when invested directly.
*article courtesy of Stephen M. Fields of Paul, Hastings, Janofsky & Walker LLP.