The classic 2001 movie A Knight’s Tale starring Heath Ledger is about a peasant in medieval times who begins a quest to change his status to become a knight. In the modern banking world, small business investment companies are following Ledger’s character’s path and turning into knights after being just a small group of capital providers 20 years ago.
The growth of the SBIC industry and its corresponding regional land grab tells a knight’s tale of its own. Like it or not, there is still a form of regional feudalism going on in the deal world, with SBICs being the beneficiaries. The list of JAMBOGs (just another middle market buyout group) goes on for miles, but many SBICs tend to have a form of regional geographic exclusivity, which is not so dissimilar to the feudalism days when owning real estate was a form of control. Having an SBIC license within a region provides a form of territorial exclusivity. This is the essence of feudalism. The Small Business Administration administers the SBIC program and licenses SBICs according to the its perceived need for small business financing. Geography is one of the SBA’s considerations, so the location of a particular SBIC and its primary market is a significant factor.
SBICs fill a financing need not provided by banks due either to higher leverage, lack of collateral or both. Similar to medieval times, there are regional fiefdoms in the SBIC world, with each region typically having one key SBIC and some type of implicit exclusivity or, at a minimum, a first look setup. Just look at the surrounding cities that comprise the major regional banking hubs and you’ll notice how each deal community tends to have one SBIC that rules the roost. There are practical reasons for this, too, including the fact that the folks who typically run these groups are deep-rooted in the deal community and local to region. So while there are literally hundreds of lower middle market private equity firms (i.e. JAMBOGS), there are typically few SBICs within the regions in which these many PE firms focus. As such, the SBICs typically get first looks at deals within their respective regions before sponsors seek other options.
This trend started a few decades ago and has been correlated with the rise of lower middle market private equity. Several innovative commercial banking executives saw the obvious need for SBIC vehicles to provide acquisition financing to support the crop of new PE firm entrants. Many of the early innovators were entrepreneurial commercial bankers who could not provide aggressive leverage terms for their sponsor clients. The SBIC format provides the perfect vehicle to provide mezzanine and an equity co-invest. This was the ideal vehicle to serve the sponsors yet still partner with the regional bank groups. At the end of the day, we live in a small world as it pertains to the lower middle market. While there might be many PE firms focused on the lower middle market, they still tend to stay local/regional, creating the dynamic of several hundred equity funds and few SBIC funds.
Being a key regional SBIC fund effectively created a recurring revenue business for the SBICs. The leading SBICs seemed to have very high conversion given the scarcity of local competing SBICs due to the exclusivity of the license. Conversely, most banks that simply just focus on sponsor coverage have much lower conversion.
The key regional SBICs have become real gateways to deal flow for commoditized banks and banking products. This system has worked well for decades, but it is starting to evolve due to increased LP awareness and interest in this market. The end result is more capital is coming into this market, searching for deals and changing the paradigm and competitive landscape. Ironically, the success and proliferation of the SBIC model is going to change the dynamic between SBICs and bank LPs. This means the banks will have a hard time keeping exclusivity with SBIC investments when the SBICs now have so many bank LPs they no longer need to rely on anyone anchor. In the early days the SBICs were more reliant on the banks for capital, but due to success of the model, this trend has reversed.
Feudalism had a similar ending when land ceased to be the only form of wealth. For those who study history, feudalism was replaced by the early capitalist structures of the Renaissance. The next decade is going to bring about a true renaissance, as LP diversification will bring new firms and foster innovation.