Becoming a Small Business Investment Company (SBIC) allows a lower middle market-focused mezzanine or equity fund access to low-cost leverage capital, which can enhance investor returns. However, companies seeking this option must be willing to navigate a potentially difficult and expensive government licensing process, and to follow the ongoing compliance and regulatory restrictions of the program.
For an asset-based lender, partnering with an SBIC fund offers an opportunity for the ABL to provide their customers with cash-flow financing beyond the underlying collateral and reach customers the ABL may not otherwise be able to assist. A growing number of ABLs also seek opportunities to directly invest in stand-alone SBICs across the nation, which enables product line extension as well as Community Reinvestment Act (CRA) credits for their parent institutions.
The U.S. Small Business Administration (SBA) began the SBIC program in 1958. This program was intended to be a vehicle for supporting private sector funds that would focus on the capital needs of domestic small businesses. Since it began, the program has provided more than $60 billion in flexible debt and equity to help grow more than 100,000 small businesses, including Apple, Costco and Staples, and today there are 292 licensed SBICs.
The program is entirely self-funded from fees paid by the license holders and by the issuance of public debenture bonds that are sold into the market and priced off a slight premium to the rate of ten-year U.S. Treasuries. The current administrator of the program is Pravina Raghavan, and the SBA maintains a website dedicated to the program and process at www.sba.gov/inv. In addition, the Small Business Investment Alliance (www.sbia.org) serves as the leading trade association for small business-focused private equity and debt funds, including SBICs and Business Development Companies (BDCs), and provides valuable information and direction for would-be applicants.
How Does the Program Work?
The Investment Division of the SBA manages the program and authorizes licenses in accordance with regulations that have been developed over the program’s 55-year history. From time to time, the SBA launches new initiatives within the scope of the program based on feedback from the SBIC community, SBA staff and Congress.
For example, today there are set-asides and incentives in areas like renewable energy, low- and moderate-income communities and certain rural areas that are underserved by other sources of private capital. By becoming a licensed SBIC, the private investment company is able to access leverage against committed equity raised by the company from individual and institutional investors. This leverage is one of the primary reasons for seeking a license. For every dollar of committed private equity, an SBIC is able to borrow through the SBA up to two times leverage at a fixed cost of capital equal to the ten-year Treasuries plus a 1%-2% premium. Today, the cost of capital is about 4% interest only.
Furthermore, the SBIC has no prepayment penalty. In simple terms, a fund that has $50 million in committed private capital has access to up to $100 million of leverage from the SBA, and consequently, has the ability to invest up to $150 million total over its investment period.
Another important feature of the program, which reflects its public interest focus, is that it allows banking institutions that are subject to the provisions of the CRA to receive CRA credit for equity that they invest into an SBIC licensed fund as a limited partner. In our fund, for example, we have six participating banking institutions — all of which are within our market area. Bank participation also leads to opportunities for the banks to use the SBIC as a means to give their lenders “line extension” with customers that are seeking flexible capital in the form of mezzanine and equity capital for growth initiatives or ownership transfer through leveraged buyouts or management buyouts.
What Types of Investments Can SBICs Make?
While the program is flexible and contains funds with various investment strategies, many SBICs are seeking to invest their capital as mezzanine or second lien debt. This debt is characterized by having a subordinated position on the company’s collateral and is generally underwritten against the proven or pro forma cash-flows of the business. While structure and terms vary, funds are typically seeking to provide investments on a no or limited amortization basis with a current interest rate of between 10% and 14% and with some form of earning enhancement such as PIK interest or equity warrants. SBICs also have the flexibility to invest some portion of their capital in the form of preferred or common equity — enabling many companies to take advantage of putting growth capital to work while not increasing leverage.
Investment size is limited to small businesses by the rules of the program. These are generally defined as companies with tangible net worth of less than $18 million and average after-tax income for the prior two years of less than $6 million, but an alternative test based on industry revenue and employee counts also can be used.
Qualify & Applying For a License
The SBA has a very formal process to approve new licensees that can often take 12 to 24-plus months. Typically this process involves a pre-screening conversation with the SBA, followed by the completion of a Management Assessment Questionnaire (MAQ), which hopefully then leads to a “green light letter” for a fund to begin its fundraising process and finally the formal license application process.
As an initial matter, potential licensees need to consider whether they can qualify for a license, before getting too deep into the process. Qualifications focus on:
• Team history and background of working together in similar funds or structures, prioritizing credit/lending experience,
• Demonstrable track record with multiple successful exits in similar investments,
• Investment philosophy and focus in line with the goals of the program and
• Ability to successfully fund raise from limited partners.
In our case, after successfully completing our MAQ, we received our green light letter in the fall of 2011 and our formal license in the summer of 2013. In the interim we had to satisfy the SBA’s requirements, secure our limited partner commitments, organize our new fund and spin out from our former parent bank.
Entities that believe they could qualify under the program and are interested in pursuing a license should seek the advice of counsel and start to organize for the pre-screen and MAQ. The Small Business Investor Alliance also can be a great resource as you evaluate the program and navigate the process. Be aware that the program has its own small ecosystem of respected service providers including a handful of qualified law firms with experience guiding firms through the process.
Is It Worth It?
For those with the experience and interest, the SBIC program provides them and their investors with a significant resource through access to low-cost leverage. The SBA estimates that an SBIC that uses leverage is able to improve the overall returns to their investors of between 400-600 basis points. In challenging times, particularly as the cost of private leverage starts to increase as the economy recovers, the SBIC advantage in terms of the cost of capital against the spread will outdistance other structures like the BDC.
Also, being a licensed SBIC enables entities to seek new licenses going forward once their fund has been invested. Many of the current SBICs are funds on their second, third or even fourth license. Therefore, in the long run, upfront cost to start and time invested can be an investment well spent over several funds.
Joseph Bute and Tyson Smith are partners at F.N.B. Capital Partners, a $175 million SBIC based in Pittsburgh, PA, which grew out of F.N.B. Capital Corporation, the merchant banking arm of First National Bank of Pennsylvania. Today the fund is actively seeking investments in support of leveraged buyouts, growth financing and supporting succession opportunities for managers and outside investors in lower middle-market companies throughout the eastern U.S.