SBICs – Breaking it Down
By Sheri Lejman; Partner, Marcum LLP, Alternative Investment Group and contributions from Marni Pankin; Partner, Marcum LLP, Alternative Investment Group
During 2010, Small Business Investment Companies ("SBICs") provided small businesses in the United States with $1.59 billion of capital, either through investments in equity securities, loans, or debt with equity features. As of the most current information published by the United States Small Business Administration ("SBA"), who administers the SBIC Program through the SBA’s Investment Division, there are almost 400 SBICs in existence today. The 2008 economic and credit crisis left small businesses in a tough position to obtain funding as capital flow from traditional sources dried up. As a result, the SBIC Program has become more popular as an alternative method to finance small business.
So what should you know about SBICs? In this article, we will provide the background and general information, which may help you understand more about SBICs, as well as help you determine if an SBIC is a viable business pursuit for you.
What is an SBIC?
The first SBICs were, in fact, some of the first professionally managed private equity and venture capital firms in the United States. The SBIC Program was established by the United States ("U.S.") Congress in 1958.
The primary purpose of establishing the SBIC Program by the U.S. Congress was to address concerns related to an existing funding gap in our capital markets for small-growth oriented businesses in the United States. Additionally, the SBIC Program was intended to help foster technology and technological advances of U.S. entrepreneurs in order to compete with other world powers at that time, as well as to serve as a mechanism to spur economic growth for the U.S. economy.
Since their inception, SBICs have been a source of financing to several well known companies including Apple Computer1, Costco1, Gymboree Corporation1, and Restoration Hardware, Inc.1, just to name a few.
According to the SBA:
"As a key component of the private equity industry, the SBIC Program has played a significant role in the creation of jobs and growth in the U.S. economy over the last 45 years. The most exciting potential of an SBIC investment is how it can turn one small company into a great success story – spurring innovation across industries and dramatically changing the way we live and work."
Why become an SBIC?
It’s about leverage.One of the primary reasons a U.S. investment company would desire to be a licensed SBIC is to take advantage of financing provided by the SBA to SBICs.The financing provided can be less expensive than other sources of financing outside of the SBIC Program.
The leverage provided to an SBIC is in the form of debentures through the Debenture Program (further discussed below). These debentures are interest only, with a bullet payment of the principal at the end of the loan, which is a 10 year maturity.Debentures are not secured loans and the SBIC’s general partner is not personally liable. The leverage available is generally limited to two times private capital paid in. Before an SBIC is permitted to obtain financing from the SBA, it must be licensed with the SBA, which is a process that historically can take anywhere from 6 to 10 months.Prior to licensing, an SBIC must raise capital from private investors of at least $2.5 million. Private capital of an SBIC includes the contributed capital of an SBIC licensee and its investors, as well as any unfunded binding commitments from institution investors.
What is the process?
Historically, there were two primary ways the Government would assist SBICs:
- The Participating Securities Program; and
- The Debenture Program.
The Participating Securities Program was a program where the U.S. Government would take an equity stake in the SBIC as a limited partner, in the form of preferred limited partnership interests.The Participating Securities Program was terminated in 2004, due to losses sustained from tech boom investments, as well as a broader policy decision by the government. The last funding for the Participating Securities Program to an SBIC occurred in late 2008.
On the other hand, the SBIC Debenture Program is alive and well, and is the current manner by which the Government assists SBICs, as further discussed above.The Government finances the Debenture Program by a pooling process of the loans that have been made to SBICs from the SBA.The SBA often obtains assistance from investment bankers to facilitate the sale of such pooled SBIC debentures to institutional buyers in the form of trust certificates. The investment bankers are typically paid a 0.375% underwriting fee. These trust certificates are normally sold two-times per year to institutional buyers, and are Government guaranteed with a fixed interest rate and a 10 year maturity.
What are the primary regulations and reporting requirements that an SBIC must follow?
Being an SBIC requires the investment company to adhere to certain regulations and polices, as well as reporting requirements.
The following is a general listing of some of the primary standards:
- Idle funds of the SBIC are to be invested in liquid, safe and short-term investments;
- Investments of the SBIC are valued annually (and semi annually if leverage is used) per valuation guidelines approved by the SBA;
- SBICs using leverage must be in compliance with its leverage terms. An SBIC will not be in compliance if its capital impairment ratio, as defined by the SBA, exceeds permitted levels. In calculating its capital impairment ratio, an SBIC would consider its outstanding leverage, realized and unrealized losses, amount of private capital, etc. The capital impairment ratio must be calculated quarterly and the SBA must be notified promptly if such capital impairment exists;
- As long as an SBIC has outstanding leverage, unaudited financial statements on SBA Form 468 (Short Form) must be submitted to the SBA within 30 days of the close of the SBIC’s fiscal quarter;
- Annual audited financial statements (audited by an independent public accountant) must be filed within 90 days after the SBIC’s fiscal year end. The independent public accountant must also review the SBIC’s valuation procedures in relation to its investments, including the adequacy of the SBIC’s documentation of its valuation methodologies, procedures, etc.;
- Along with the annual audited financial statements, an SBIC must prepare SBA Form 468 (Long Form) in accordance with SBA's Accounting Standards and Financial Reporting Requirements for Small Business Investment Companies;
How does valuation differ between SBA guidelines and GAAP?
The "reported value" on SBA Form 468 of loans and investments will differ in certain instances from "fair value," which is the measurement of value that would comply with generally accepted accounting principles ("GAAP").The primary differences between the two measurements are that (i) an increase in value above investment cost may be reflected in the reported value only if it has a specific permitted basis under the SBIC licensee’s valuation policy; (ii) liquidity discounts, which are prohibited under GAAP, must be considered for inclusion in reported value; and (iii) the reported value of interest-bearing securities is not adjusted for changes in interest rates.It is expected that reported value will not exceed, but may be less than, fair value.2
The SBA realizes that the differences between reported values and GAAP-compliant fair values may be significant.There also may be other differences between SBA Form 468 and GAAP financial statements, including but not limited to, the treatment of unrealized gain/loss, presentation of financial highlights, etc. As a result, the financial statement presentation may be considered an other comprehensive basis of accounting ("OCBOA") and financial statement auditors can elect to provide the SBA with an OCBOA audit opinion rather than a GAAP audit opinion, with the financial statement auditor’s report stating that the financial statements have been prepared in accordance with accounting practices prescribed or permitted by the US Small Business Administration.The SBA has no objection to this practice, provided there is appropriate footnote description of the SBA-GAAP differences.2
What is the organizational structure of an SBIC?
An SBIC is a privately owned and operated investment company licensed with the SBA. An SBIC’s structure is similar to that of a traditional private equity investment firm, where there is a general partner that can take the form of a separate entity organized as a limited liability company. The investment company is typically formed as a limited partnership, although it can also be organized as a corporation or a limited liability company.A limited partnership structure is the legal structure that is most encouraged by the SBA.
Investors of an SBIC may be either domestic or foreign individuals or entities. The SBA does, however, require a certain percentage of investors to be limited partners who do not participate in or otherwise control management.Lastly, there are restrictions on transfer of ownership by investors, without the SBA approving such transfer first.
What can SBIC’s invest in?
An SBIC may make investments in portfolio companies in the form of a loan, equity securities, or debt with equity features. There are, however, limitations as to the types of portfolio companies that an SBIC can invest in (i.e. an SBIC cannot invest in leasing companies, banks, many kinds of real estate projects, single purpose projects, etc.).
Further, SBICs need to invest in U.S. small businesses. In fact, at least 25% of invested funds are required to be made to "Smaller Enterprises." Smaller Enterprises are considered smaller than small businesses and are defined as U.S. companies with average net income of $2 million and net worth of not more than $6 million.
What type of experience should management of an SBIC have?
The SBA expects management teams to be senior level decision makers with experience in private equity/venture capital funds. Management should exhibit strong deal flow experience with the investment types and strategy of the proposed fund and also have a realized track record of above average returns benchmarked against funds of a similar vintage year and style. Investment experience of management needs to be as a principal rather than an agent (i.e. investment banker, consultant or broker).And management needs to demonstrate real life experience and hands-on involvement with portfolio companies, preferably both in operations and finance.
What SBIC resources exist?
There are several resources available for learning more about SBICs and obtaining necessary assistance and guidance.
The most notable organization is the National Association of Small Business Investment Companies ("NASBIC"), which is located in Washington, D.C. The NASBIC provides a variety of information and services to its members and publishes regularly to assist its members with keeping up on current news and regulations related to SBICs.
Other resources are attorneys, fund administrators and CPA firms who specialize in servicing SBICs and have the requisite experience in assisting with initial set up of the fund and related documents, preparing and filing forms with the SBA, performing in-house accounting and reporting to investors, assisting with valuation of investments, conducting financial statement audits, preparing tax returns, and assisting with tax planning strategies.
Where do we go from here?
The SBA continues to support their financing efforts of SBICs, and encourage new applicants to apply.So far, there appears to be no real negative impact on SBICs or reduction of funding per the 2012 Proposed Budget from the Obama Administration.Also, there seems to be no significant changes regarding the approval for the SBIC Debenture Program expected in the near future. The budget for the program is set at $3 billion for fiscal 2012, which means $3 billion of available leverage to SBICs for the upcoming year.However, this will be an area to watch as the U.S. Congress has their say on this budget as they work through a budget resolution.
If you have an interest in forming an SBIC or if you have additional questions, you can first start by going to the SBA website and/or the National Association of Small Business Investment Companies’ website.Alternatively, you can contact one of Marcum LLP’s experienced professionals-on the West Coast, Sheri Lejman, firstname.lastname@example.org or on the East Coast, Dennis Schall, email@example.com.
1 Information obtained from U.S. Small Business Administration http://www.sba.gov/aboutsba/sbaprograms/inv/INV_SUCCESS_STORIES.html
2 Information obtained from U.S. Small Business Administration