The Small Business Investment Company (SBIC) Program enables private equity fund managers to access government leverage at rates typically lower than traditional lending sources. The SBIC Program aims to grow small businesses by facilitating access to growth capital for lower middle-market companies.
The U.S. Small Business Administration (SBA) oversees the SBIC Program through its Investment Division, located in Washington, D.C. The SBIC Program encourages the creation of SBIC funds to increase the flow of investment capital to small businesses and smaller enterprises in the United States. Since the establishment of the SBIC Program, SBIC funds have provided billions of dollars of investment and financing, helping to create or preserve hundreds of thousands of jobs.
Private equity fund managers own and operate SBIC funds and have the sole responsibility for their investment decisions. One of the most compelling benefits of the SBIC Program is that licensed SBIC funds gain access to long-term financing through securities known as “Debentures,” which are sold in the public market and guaranteed by the U.S. government. The Small Business Investment Act of 1958 (SBIC Act) authorizes SBIC funds to obtain long-term leveraged funds via the Debentures at favorable interest rates in order to fund debt and equity investments in qualifying small businesses. The Debentures obtained under the SBIC Program generally carry rates lower than would otherwise be available from traditional lending sources. This enables SBIC funds to make investments in greater amounts than would be possible solely with private funds.
TYPES OF DEBENTURES AND SBIC FUNDS
In 2023, the SBA expanded the scope of the SBIC Program by introducing Accrual SBIC funds and Reinvestor SBIC funds. These new types of funds supplement the traditional SBIC licenses that are available and expand the scope of the SBIC Program to allow fund managers with investment strategies that were previously poor fits for the SBIC Program or ineligible altogether to now participate.
The “Standard Debenture” available to licensed SBIC funds has a maturity of 10 years and requires semi-annual interest payments. The size of the SBIC fund’s capital commitments from its investors determines the amount of available leverage under the Standard Debenture for which the SBIC fund is eligible.
SBIC funds accessing the Standard Debenture are generally eligible for up to two tiers of leverage on their private capital, up to a statutory limit of $175 million of leverage for a single SBIC fund. This means that an SBIC fund with $75 million in private capital commitments could have a total fund size of up to $225 million, with up to $150 million of SBA leverage through the Standard Debenture. Since the Standard Debenture requires semi-annual interest payments, it is commonly utilized by SBIC funds that focus on debt or credit investment strategies that can generate current cash flow to meet their debt service requirements.
The new regulations issued by the SBA in 2023 to establish Accrual SBIC funds also promulgated regulations to establish a new type of Debenture, known as “Accrual Debentures,” which are designed to align with equity-oriented SBIC funds or those pursuing long-term investment strategies.
As is the case with the Standard Debenture, the Accrual Debenture has a maturity of 10 years. However, instead of requiring semi-annual interest payments, interest under the Accrual Debenture will accrue over the 10-year term, which will then be payable along with the principal at maturity. Unlike the Standard Debenture, an Accrual SBIC fund may only receive up to 1.25 tiers of leverage from Accrual Debentures instead of the 2.0 tiers available under the Standard Debenture – the SBA states that this arrangement is intended to mitigate risk inherent to the nature of equity investments. However, this maximum amount may be further reduced by the SBA as it will aggregate the total amount of principal under the Accrual Debenture with 10 years of anticipated accrued interest on such principal, and such total may not exceed the statutory maximum of $175 million.
In its adopting release, the SBA provided the following example of this limitation:
“[I]f an Accrual SBIC has $100 million in Regulatory Capital, the total Accrual Debenture principal it may be approved for may be only $118 million if the forecast interest would accrue to approximately $57 million over a ten-year timeframe at a four percent interest rate, since higher amounts would result in SBA guaranteeing outstanding leverage amounts in excess of $175 million, the current statutory maximum for Leverage available to a single Licensee.”
Accrual Debentures will only be available to SBIC funds that are specifically licensed by the SBA as an Accrual SBIC fund or a “Reinvestor” SBIC fund (as discussed below), and the SBIC applicant must apply for such designation at the time of its application. Standard SBIC funds may only issue the Standard Debenture.
The 2023 SBIC Program update also created the “Reinvestor SBIC fund.” A Reinvestor SBIC fund is a type of Accrual SBIC fund that pursues a fund-of-funds investment strategy, in which investments by the fund are made in underserved reinvestors (except banks, savings and loans not insured by agencies of the federal government, and agricultural credit companies) that in turn make investments in qualifying small businesses that have at least 50% of their employees in the U.S., are headquartered in the U.S., and are owned by U.S. citizens or entities, among other SBA requirements.
Though “underserved” is not defined by the SBA, the adopting release stated that “[b]y more broadly defining ‘underserved,’ SBA can maintain flexibility and agility to align with evolving market conditions by clarifying what constitutes ‘underserved’ through policy notices in order to increase its economic impact to underserved communities. The SBA’s goal is to cast a wide net, not only including Disadvantaged Businesses, but also potentially extending the group status to ‘rural and low-and-moderate-income areas.’” These Reinvestor SBIC funds also have the ability invest in other unlevered SBIC funds. Reinvestor SBIC funds are eligible for Accrual Debentures.
The SBIC Program also permits a fund manager to apply for a license to operate as an unlevered SBIC fund, meaning the SBIC fund will not be eligible for SBA leverage of any kind. Although an unlevered SBIC fund is not eligible for the benefits of SBA leverage, it is subject to fewer restrictions by the SBA (since the SBA is not guaranteeing any of its outstanding leverage), while remaining a qualified investment that is eligible for Community Reinvestment Act credit consideration (see below). As an example, bank-owned SBIC funds are typically unlevered.
TYPICAL INVESTORS IN SBIC FUNDS
Third-party investors (i.e., the limited partners in the SBIC fund) provide the necessary private capital to SBIC funds. These investors are typically high-net-worth individuals, banks and other financial institutions, endowments, public and private pension funds, and other institutional investors.
SBIC funds must disclose any investor owning more than 10% of the fund (and each investor owning 10% or more of those 10% investors). Additionally, the SBA requires investors owning 33% or more of an SBIC fund to submit to a formal background check and to SBA fingerprinting policies. An SBIC fund (excepting unlevered SBIC funds) must obtain at least 30% of its private capital from at least three investors who are not affiliated with the general partner or the management of the SBIC fund. This is referred to as the Management-Ownership Diversity requirement.
Banks often provide a source of significant private capital for SBIC funds because bank investments into SBIC funds:
(1) are exempt from the Volcker Rule otherwise restricting bank investments into private equity funds,
(2) are exempt from certain portions of the Gramm-Leach-Bliley Act, and
(3) may generate Community Reinvestment Act credit for those investments. However, the SBIC Act restricts banks from investing more than 5% of the bank’s capital and surplus in SBIC funds, measured on an aggregate basis.
Volcker Rule Exemption
The Volcker Rule, promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act, limits aggregate commitments that financial institutions can make to private equity and similar funds. However, the Volcker Rule contains a specific exception for SBIC funds, meaning the Volcker Rule’s limitations do not apply to investments by financial institutions into SBIC funds.
Gramm-Leach-Bliley Exemption
The Gramm-Leach-Bliley (GLB) Act exempts investments by banks into SBIC funds from the capital charges otherwise required under the GLB Act, so long as they represent in the aggregate less than 15% of the tier one capital of the bank or the bank holding company. Furthermore, ownership of 15% or more of the equity interests in a small business financed by an SBIC fund affiliated with a bank will not give rise to the presumption that the small business is an affiliate of the bank or the bank holding company.
Community Reinvestment Act Credit
As an additional benefit, banks, federal savings associations, and their holding companies may receive Community Reinvestment Act (CRA) credit for a limited partnership investment into an SBIC fund. An investment in an SBIC fund, whose regional focus includes the financial institution’s CRA assessment area, is specifically identified as a type of investment that will be presumed by the regulatory agencies to promote economic development and meet the standards of a “qualified investment” for CRA purposes. SBIC funds provide these types of financial institutions with an attractive alternative to grants, pools of mortgages in low and moderate income areas, qualified tax benefit transactions, and other investments routinely used to satisfy CRA requirements. As a result, banks play an important role in providing a significant capital base for SBIC funds.
LICENSING PROCESS AND SBA OVERSIGHT
The SBA thoroughly vets an applicant for an SBIC license and its management team prior to issuing an SBIC license. First-time applicants undergo an initial review after the filing of a Management Assessment Questionnaire (MAQ) with the SBA.
The MAQ generally contains a description of the applicant’s investment strategy and proposed operations, together with a detailed summary of each principal’s background and investment experience. If the SBA’s investment committee issues a “green light letter,” the applicant can then raise private capital before filing its formal SBIC license application. The license application includes formal background checks on each of the applicant’s principals. Applicants are required to identify whether they intend to issue Standard Debentures as a traditional SBIC fund or Accrual Debentures as an Accrual SBIC fund or Reinvestor SBIC fund in connection with the license application. The current fees for filing the MAQ and license application are $11,500 and $40,200, respectively, and each fee is required to be adjusted annually for inflation.
Funds applying for an SBIC license should anticipate at least eight to 10 weeks for the processing of their MAQ, a period of up to 18 months to raise the necessary private capital following the receipt of the green light letter (this window is driven exclusively by the applicant’s fundraising success), and an additional three to four weeks for the review and processing of the formal license application.
There is an expedited licensing process available to subsequent funds that meet certain conditions. Generally speaking, the subsequent fund should have substantially the same management team and investment strategy as the prior SBIC fund, a clean regulatory record, a fund size that is not more than 133% the size of the prior SBIC fund, and a relatively stable limited partner base. If these criteria can be met, the subsequent applicant can submit a short form MAQ through a streamlined process designed to reduce the cost and time associated with obtaining an SBIC license.
After the SBA accepts the formal SBIC license application, and prior to receipt of a license to operate as an SBIC fund, the fund has the option to hold interim closings and consummate qualifying investments in small businesses (known as pre-licensing investments). Pre-licensing investments qualify as part of the SBIC fund’s private capital used to calculate the amount of Debentures available to the fund after licensing. The amount of private capital invested in pre-licensing investments, therefore, can accelerate an SBIC fund’s ability to access Debentures once it receives its SBIC license. All such pre-licensing investments must be submitted to the SBA for prior approval. The SBA will not underwrite such investments, but merely determine whether they comply with SBIC regulations. Following receipt of the license, prior approval of further investments by an SBIC fund is not required.
The SBA regulates the SBIC Program by requiring SBIC funds to comply with certain reporting and examination requirements. SBIC funds must maintain certain minimum levels of capital, keep certain books and records, make them available for SBA examination, and prepare valuations of their portfolio securities in accordance with prescribed valuation guidelines. They are also required to file annual reports containing financial, management, and other information and to file notices of certain material changes in their ownership and operations.
An SBIC fund is subject to a regulatory review no less than every two years by the SBA’s Office of SBIC Examinations. These examinations are designed to ensure SBIC funds operate in compliance with the SBIC regulations or determine those instances when they have failed to do so. If an SBIC fund defaults on its payment obligations under the Debentures, fails to comply with any term of its securities, or violates any applicable law or regulation, the SBA has the right to accelerate the maturity of all amounts due under its Debentures. Additionally, the SBA can bring suit for the appointment of a receiver for the SBIC fund and for its liquidation.
QUALIFYING SMALL BUSINESS INVESTMENTS
SBIC funds may invest only in what the SBA defines as “Small Business Concerns,” which generally include companies, together with its affiliates, with a tangible net worth of less than or equal to $24 million and average after-tax profits in the prior two years of less than or equal to $8 million. These limitations are subject to periodic adjustments by the SBA to account for inflation.
Additionally, at least 25% of an SBIC fund’s investments must be in what the SBA calls “Smaller Enterprises.” Smaller Enterprises are companies, together with their affiliates, with a tangible net worth of less than or equal to $6 million and average after-tax profits in the prior two years of less than or equal to $2 million. These standards for Smaller Enterprises are set by statute and, therefore, are not subject to inflationary adjustments by the SBA.
There is an alternative test based on industry-specific thresholds expressed in terms of revenues and number of employees, which may allow investments that do not meet the requirements of the Smaller Enterprise tests. Additional restrictions apply if the SBIC fund’s investment will finance a change in ownership of a business.
Importantly, an SBIC fund may continue to own its interest and make follow-on investments in portfolio companies which no longer qualify as small businesses as long as the portfolio company was a small business at the time the initial investment was made.
Bryan P. Bylica is a member at Bass, Berry & Sims PLC. As an investment funds lawyer, Bryan counsels private equity funds, SBIC funds, RBIC funds, hedge funds, venture capital funds and other similar investment vehicles in all stages of their life cycle including formation, capitalization, SBIC and RBIC licensing, investing, and winding up. He is one of only a handful of lawyers nationwide that represents SBIC and RBIC funds throughout the licensing process and in post-licensing regulatory and compliance matters. Bryan can be reached at bryan.bylica@bassberry.com.
Philip Kassel is an associate at Bass, Berry & Sims PLC. Phil advises investment funds throughout all stages of a fund’s life cycle. He has extensive experience drafting PPMs, operating agreements, and subscriptions agreements for various types of private equity funds and asset classes. Phil can be reached at phil.kassel@bassberry.com.
Danny H. Harris is an associate at Bass, Berry & Sims PLC. Danny counsels clients on corporate and securities issues including mergers and acquisitions, capital markets transactions, and securities regulations matters and filings. In addition, he represents private equity firms and portfolio companies in various transactions. Danny can be reached at Danny.Harris@bassberry.com.
