By Stephen Newton
With nearly $690 billion in outstanding loans for small businesses in 2016, banks have a proven track record of successfully providing credit for small business owners and entrepreneurs. For nearly 50 years, one way banks have done this is through small business investment companies, or SBICs, which are private organizations licensed by the Small Business Administration to stimulate small business growth through long-term investments. Since they were established in 1958, SBICs have provided billions of dollars to more than 100,000 businesses through public-private partnerships that offer banks a competitive asset class within an attractive regulatory environment.
How are SBICs structured?
As privately owned and managed investment funds that use capital with an SBA guarantee, SBICs make debt and equity investments in qualified small businesses. Three types of SBIC licenses allow for flexibility: standard, impact investment and early stage. Funds have the option to supplement the private capital with leveraged SBA-guaranteed debentures. When forming funds, banks traditionally use leveraged SBICs, as they provide access to low-cost funding and maximize potential returns. SBA debentures are non-amortizing securities with interest rates fixed at a premium over the 10-year Treasury note. They mature and are payable in full by the end of the 10-year term. The SBA will commit up to two dollars of debt for every dollar a fund raises, subject to a cap of $150 million. SBIC managers are required to initially raise a minimum of $5 million, though they typically raise significantly more. The average debenture SBIC raised $52.6 million in fiscal year 2016, while receiving $61.9 million in SBA-guaranteed debentures.
What do SBICs invest in?
Funds must invest in small businesses but have discretion to choose companies across various industries with limited exceptions for real estate and financial intermediaries. A recent Congressional Research Service report showed 25.8 percent of SBIC financing goes towards manufacturing, while professional, scientific and technical services receive 14.6 percent of funding. SBIC funds typically focus on industries in line with their managers’ expertise. Companies received funding across 47 states in FY 2016, with the South and Mid-Atlantic regions claiming the most, followed closely by the Pacific West.
How long does it take to form an SBIC?
As of March 31, 2017, there were 317 operating SBICs, with typically 25-50 in the fundraising process at any one time. The SBA generally takes 6 to 12 months to grant an SBIC fund license based on the applicant’s successful private equity investment experience and business plan. Once the license is received and a debenture SBIC raises the required $5 million, funds may use the SBA-issued leverage. The SBA issued twenty licenses during 2016.
Why do banks invest in SBICs?
While SBICs’ private investors range from pensions to high-net-worth individuals, banks should consider the advantages these funds offer. Performance data is not available for individual SBICs, but the SBA Office of Investment and Innovation’s most recent annual report in 2014 showed a debenture SBIC’s median internal rate of return was 14.2 percent, with a top quartile annual return of 26.3 percent from 2000 to 2010. This closely resembled typical private equity returns, according to the SBA.
SBICs also provide several regulatory benefits. Banks can satisfy Community Reinvestment Act credit requirements by investing in SBICs as long as the SBIC is either located or doing business in a bank’s assessment area. Additionally, SBIC investments are exempt from the Volcker Rule, allowing banks covered by Volcker to represent more than 3 percent of an SBIC fund.
Other practical benefits enhance a bank’s participation in SBICs. Banks may refer a small business that does not meet the banks’ underwriting guidelines to the SBIC it invests in. In turn, SBICs are more likely to recommend the commercial banking services of their bank investors to firms in the SBICs’ portfolio. This provides an opportunity to develop relationships with new firms early in their business cycle.
