To SBIC or not to SBIC?

An enviable carve-out from the US Investment Advisers Registration Act bill, and possible new funding from the government, might make structuring your fund as a Small Business Investment Company a tantalising prospect.

As the US Private Fund Investment Adviser’s Registration Act awaits a full vote in the House of Representatives, incentives in the bill – including an exemption for venture capital funds and small business investment companies (SBICs) – will likely increase interest for SBIC licenses. 
The venture capital carve-out is only partial, as venture capital funds will still be required to provide some information, to be determined, to the Securities and Exchange Commission. It’s also unclear how the SEC will choose to define venture capital. SBICs, on the other hand, are clearly legally defined, and exempted wholesale from the registration process and the additional reporting requirements that the bill will stipulate.
Another bill that is slated to be approved by the Committee today will give SBICs more flexibility and access to government funding. That bill will likely be accompanied by the similar but separate Small Business Early Stage Investment Act of 2009, another source of government funding which SBICs will be well positioned to take advantage of.
With all these incentives lined up, early stage investors might start thinking about whether registering as an SBIC could be a smart move. Brett Palmer, president of the National Association of Small Business Investment Companies (NASBIC), said he’s seen a dramatic increase in applications for SBIC status since the financial crisis. 
“The programme has seen a significant uptick since the financial crisis of last year, because it’s a form of low-cost capital that’s sure, and frankly right now if you’ve got access to capital that’s sure you’re in a pretty good place,” Palmer said.
The NASBIC training classes are a prerequisite for obtaining an SBIC license; despite doubling the number of classes available this year, every session was sold out, he said. This surge in interest has caused the Committee to include language in the new legislation that would speed up the licensing process, bringing wait times down from six months to 60 days. 
The SBIC programme was created in 1958 to fill a gap in financing for entrepreneurs and early stage companies. The Small Business Administration significantly reduced the size of the SBIC programme in 2005, because a 9 percent profit cap was making it difficult for the SBA to make enough money to continue investing in future funds. But today the programme pays for itself, Palmer says, and is getting bigger as interest ticks up. Currently, SBICs make over 65 percent of all venture financings, the SBA says. 
In order to qualify for the programme, a management team must submit to a government background check, and must have a proven track record of success in their investment sector. An SBIC may only invest in “small businesses”, defined as having a net worth less than $18 million and after-tax income less than $6 million for the prior two years. The team must present proof that they can raise a minimum private capital commitment of either $5 million for a debenture fund, or $10 million for an equity fund. It’s a rigorous process, Palmer said, and not everyone wins approval.
“You can’t just raise private money, have a nice resume, and walk in; you really have to have been proven in your marketplace to access the programme,” he said.
For every $10 million in private equity raised, managers can receive $20 million in leverage from the government, typically at a very low cost of capital. A recent pooling carried a 4.2 percent interest rate, Palmer said. The government acts as the preferred limited partner in the fund, and is first in line to receive distributions. There is a leverage limit of $150 million per fund, and a leverage limit of $350 million for a “family of funds”. 
If a guaranteed pool of low-cost capital isn’t incentive enough, the Small Business Early Stage Investment Act of 2009 should make venture capitalists sit up and take notice. It would amend the Small Business Investment Act of 1958, the same one that established the SBIC programme, to create a new programme in which the government matches funds raised for early stage investments in targeted industries. A fund need not be registered as an SBIC to participate, but being an SBIC allows candidates to jump to the head of the approval list, because many of the criteria for participation are already met in the process of obtaining an SBIC license.
“For VC funds that are trying to raise capital, and they were planning to raise $100 million but the market’s really tough right now and you can raise $50 million, now you can actually do that,” Palmer says.