A SUMMARY GUIDE TO SMALL BUSINESS INVESTMENT COMPANIES By Christopher R. West, Esquire Semmes, Bowen & Semmes (410) 576-4772 cwest@semmes.com and R. Michael Haynes, Esquire Semmes, Bowen & Semmes (202) 966-5102 mhaynes@semmes.com January, 2011 Founded in 1887, Semmes, Bowen & Semmes serves a diverse clientele of businesses and individuals in the Mid-Atlantic region of the U.S. and across the nation. Through five offices in key locations in the District of Columbia, Maryland and Northern Virginia, more than 75 attorneys provide comprehensive legal representation in an extensive range of practice areas. The Semmes SBIC practice is co-chaired by Mike Haynes and Chris West. Mike formerly served as Chief Counsel of the U. S. Senate Committee on Small Business (with oversight over the SBA) and as General Counsel of NASBIC (the National Association of SBICs). Chris serves on the Firm s Management Committee and has nearly 15 years of experience in representing SBICs. This publication was prepared on the date set forth above and is believed to be accurate as of that date. The information contained herein may not apply to any particular situation. This publication is not intended as a substitute for legal advice and does not constitute the creation of an attorney-client relationship. Semmes, Bowen & Semmes 25 South Charles Street 1001 Connecticut Avenue, NW Suite 1400 Suite 1100 Baltimore, Maryland 21201 Washington, D. C. 20036
A SUMMARY GUIDE TO SMALL BUSINESS INVESTMENT COMPANIES Small Business Investment Companies ( SBICs ) are government-supported private equity funds which make investments in American small businesses under licenses granted by the U.S. Small Business Administration ( SBA ). Once licensed, SBICs must comply with SBA regulations. I. BENEFITS OF BECOMING LICENSED AS AN SBIC A. SBA Leverage Once licensed as an SBIC, a private equity fund qualifies for up to three times its private capital in the form of low interest, long-term government-guarantied loans, called Leverage. For example, a fund with $40 million in private capital can qualify for up to $120 million in Leverage, thus transforming a $40 million fund into up to a $160 million fund. There are several ways in which Leverage works to the benefit of a fund. First, because the fund always expects its return on its investments to greatly exceed the very low rate of interest on the government-guarantied loans, the difference redounds to the benefit of the fund s investors, thus significantly enhancing the fund s IRR. SBA statistics suggest that a fund s IRR increases between 3% and 6% as a result of using Leverage. Secondly, because the Leverage triples or even quadruples the size of the fund, it can invest larger amounts in each of its portfolio companies and thus take advantage of more and better investment opportunities. Thirdly, since the fund s management fees are computed based upon the total money under management, the existence of the Leverage results in considerably higher management fees. B. CRA Credit for Bank Investors Regulations issued pursuant to the federal Community Reinvestment Act ( CRA ) present most banks with a continuing need to make investments that qualify for CRA purposes. The CRA Regulations specifically identify an investment in an SBIC as a type of investment that will be presumed by the banking regulatory agencies as a qualified investment for CRA purposes. So long as an SBIC is located in or doing substantial business in the region in which the bank s assessment area is located, the banking regulators should accord CRA credit to a bank investment in such an SBIC. This gives an extra edge to SBICs over other private equity funds, which are not so favored by the CRA regulations. However, because the CRA regulations are subject to interpretation by federal banking compliance officers, banking regulatory agencies have occasionally declined to give full CRA credit to bank investments in SBICs when the SBICs have not been headquartered within the bank s assessment area and when the SBICs have not made any investments within the bank s assessment area.
C. SBA Validation Can Assist in Recruitment of Private Investors As will be discussed at greater length below, at the end of the initial part of the SBA licensing process, the SBA makes a decision as to whether to encourage a group of prospective fund managers to file a formal license application, and upon determining that the management group is qualified, will provide such a fund management team with a green light letter. The green light letter states that, based upon an initial review of the materials submitted by the fund management team and its presentation to the SBA s Investment Committee, the fund management team has been found to have met the SBA s comprehensive, professional standards for evaluating proposed SBIC managements and is therefore invited to file a formal application for an SBIC license. Many private equity fund managers have successfully used such green light letters to convince prospective private investors to make financial commitments to their funds. D. Active Trade Association and Nationwide Network of Fellow SBICs The National Association of Small Business Investment Companies ( NASBIC ) is a prominent and very active trade association for participants in the SBIC Program and hosts an annual convention of SBICs as well as numerous regional SBIC conferences. Many SBICs find that such opportunities to network with other SBIC managers lead to valuable referrals as well as potential investment partners. II. THE LICENSING AUTHORITY The SBA s Investment Division administers the SBIC program. The Investment Division is currently headed by SBA Associate Administrator Sean Greene, himself a former venture capitalist. The Associate Administrator position is a political position subject to appointment by the President of the United States. All other positions within the Investment Division are civil service positions. Harry E. Haskins is the Deputy Associate Administrator of the Investment Division. Harry has held this position for many years, with a brief sabbatical spent in another federal agency, and on several occasions has served as acting Associate Administrator. Other key officers of the Investment Division include: Carol Fendler, Director of the Office of Licensing and Program Standards, Marja C. Maddrie, Chief of the Office of SBIC Operations and Thomas G. Morris, Director of the Office of SBIC Liquidation. The Investment Division is located at the SBA s national headquarters at 409 Third Street, SW in Washington, D. C. 20006. III. RELEVANT STATISTICAL INFORMATION ABOUT THE SBIC PROGRAM The SBIC program was created by Congress in 1958. Since 1958, SBICs have invested over $55 billion in small U. S. companies. In the fiscal year ending on September 30, 2009
alone, SBICs participated in nearly 2,700 financings, investing $1,856,000,000 in 1,470 small businesses. Many major American small businesses were assisted by SBIC financings during their early years. These include: Intel, Apple Computer, Federal Express, JetBlue Airways, Staples, Outback Steakhouse, Radio One and Build-a-Bear Workshop. As of April, 2011, the SBA had nearly $7.9 billion in Leverage outstanding to SBICs as well as outstanding commitments to issue Leverage. There were 307 licensed SBICs in fortythree states. Starting in 1994, the SBA offered private equity funds a variation of the SBIC program known as the Participating Securities program. This program incurred very significant losses in the early years of this century due to the so-called dot.com crash in 2001, and further licensing under this program was discontinued in 2004. The basic SBIC program, known as the Debenture program, continues to operate very successfully, and in fact, the SBA is endeavoring to make the program more user-friendly in order to license more SBICs. In the fiscal year that ended on September 30, 2009, eleven new SBICs were licensed by the SBA. In the fiscal year that ended on September 30, 2010, an additional twenty-three new SBICs were licensed. As will be discussed in detail later, the first step in the licensing process is for an applicant to submit a Management Assessment Questionnaire ( MAQ ) to the SBA. In 2008, only 19 MAQs were submitted while in 2010, 51 MAQs were submitted. IV. THE DEBENTURE PROGRAM The most salient factor of the Debenture program is that Leverage is customarily made available to SBICs in the form of Debentures, which are ten year unsecured loans which require interest to be paid semi-annually. (Under limited circumstances, Leverage is made available through special Debentures with zero coupons for the first five years see the discussion below under The LMI Program, the Impact Investment Program and the Energy Saving Debenture Program.) Also, the SBA expects to roll out a new limited program entitled the Early Stage Innovation Fund in 2012. This program is also described below. The practical effect of the semi-annual interest requirement is that SBICs must necessarily invest most of their capital in cash flow positive companies that will be able to pay interest to the SBICs semi-annually so that the SBICs in turn will be able to pay the SBA interest on the Debentures semi-annually. The Debenture program is thus well suited to the mezzanine iinvesting model and is not very well suited to an equity investing model, although many Debenture SBICs do engage in equity investing with a portion of their capital.
V. THE LICENSING OF FIRST-TIME FUNDS A. The Chronology of a Successful License Application First, each applicant is required to complete a comprehensive Management Assessment Questionnaire (the MAQ ) focusing on the proposed business plan of the fund and the backgrounds of each of the proposed managers of the SBIC. The MAQ is an initially intimidating document and indeed takes a great deal of thought and time to prepare. The fund s management team should anticipate spending between one and three months on initial drafting and then working with the fund s SBIC lawyers to revise and complete the MAQ. Second, upon submission of the MAQ to SBA, an analyst in the Office of Program Development reviews the MAQ, performs initial due diligence on the management team and then prepares a merits and concerns memo dealing with the qualifications of the proposed management. Thereafter, the SBA s Investment Committee meets, discusses the MAQ, and determines whether to invite the management team to make a formal presentation on the management team s background, qualifications and investment strategy. If it determines that the management team does not have the appropriate qualifications required by the SBA, it will inform the applicant that it will not be invited to make a formal presentation to the Committee. Otherwise, it will invite the management team to meet with the Committee. This internal SBA review typically takes about three months and recently at times has taken longer due to the fact that the SBA has experienced a large inflow of newly filed MAQs. Third, if the management team is invited to make a formal presentation, the management team will meet with the members of the SBA s Investment Committee in order to discuss the nature of the contemplated SBIC and the credentials of the management team. Following this presentation, the Investment Committee will either issue a green light letter formally inviting the management team to file a license application or will advise the management team that licensure is doubtful and that the team will not be invited to submit an application. The Investment Committee generally makes this decision within two weeks after the meeting with the management team. Fourth, assuming that the applicant is invited to file an application, the next step is for the fund to finalize the SBIC s business plan, to prepare all of the necessary legal documents, to complete the additional application forms and exhibits not previously completed as a part of the MAQ, to complete and/or assemble the other materials required to be included in the application package, and to secure binding commitments representing not less than $5 million from private investors who meet the SBA s diversity requirement. Upon receipt of the application as well as a $15,000 filing fee, the SBA will write the applicant a formal letter stating that the application has been accepted and assigned to a particular licensing analyst. The timing of this stage of the process can vary widely. Usually the required documentation can be completed within several weeks, but the process of securing private capital can be time consuming. In addition, at some point during the process, each of the managers of the SBIC will need to attend a day-long training class conducted by the SBA. These training classes are generally held in Washington, D. C. several times each year, but classes are occasionally held at other
locations, most frequently in conjunction with the annual fall Middle Market Funds (NASBIC) convention. Fifth, the SBA processes the license application. At some point during the processing, the SBA sends a formal comment letter to the applicant, requesting a prompt response to any questions posed by the SBA about the application. In addition, Art Spivey, Chief of the Licensing Unit may also invite the management team to come to Washington, D.C. for another meeting with him and the Licensing Analyst assigned to the application regarding any open matters or questions. Once satisfactory responses have been received by the Licensing Unit to all inquiries, the SBA s Investment Committee meets and decides to approve or deny the application. This recommendation proceeds through internal channels at the SBA and, after the approval of an Agency level committee, ultimately is approved by the Administrator of the SBA. Following this final approval, the license is issued. The SBA attempts to complete the processing of first-time license applications within five months. SBA statistics show that 65% of license applications have been processed in under six months. The remaining license applications that have taken over six months to process generally have had special problems. SBA statistics reveal that, on average, 51% of applicants submitting MAQs receive green light letters from the SBA. Anecdotal information suggests that applicants using experienced counsel to work with them on the MAQ tend to have a considerably higher success rate than other applicants. SBA statistics further reveal that of applicants receiving green light letters, about half are ultimately licensed. This disparity is largely explained by the fact that, especially during the years since 2007, many applicants have been unable to raise the necessary private capital to file their license applications and execute their business plans. B. The Management Assessment Questionnaire ( MAQ ) The original idea behind the Management Assessment process was to shield prospective applicants from having to jump through all of the licensure hoops until the SBA is fairly certain that the management team appeared to be qualified and licensure appeared to be likely. Over the years, however, the Management Assessment Questionnaire, which was originally intended to be a quick, down and dirty review and assessment of the credentials of the management team, has undergone several iterations and has become an extremely lengthy and comprehensive document which takes a very considerable amount of time to complete. The Management Assessment Questionnaire is unquestionably the most important document that the applicant will prepare. The SBA believes that its most critical decision in the context of licensure is whether to put its trust in the SBIC s management team. Because millions of dollars of taxpayer money will be placed in the hands of the managers of each licensee, and because the SBA will receive sharp scrutiny from Congress and other government managers if SBICs should fail, the SBA is understandably very cautious about awarding SBIC licenses. The purpose of the Management Assessment is to permit the SBA at the outset to assess the qualifications of the management team and the proposed business plan of the proposed SBIC. The SBA is looking for experienced private equity investment managers whose business backgrounds would indicate that there is a high probability of the SBIC s business success, given the collective background and experience of a team, relative to the types of investing being
proposed in the business plan. The proposed management team need not have functioned as a team previously, but the SBA will give the application extra scrutiny if the members of the team have not worked together before. Each management team will be looked at on a case-by-case basis within the context of its own unique qualifications and business plan, but in every case, experienced management is essential. The SBA s general standard is that at least two members of the management team who will be devoting a substantial part of their time to the SBIC should have at least five years of successful private equity investment experience at a decision-making level. Further, the type of private equity investing that the SBIC proposes to engage in should be the same type of investing successfully pursued in the past by the SBIC s managers. In particular, the current view of the SBA is that different skill sets are required for successful early stage venture capital fund managers than for later stage mezzanine fund managers; therefore the SBA will be skeptical that a management team with demonstrated success in the early stage venture space will be able to successfully manage a later stage mezzanine fund. A group of mangers interested in obtaining an SBIC license should engage an experienced SBIC attorney no later than the time that they decide to work on their MAQ. The SBA has lots of policies, preferences, assumptions and predilections that are not written down, and experienced counsel can provide immense value to a management group during the MAQ process by steering them away from problematic responses and working with the client to structure the proposed SBIC in such a way as to enhance the likelihood that the MAQ will be received favorably. C. Exhibit F of the MAQ The most critical element of the entire MAQ is its Exhibit F, an Excel spreadsheet that requires each of the SBIC s managers to input extensive data about their investment track records. Exhibit F instructs the managers to identify all funds that they have been involved with that are ongoing or that included any investments terminated within the ten year period preceding the submission of the MAQ. If one of the SBIC s managers was a voting member of the Investment Committee of a fund, the manager must present the data for the performance of the entire fund. If the manager was working at a fund but was not a member of the fund s Investment Committee, the manger may claim specific investments made by the fund on his or her track record provided that: (a) the manager had major responsibility for due diligence; (b) the manager was the lead person in structuring the investment; (c) the manager was the lead in recommending the deal to the Investment Committee; and (d) the manager was the lead for the firm in post-closing oversight over an extended period of time. Exhibit F has the capability of creating a synthesized fund. This option is used by a manager of the SBIC who: (a) made investments on a one-off basis with personal funds, or (b) made investments through an entity for which the manager had full discretionary voting authority, or (c) made investments through a formal fund in which the manager was a principal for less than half of the fund s life, or (d) made an investment through an entity formed for the
specific purpose of making the investment, where the manager was primarily responsible for raising the entity s capital from investors and had decision-making authority over all aspects of the investment as the entity s general partner or managing member. D. The Preparation of the MAQ While experienced SBIC attorneys have copies of the MAQ on their computers, the SBA requires all groups of fund managers interested in applying for an SBIC license to contact the SBA directly by e-mail requesting the SBA to forward a MAQ to them. This enables the SBA to track the level of serious interest in the SBIC program. The address to which such a request should be sent is MAQrequest@sba.gov. Working on a MAQ is not the time for a team of fund managers to hide their candles under a bushel. As the managers discuss their qualifications, it is important for them to let the depth of their experience show and to provide whatever explanation is necessary to flesh out their respective backgrounds. Whenever possible, it is helpful to use case examples in order to illustrate the experience of the managers. At the same time, if a manager has had limited (or no) experience in a particular area, it is vital that the manager avoid embellishing. The SBA will call all references and will perform independent research to assess the qualifications of applicants, and erroneous information could prove fatal to an application. VI. THE ORGANIZATION OF AN SBIC Initially, it cannot be stressed too much that, even though the money coming to an SBIC from the SBA will be characterized as loans, because the SBA will provide up to two-thirds of the money available to the SBIC, it sees its role as far more than a lender. Rather, as the licensing agency ultimately responsible for determining the amount of Leverage provided to the SBIC and its managers, the SBA sees itself more as a two-thirds partner with substantial regulatory authority over the operations of the SBIC. Accordingly, in licensing an SBIC, the SBA greatly prefers that SBICs use a standard basic form of limited partnership agreement, organize and structure themselves in standard ways, and comply with a myriad of rules and regulations developed over the years. Virtually every Small Business Investment Company ( SBIC ) is organized as a limited partnership. (While the U. S Small Business Administration permits an SBIC to be a corporation, it is quite rare for the proponents of an SBIC to choose to use the corporate vehicle, and because the SBA rarely sees a corporate SBIC and does not have a Model Agreement for this type of structure as it does for a limited partnership, it will take the SBA staff considerably longer to process an application for a corporate SBIC.) The limited partnership is generally set up with an initial ten-year life. The working assumption of the SBA is that for the first five years the SBIC will make investments in portfolio companies and for the second five years the SBIC will exit those investments. (Provision is made in the Limited Partnership Agreement for the General Partner to extend the life of the SBIC for one or more additional years in the event that all of the SBIC s investments have not been exited by the end of the tenth year of the fund s life.)
The investors in the SBIC are its limited partners. In order to protect the limited partners from potential liability stemming from acts of the SBIC, they cannot play an active role in the management of the SBIC. Therefore, the Limited Partnership Agreement provides for the limited partners to be consulted and to vote on Partnership matters only with respect to matters involving their ownership interests and when extraordinary situations occur. The SBIC is run by its General Partner. The General Partner is generally set up as a limited liability company so that it pays no taxes but rather any income flows through the General Partner to its Members, and any taxes are paid by the Members. Another advantage of using an LLC as the General Partner is that, so long as the LLC conducts itself properly, the Members of the LLC are insulated from any personal liability for acts of the LLC or of the SBIC. The active managers of the SBIC are the Members of the General Partner LLC. As the Members of the General Partner, the managers comprise the SBIC s Investment Committee, control the operations and budget of the SBIC, and make final decisions on the SBIC s investments and its exits from investments. Each member of the Investment Committee must be thoroughly vetted by the SBA, including FBI fingerprint checks, and a fund will only be licensed as an SBIC after each member of the Investment Committee is found to be qualified. No entity or individuals other than the General Partner and the managers approved by SBA will be permitted to control or direct the operations of the SBIC Many SBICs elect to set up a separate Management Company to actively manage the day to day operations of the SBIC. Because the Management Company can engage in activities other than to manage the SBIC, this provides it with certain flexibility that the General Partner does not have, since the SBA requires the General Partner to be a sole purpose entity. The way that this works is that the General Partner and/or the SBIC enters into a Management Services Agreement with the Management Company which provides that the Management Company will, among other things, provide the SBIC with a suitable office and with appropriate staff, will pay all utility bills and otherwise will pay all expenses necessary to enable the SBIC to function properly. The Management Company can either be set up as a corporation or a limited liability company. Generally, it is owned by the active managers of the SBIC. VII. THE FLOW OF MONEY TO AND FROM AN SBIC In the typical case, the limited partners of the SBIC execute Subscription Agreements in which they make legally-binding commitments to contribute capital to the SBIC upon the issuance of capital calls by the General Partner. The SBIC is then able to obtain Leverage (loans) from the SBA in an aggregate amount equal to up to three times the amount of private capital contributed to the SBIC by the limited partners. In other words, an SBIC with $40 million of capital commitments by the limited partners can obtain up to $80 million in Leverage from the SBA. (The third tier of Leverage, in this case an additional $40 million, is not a sure bet but will be the subject of a decision by the SBA following appropriate due diligence at the time that the first two tiers of Leverage, in this case $80 million, have been invested by the SBIC.)
Generally, an SBIC pays management fees each quarter. The fees either go to the General Partner or, in the event that a Management Services Agreement has been executed, the Management Company. The management fees are used to pay for rent, administrative staff, and utilities, the salaries of the managers and the other expenses of operating the SBIC. The SBA approves the formula that the SBA proposes to use to compute the management fees. The SBA has issued a policy statement in the form of a TechNote that places limits on the amount of management fees that it will be willing to approve. For the first five years of the life of an SBIC, management fees cannot exceed more than 2 ½% of committed private capital plus an assumed two tiers of Leverage totaling up to $60 million, cannot exceed more than 2% of committed private capital plus an assumed two tiers of Leverage totaling over $120 million and cannot exceed a gradually diminishing permitted percentage from 2 ½% down to 2% for committed private capital plus an assumed two tiers of Leverage totaling between $60 million and $120 million. For the remainder of the life of the SBIC, the same percentages continue to apply but management fees are computed based on the amount of capital deployed in investments by the SBIC. Of course, the Limited Partnership Agreement can provide for a lower management fee than the maximum fee permitted by the SBA, and it is not unusual for our clients to opt for a fee that doesn t exceed 2%. The only other compensation available to the fund s managers is their share of the carry. The carry consists of all money available to be distributed by the SBIC after: (a) the SBA has been paid back, (b) the capital contributed by the limited partners has been returned to them and (c) all other expenses of the SBIC have been paid. The standard breakdown of the carry is 80% to the limited partners and 20% to the General Partner. The General Partner s share of the carry if the investment program of the SBIC turns out to be successful is intended to motivate the members of the General Partner to literally lay awake at night pondering what more can be done to advance the prospects of the SBIC. The SBA will permit a General Partner to give away up to one-quarter of its 20% carried interest to non-managers but will be very concerned if a General Partner should propose to give away a higher portion of its carry. VIII. FEES PAID TO THE SBA FOR LEVERAGE One of the concerns frequently raised by our clients is how much money an SBIC must pay the SBA for its Leverage. There are various fees, and they are set forth in various reference materials. At this time, the only Leverage being made available to SBICs is Debenture Leverage. Debentures are unsecured debt instruments, the repayment of which is guarantied by the SBA (and thus backed by the full faith and credit of the United States government). For the fiscal year ending on September 30, 2010, the government has authorized $3 billion of Debentures to be issued. It is likely that at least that amount of Debentures will be authorized to be issued in 2011. The Debentures are sold in the public markets periodically and are priced (i.e., the interest rate applicable to the Debentures is established) based on the condition of the public markets at the time that the Debentures are issued.
Generally, the interest rate assigned to the Debentures is between 50 and 250 basis points over the then-prevailing interest rate on Treasury Notes with ten year maturities. The most recent public offering of Debentures occurred in March, 2011. At that time, the interest rate assigned to the Debentures was 4.084%. An SBIC issuing Debentures must not only pay the interest rate assigned to the Debentures at the time of their public sale but must also pay a charge to the SBA in order to enable the SBA to defray any losses expected to occur in connection with the Debentures. (This means that the SBIC program is cost-free, insofar as the government is concerned, one reason why it is so popular with both political parties.) The SBA charge is adjusted annually. The SBA charge for a particular Debenture is the charge that was operative at the time that the SBIC obtained the Leverage Commitment pursuant to which the Debenture is issued. The SBA charge is added to the interest rate assigned by the public markets, resulting in an aggregate interest rate. For Debentures issued pursuant to Leverage Commitments obtained in FY2010 (October 1, 2009 September 30, 2010), the SBA charge is 0.285%. This means that an SBIC obtaining a Leverage Commitment in September, 2010 and taking down Leverage in October, 2010 would only pay interest totaling 3.5% (4.084% + 0.285%). In addition to the interest charge, an SBIC must pay a one-time fee at the time that it secures its Leverage Commitment and additional one-time fees at the time that it obtains Leverage draws pursuant to such Commitments. At the time that the SBIC reserves SBA Leverage, it must pay a one-time 1% commitment fee based on the dollar amount of Leverage reserved. An additional 2% user fee, a 0.375% underwriter fee and a 0.05% administrative fee is deducted from the proceeds of each Leverage draw.