The update, titled Small Business Investment Company Investment Diversification and Growth, has a broad impact on the current SBIC program and represents the most significant change to the program in decades. Among other changes, it creates new types of SBICs, modifies existing regulations to improve operational aspects of managing an SBIC, and updates the licensing process to encourage more fund managers to apply to the program.
The SBA indicated it hopes that the regulatory updates will expand the universe of private investment fund managers interested in the SBIC program, increase the flow of capital to underserved small businesses, and promote investment in businesses that are capital-intensive and critical to national security. This summary highlights certain key changes.
Background
The SBIC program’s stated mission is to encourage private capital investment in American small businesses, allowing them to grow, expand and modernize. This is accomplished through the SBA’s licensing and monitoring of private investment companies, which are commonly investment funds organized as limited partnerships that raise capital from private limited partners. The private capital raised is typically leveraged using SBA guaranteed debentures, which can often increase the fund’s deployable capital and enhance private capital returns.
Created by the U.S. Congress in 1958, SBICs have cumulatively invested over $123 billion in American small businesses since the inception of the program. There were 308 active SBICs as of Sept. 30, 2022, and approximately 78% utilize debenture leverage. SBICs made $7.9 billion of investments in 1,217 small businesses during the federal government’s fiscal year ended Sept. 30, 2022, with SBICs that utilize debentures making approximately 20% of these financings as equity-only investments. Highlighting a focus area for the SBA, only 7% of all financings were to small businesses owned by women, minorities or veterans.
The regulatory framework for SBICs has evolved over the years, with different license and leverage types becoming available and then later being modified or withdrawn. The last effort focused on equity investment, the Participating Securities Program, was launched in the early 1990s and created a form of nondebt SBA financing. Under that program, the SBA’s investment took the form of a preferred limited partnership interest, where the SBA earned a preferred return and a profit share. The lack of debt service encouraged licensees to invest in equity instruments, particularly for venture capital and growth-stage investments. This program suffered losses in the early 2000s in connection with the dot-com bubble, and the SBA stopped licensing these funds shortly after.
Since the Participating Securities Program ended, the primary way the SBA has provided capital to SBICs is through issuing SBA-guaranteed debentures. Debentures generally have a 10-year term, are non-amortizing and can be prepaid without penalty. Interest rates for newly issued debentures are set semiannually and are based on market pricing, typically ranging from 0.4% to 0.7% above the current 10-year Treasury rate. Interest payments are due semiannually, encouraging SBICs to invest in securities that generate current cash returns. The most recent debentures, priced in March 2023, carry a 5.168% rate, the highest since September 2008. The SBA typically commits to provide leverage to an SBIC, which the SBIC can then draw upon as needed through its life. Leverage may be committed to an SBIC at a 1:1 ratio to private capital, up to a 3:1 ratio to private capital, though 2:1 is most common. A single SBIC may use up to $175 million in debentures, while a fund family may use up to a combined total of $350 million at any time.
SBICs have been limited to investing in companies that meet certain criteria, chiefly being small or “smaller” businesses, as defined by the SBA. Portfolio companies must also be based in the United States, and prior to the July revision could not be primarily re-lenders, reinvestors, real estate projects or companies that will use the proceeds outside of the United States. SBICs have to abide by certain regulatory restrictions when structuring an investment, including limitations on interest rates charged to borrowers.
SBICs are subject to periodic reporting requirements, including filing quarterly and annual financial statements, notifying the SBA upon the occurrence of certain events and reporting certain information related to the financing of a new investment. The SBA requires that SBICs follow an SBA basis of accounting, which differs from U.S. generally accepted accounting principles (GAAP) in several key areas, and has published specific SBA model valuation guidelines. Most SBICs will also prepare financial statements on a U.S. GAAP basis for non-SBA purposes, such as to meet private investor obligations under their limited partnership agreement or to satisfy requirements of the Securities and Exchange Commission if the SBIC is associated with a registered investment advisor.
The SBIC program has a long track record of operating with a zero taxpayer subsidy rate, and the SBA monitors its licensees to address potential credit concerns. SBICs are subject to annual examinations for regulatory compliance, must prepare calculations that provide insight into the their current financial position, and are subject to enhanced monitoring or other remedial actions for noncompliance.
