📈 How the SBIC program drives outperformance for investors

While everyone else is talking about this summer’s box office smash hits – Barbie, Oppenheimer, and The Sound of Freedom – here’s the story you haven’t been hearing about…

We are currently going through a historic modernization of how small business lending works in America.

Not only did the Senate Small Business and Entrepreneurship Committee recently vote to advance 11 bills that aim to bolster small-business lending, and modernize the Small Business Association (SBA)...

Isabella Casillas Guzman – the 27th Administrator of the SBA – recently finalized a rule to modernize the Small Business Investment Company (SBIC) Program as part of President Biden’s broader “Investing in America” agenda.

Here’s why this is something worth paying attention to… 

According to Bailey DeVries, Associate Administrator for Investment and Innovation and Acting Associate Administrator for Capital Access.

What kinds of businesses, you ask?

Icons of American industry, including such household names as Federal Express, Apple, Intel, Costco, Tesla, Whole Foods, and Callaway Golf, all received SBIC funding in their early stages of growth.

Not only have SBICs delivered documented outperformance compared to similar private equity funds – Since 1998, SBICs that benchmark in the top half of private equity have delivered a five to 10 point boost in the IRR delivered to LPs as a result of SBA leverage…

It’s also one of the most efficient, job-creating programs within the government; A 2017 Library of Congress study found that SBIC-backed small businesses created almost three million new jobs, and supported an additional 6.5 million jobs over a 20-year period.

What does this mean for Private Capital Insiders seeking outsized returns in early stage opportunities?

That’s the topic in this issue of the Weekend Edition.

-Equifund Publishing

P.S. We’re putting together our editorial calendar for August/September right now and would love to get your feedback on what types of content you’ve enjoyed and would like to see more of.

Generally speaking, the WEEKDAY edition tends to focus more on a “nuts and bolts” investor education topic – like how the Game of Money works, portfolio construction, due diligence and underwriting, and the various investment accounts you can set up.

And the WEEKEND edition tends to focus more on market commentary – either from a sector perspective, industry perspective, or regulatory perspective.

We’re also planning on adding a monthly “Office Hours” webinar with Equifund co-founders Jordan Gillissie and Jake Hoffberg so members can get a chance to “meet” our team, ask questions, and otherwise be part of our growing community.

Hit reply and let me know what content/topics you’d like to see more of in the next 30-60 days.

The Problem With Financing Early Stage Companies

Accessing financial capital is one of the biggest barriers entrepreneurs face in starting and expanding their businesses.

Raising capital has never been easy. But in today’s economy, it is even more difficult – especially for small businesses – to get funding.

According to The Office of the Advocate for Small Business Capital Formation’s 2022 annual report:

• Access to capital was the number one barrier to company survival

• 75% of entrepreneurs have experienced challenges in obtaining capital

• 89% of entrepreneurs say access to capital is limiting their business growth potential

• 78% of entrepreneurs say access to capital is limiting their day-to-day operations

This situation has compelled an otherwise highly partisan Congress to get behind one of the few federal programs designed to alleviate these lack of access to capital problems.

Enter: The Small Business Administration and the Small Business Investment Company Program

On July 30th, 1953, President Dwight Eisenhower signed the Small Business Act of 1953 into law, creating a new agency, the U.S. Small Business Administration (SBA).

Today, the SBA is the only cabinet-level agency fully dedicated to supporting America’s nearly six million small businesses and entrepreneurs. Despite its size – representing less than one percent of annual discretionary spending – the SBA has a tremendous impact on the U.S. economy.

The SBA's mission, often characterized by the three C's - capital, contracting, and counseling - reflects its commitment to "aid, counsel, assist, and protect, insofar as is possible, the interests of small business concerns."

• Capital: SBA provides funding opportunities and access to credit through programs like the 7(a) loan program, supporting small business growth and sustainability

• Contracting: SBA sets aside government contracts for small businesses, including disadvantaged ones, boosting diversity and competitiveness in the contracting arena

• Counseling: SBA offers counseling services through SBDCs, WBCs, SCORE, and VBOCs, equipping entrepreneurs with valuable guidance and skills for successful business management

By 1954, the SBA started providing loans and guarantees to small businesses, aiding them in securing the necessary funding for growth and expansion. Additionally, the agency extended its assistance to victims of natural disasters, offering financial support to rebuild and recover.

Recognizing that small businesses were struggling to access adequate credit, to keep up with technological advancements and remain competitive, a Federal Reserve study in 1957 highlighted the pressing need for further support.

As a response to this growing credit gap, President Eisenhower signed into law the Small Business Investment Act of 1958, which established the Small Business Investment Company (SBIC) program – designed to link public and private investment. Consequently, it fills an important role in the capital markets for businesses that have outgrown SBA’s flagship 7(a) loan program.

The mission of the SBIC program is to enhance small business access to capital by stimulating and supplementing “the flow of private equity capital and long-term loan funds which small-business concerns need for the sound financing of their business operations and for their growth, expansion, and modernization, and which are not available in adequate supply.”

The SBA carries out this mission by licensing and monitoring privately owned and managed investment funds.

Fund management teams that successfully complete the application process, may access this low-cost program, leveraging up to two times the private capital they raise.

• For every $1 the fund raises from private investors (“Private Capital”), SBA will commit up to $2 of SBA-guaranteed Debentures (“Debentures”), subject to a cap of $175 million.
  

• The maximum leverage for a group of commonly controlled SBICs is $350 million.

These funds then invest in a portfolio of U.S. small businesses seeking to create jobs, foster innovation, and fuel economic growth.

An SBIC may make investments in the form of:

• Debt: A typical SBIC loan ranges from $250,000 to $10M, with an interest rate between 9% and 16%
  

• Equity: SBICs invest in a business in exchange for a share of ownership in the company. Typical investment amounts range from $100K to $5M
  

• Debt/Equity Hybrid: Financing includes a combination of loans and ownership shares. Loan interest rates are typically between 10% and 14%. Investments range from $250K to $10M

Today, the SBIC program is comprised of more than 308 discrete private funds, across mezzanine, private credit, buyout, growth, venture, and multi-strategy, which collectively has more than $40 billion in public and private assets under management.

In 2022, SBICs invested $8 billion in more than 1,500 companies, which created and sustained over 103,000 U.S. jobs.

Also according to the SBA, Limited partners of SBIC-licensed funds benefit from several advantages that aren’t available to other types of investment funds.

• Regulatory benefits: Certain exemptions from registration requirements with the SEC are available to SBICs and their advisers
  

• Rapid deployment of funds: With a leverage commitment from the SBA equal to two times the private capital raised, fund managers are able to minimize the time spent on fundraising and focus on making investments
  

• Flexible fund structure: SBICs are allowed to organize themselves as stand-alone entities, drop-down vehicles, or side-car vehicles [publishers note: these are things that institutional investors care about, but are largely irrelevant to retail investors]
  

• Strong, stable returns: The low cost of SBA capital provides fund managers with pricing flexibility across cycles, while the 10-year term on SBA Debentures avoids the problems of duration mismatch
  

• Community Reinvestment Act credit: Investments in SBICs may be eligible for Community Reinvestment Act credit
  

The opportunity of investing in small businesses: Despite being the bedrock of the American economy, U.S. small businesses remain underserved and represent a value opportunity for investors

The SBIC Modernization: What it is (and why private capital insiders should care about the recent updates)

On October 19, 2022, the U.S. SBA published a notice of proposed rulemaking to revise the regulations for the SBIC program.

Why? To significantly reduce barriers for new SBIC fund managers and funds investing in underserved communities and geographies, capital intensive investments, and technologies critical to national security and economic development.

Up until recently, there was only one form of SBIC lender broadly called “Standard SBICs.”

SBICs borrow leverage by issuing debentures, which are unsecured 10-year loans issued by the SBIC, that have interest payable just semi-annually. Most debentures bear a temporary interest rate until they are pooled and sold to the public.

Because the traditional debenture structure requires the SBIC immediately to begin making loan repayments to SBA, much of the financing provided by SBICs has been to relatively later-stage businesses.

For this reason, the SBA believes that the Standard Debenture does not align with the cash flows needed for what’s often referred to as “patient capital” – strategies that primarily invest in the equity of, or provide revenue-based financing to, Small Businesses.

And for this reason, the SBA finalized wide-ranging revisions to the regulations governing the SBIC program, on Thursday, July 13, 2023.

The regulations make nearly three dozen revisions to 13 CFR §107 and §121, and taken together, represent the most significant regulatory changes to the SBIC program in a quarter of a century.

Among other things, the new ruling will now create an additional type of SBICs (“Accrual SBICs”) – along with the new Accrual Debenture – designed to be more useful for early stage companies.

Under an accrual debenture, SBICs could make investments in earlier-stage companies that produce returns over the 10-year period, instead of right away.

The final rule also limits Accrual SBICs to a maximum of 1.25 tiers of leverage – significantly less than the two tiers for which most Standard Debenture SBICs are eligible.

The regulations will be effective August 17, 2023.

And this leads us to perhaps the bigger story…

A Renewed Call for SBA Reauthorization

On December 8th, 2022, the U.S. Senate Committee on Small Business & Entrepreneurship Chair, Ben Cardin (D-Md.), introduced the Small Business Administration Reauthorization and Modernization Act of 2022 — legislation to reauthorize and modernize key SBA programs, including the agency’s entrepreneurial development, capital access, and contracting programs.

According to Chair Cardin,

The SBA is long due for reauthorization, and I am proud to introduce this package that will reauthorize and improve numerous programs to better serve and expand access to our entrepreneurs and small business owners.

I look forward to engaging with my Republican colleagues on the Committee, and my colleagues in Congress to move this package forward and reauthorize the SBA in the upcoming 118th Congress.

Reauthorization of SBA used to be a regular occurrence in Washington. Between 1980 and 2000, Congress reauthorized SBA seven times, with reauthorization periods ranging from every two to five years.

As the SBA celebrates 70 years since its founding on July 30, 1953, small business owners from Goldman Sachs’ 10,000 Small Businesses Voices are marking the occasion by calling on Congress to reauthorize and modernize the agency for the first time in 23 years.

According to Goldman Sach’s report:

For those who have been following the ongoing JOBS Act 4.0 updates, these coinciding updates to capital formation in America appear to be getting ready to hit the Senate floor, just in time for the upcoming elections.

Final Thoughts

While we here at Equifund aren’t an SBIC lender (and don’t have plans to become one)...

We like to view ourselves as a “Capital Stack Solution” for the issuers we partner with.

Inevitably, this means having an understanding of what types of financing options are available for the types of Issuers we support.

Why? As we’ve said many times already, “as early stage investors who own common stock, our biggest risk is being subordinated by another round of financing.”

With what appears to be more – and more affordable – capital sources for early stage companies, we could be seeing more of our issuers combine these types of financing options in addition to equity crowdfunding.

As these stories develop, we’ll continue to explore these other government sources of funding – especially non-dilutive grant funding – that may provide early stage companies with a competitive advantage…

And potentially provide investors with better, risk-adjusted returns by lowering the “fee drag” associated with the cost of capital.