With government-guaranteed debt at a new historic low rate, a number of firms are looking at the prospect of raising funds organized as small business investment companies, or SBICs.
, the chief investment officer of Southland Capital Management, a hedge fund in Santa Monica, Calif., said interest in SBICs is strong among business development companies, a category of publicly traded closed-end funds that provide debt or equity to small businesses. “At least half the 24 companies we track have arranged or applied or are considering applying for an SBIC license,” Marshi wrote this month on his blog, BDC Reporter.
Why the sudden interest? In a market where leverage can be hard to find, especially for smaller deals, SBICs represent a versatile, inexpensive funding mechanism. “It’s cheap money, and it’s very patient money,” said one of our sources, a buyout pro who is watching the SBIC market develop. “It’s there and available for 10 years.”
The SBIC model also is flexible, suitable both for control-equity investors such as Riverside and for lenders such as Golub. It can exist as part of a larger fund complex or as a standalone investment vehicle. A sponsor raises funds for an SBIC like any other fund, but the government does impose limitations. The fund can be no larger than $75 million, and no single limited partner can provide more than 70 percent of the commitments.
As the fund makes its investments, it can borrow up to $150 million from the SBIC Funding Corp., an arm of the U.S. Small Business Administration, at a rate tied to 10-year Treasury bonds. The agency also limits its lenders to “two tiers” of leverage, so an SBIC fund tops out at $225 million, with some exceptions.
The SBIC Funding Corp. priced nearly $563 million of debentures in September at 3.215 percent, the lowest rate at the semi-annual pricing since the SBA established its debenture program in 1958. This capital is now available to provide leverage to 54 SBIC funds. The reason for the low interest rate, according to Mark A. Kromkowski, a partner in the Chicago office of the law firm McGuireWoods LLP: “The credit worthiness of SBIC funds has gone up.”
Another factor in the growth of SBICs is that alternative sources of leveraged financing remain scarce. The collateralized loan obligation market, which collapsed during the financial crisis, remains in ruins, and hedge funds, which were a significant source of mezzanine financing during the mid-decade boom, have now shied away from the asset class.
“SBICs are trying to fill the gap in the lower middle market,” said Dominick P. DeChiara, a partner at the law firm Winston & Strawn LLP in New York and co-chair of the firm’s private equity practice. “After experiencing the large number of redemptions during the credit crisis, we’ve seen hedge funds severely cut back on the number of illiquid positions they’re willing to hold.”
For all their growing appeal, SBICs are no panacea. Sponsors must comply with federal regulations and face audits by the SBA. The money must be invested domestically, and it must go to small businesses. By the employee headcount standard used by most SBICs, target investments may have as many as 500 to 1,000 workers, depending on the industry.
Mid-market sponsors have often shied away from raising SBIC funds because of the perceived complexity. But McGuireWoods’s Kromkowski said, “When they look at deals they could have done, 85 to 90 percent fit.”