Funds draw big attention with small-business debt

Institutional investors increasingly are investing in private equity funds leveraged with Small Business Administration debt for their promise of higher returns.

Investors have committed $9.4 billion to 257 funds backed by debt provided by the SBA's Small Business Investment Co. debenture program as of Sept. 30. For its part, the SBA through this program has more than $6.4 billion invested in those same 257 funds, and that's not counting another $2.4 billion in uninvested commitments.

For investors and private equity fund managers, there's a lot to love about the debt program. The SBIC offers qualified funds leverage of up to three times investors' capital commitment at below-market interest rates. The debt is in the form of unsecured 10-year notes, with interest-only payments due twice a year. Investors' return on their investment is about 14 percentage points higher than a commitment to a domestic small-cap private equity fund.

The Small Business Administration offers the program to stimulate growth of small businesses. The SBIC license gives private equity firms access to low-cost debt provided by the SBA.

“From an investor's perspective, the debt program is a net positive in many cases. The rates ... are very attractive in light of anticipated (or hoped for) equity returns from the general partner,” said Mario Giannini, CEO of alternative investment consulting and money management firm Hamilton Lane, Bala Cynwyd, Pa. Hamilton Lane and its clients have about $200 million committed to SBIC funds.

Qualified firms have to follow SBA rules on a variety of issues — including the size of business in which the SBIC can invest — and strict due diligence oversight, which also works out well for investors. “The SBA's program is rigorous and so, for many investors, has an added benefit of another layer of diligence analysis,” Mr. Giannini said.

Earlier this year, the $146.5 billion New York State Common Retirement Fund, Albany, committed $15 million to Brightwood Capital SBIC I, a domestic small-cap to midcap private debt fund and $10 million to Monroe Capital Partners, which makes senior and junior debt loans to middle-market companies in the U.S. and Canada.

The California Public Employees' Retirement System, Sacramento, recently committed $12.5 million to Central Valley Fund II (SBIC), a mezzanine fund that invests in companies in California's Central Valley with at least $5 million in revenue and $1 million in cash flow. This is the $239.9 billion pension fund's second investment in a Central Valley SBIC-leveraged fund.

Changes in the past three years to streamline and simplify the program's process, combined with a dearth of leverage available for small to midsize private equity investments has boosted the popularity of the debt program.

In the federal fiscal year ended Sept. 30, the debt program provided a record $2.59 billion in debt up 14% from fiscal year 2011 and an 85% increase from fiscal 2010, according to data released last month by the SBA. The 2012 fiscal year had the highest volume in a single year volume in the SBIC debenture program's 54-year history.

According to data from the Chicago-based law firm Edwards Wildman Palmer LLP, investors have generally doubled their returns when they invested in a leveraged fund.

Investors like the outsize returns. According to data released this month by the Small Business Administration, Washington, the returns are more than double that of similar private equity funds. For example, an institutional private equity fund investor that makes a $3 million commitment to an SBIC fund that includes two-to-one or $6 million in leverage would earn an estimated gross return of 29% compared with 15% gross return on investment for a $9 million commitment to a small-cap private equity fund without SBIC leverage.

In the past some investors have shunned funds with added SBIC leverage because they were uncomfortable with the risk that could be added to their portfolios. But Hamilton Lane's Mr. Giannini dismissed those concerns “There's certainly the issue of added risk with leverage. However, the leverage levels are modest and the low rates make it interesting,” Mr. Giannini said.

Investors say it is “a nice return and they look at it as a subasset class within their alternative investment bucket,” said Alan Roth, partner at Edwards Wildman Palmer. Mr. Roth's practice concentrates in forming SBIC funds, working on behalf of investors and general partners. So far in 2012, the firm has 19 funds in the pipeline in various stages of licensing with the SBIC.

Another advantage is that the SBA keeps a lid on management fees that can be earned by the private equity managers. For example, the maximum management fee for the first five years in SBIC funds is prorated based on the size of the fund and the time since the fund was licensed, which usually equates to about 2% of private capital plus assumed leverage, Mr. Roth said.

What's more, the leverage reduces the number of capital calls from limited partners because the private equity firm first draws on the SBIC, Mr. Roth said.

Mark S. Hauser, managing principal at New York-based private equity firm Tamarix Capital Corp., said the firm applied for an SBIC license after the 2008 economic downturn, when it became difficult to raise any kind of capital. “The whole situation flipped on its head in 2009. Capital was difficult to raise ... banks and non-banks left the lending sector and all of a sudden, you could get money from the SBIC debt program at a low interest rate and you could lend at a higher rate,” Mr. Hauser explained.

But it's not easy. The SBIC licensing process, which can take between eight and 29 months, involves a prescreening and a management assessment questionnaire to show that the firm has two or more qualified principals and a demonstrated track record of comparable investments and multiple successful exits. Then firm executives have to make an initial investment presentation to the SBA Investment Committee. If successful, the SBIC will offer a “green light” letter allowing it to raise money; the firm cannot even file for a SBIC license until it raises its targeted capital.

Once accepted as a SBIC, a fund must comply with a variety of SBA rules including interest rate limits and portfolio diversification rules.

“The other risk is that the SBA has a number of rights and priorities of which investors need to be aware in weighing whether to be an LP. They aren't so onerous, however, to offset that incremental return that can be available with a good manager,” Mr. Giannini said.

Francie Heller, founding partner of New York placement agent firm Heller Advisory, said she has been approached by private equity firms that are seeking to raise SBIC-leveraged funds. One firm was seeking SBIC debt to invest in senior secured loans and leveraged debt of small companies.

A major advantage for both the general partner and the investors is that SBIC debt is at lower than average rates that are fixed for 10 years, Mr. Roth said. In March, for example, the Small Business Administration cut the rate to 2.245% — the lowest in the program's history.

A bill recently introduced in the U.S. House of Representatives would increase the leverage limit for a family of SBIC funds to $350 million from $225 million. The bill, H.R. 6504— the Small Business Investment Company Modernization Act of 2012 — was introduced in September and is currently in the House Committee on Small Business. The increase would allow more large private equity firms to raise SBIC-leveraged funds because they wouldn't so quickly bump into the fund family cap, said Brett Palmer, president of the Small Business Investor Alliance, Washington.

The bill has the support of President Barack Obama and a bipartisan group of legislators, Mr. Palmer said. The question is whether the bill will be passed in the current lame-duck session of Congress that's preoccupied with a looming fiscal cliff at year's end, Mr. Palmer said. “The problem is fighting for attention in a difficult political environment,” he said.

“The bill will make it eventually. There is no opposition to it. The biggest challenge is this Congress. Almost no legislation passed this Congress. It's the least productive Congress in history.”