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.