SBICs Sizzle, Offering Alternative to Bank Loans

Lenders are piling into a government booster program aimed at funding middle-market growth companies.
Alix StuartNovember 4, 2011

The U.S. government has tried many ways to get money into the hands of private companies, not all of them successful. The most recent effort, the Treasury Department’s Small Business Lending Fund, ended up disbursing to banks a slim fraction of the money it started with; the effect on bank loans remains to be seen. Past attempts to get more money out to banks through the Small Business Administration (SBA), like the 2009–2010 ARC loan program, have faced similar fates.

However, one relatively unknown government program that puts money in the hands of private-equity funds and mezzanine lenders for lower-middle-market companies seems to be taking off. The Small Business Investment Co. (SBIC) program, run by the SBA, is aimed at privately held companies with about $2 million to $10 million in EBITDA (earnings before interest, taxes, depreciation, and amortization) and a lot of growth potential. The SBIC saw a record amount of capital committed by both the government and private investors in the government’s fiscal year 2011, and pushed out $2.6 billion to midmarket companies, a 63% increase over the previous year. All that, and the dollars are likely to keep on coming.

In general, this trend “is great [for companies], because it’s more supply” of subordinated debt and mezzanine financing, and generally with high-quality investors, says Laurence R. Bronska, an attorney with McDermott Will & Emery who often arranges such deals. “Ultimately, there should be more competition, more availability, and more options for folks who are looking for growth capital.”

While pricing can be high — lenders licensed by the SBIC program tend to offer “a layer of capital that is less expensive than equity, but more expensive than typical senior credit,” says Bronska —the SBICs will often lend on an unsecured basis. This can make them a good term-financing option for companies that can’t get a loan from a bank or other traditional credit sources, he notes, particularly when it comes to growth opportunities or owner transitions.

Indeed, such funding “can be very expensive for a company, but if you balance the opportunity against the expense, on net, the company comes out ahead,” says Michael Eldredge, CFO of American Sensor Technologies, a 15-year-old pressure sensor and transmitter company that used SBIC financing for an acquisition.

Interest: Both High and Low
There are currently about 300 investment funds licensed as SBICs, with 22 licensed in the past year alone, double the average for previous years. (For a complete list by state, click here.) “We have a very robust pipeline of applicants,” says Sean Greene, who oversees the SBIC program as associate administrator for investment and special advisor for innovation at the SBA.

Applications are streaming in for a variety of reasons, not the least of which is that interest rates on money coming through the program are very low. Ironically, banks — many of which would not lend to companies that get SBIC loans — are also driving a lot of the demand, since investing in an SBIC-licensed fund carries special benefits for them. For one, the SBICs are likely to be the only sanctioned private-equity investments available to banks, thanks to the Volcker Rule. They also help banks satisfy some of their Community Reinvestment Act requirements.

And with smaller firms “crying out for capital,” Greene, a former entrepreneur who founded Away.com and then sold it to Orbitz, is doing his best to ratchet up the amount of money the program commits to private-equity funds, from a record $1.8 billion last year to the full $3 billion allowed annually under the program.

Here’s how the SBIC program works. Essentially, it’s a booster program for private-equity funds, offering them two to three times leverage for the private capital they raise, up to $150 million (for a total fund size of $225 million). The money comes at no direct cost to taxpayers, since the SBA raises the money through 10-year bonds, which are then paid back by the fund itself in semiannual installments. (For that reason, most investments are structured as debt to yield cash flow.) Funds that are licensed must follow some rules in their investing, such as not investing in financial companies, real estate, or nondomestic firms. Beyond that, says Greene, “the government isn’t making decisions about what companies to fund, and we’re not looking for upside.”

For investment firms, becoming an SBIC is, in a sense, like getting pennies from heaven. Ironwood Capital, for example, is in the process of raising its fourth SBIC fund. The SBA “has been a great partner,” says Marc A. Reich, president and founding partner of Ironwood, which manages about $400 million in total, including non-SBIC funds. “The cost of government funding is very attractive,” he says, at about 4% currently. Reich started his first SBIC about 11 years ago; most of his firm’s investors are now insurance companies and banks. He says the aspect of being regulated is “not painful” and “a very small price to pay in order to triple the amount of capital you raise.”

In fact, Reich credits the program with helping to build the universe of investment funds. “The SBIC made it possible for us and many, many other firms to get into the private-equity business; without it, we and many others would not be [here],” he says. Now that Ironwood can raise funds larger than what the SBIC allows, Reich expects its fourth fund will be the last time it taps such capital. “It was a springboard,” he says.

Renovus Capital Partners is one of the fortunate funds that saw such benefits this year. Renovus was founded in January 2010 by three private-equity professionals who had previously worked together at Leeds Equity Partners. In September Renovus announced that it had raised a total of $100 million, including SBIC funds, to focus on companies in the education industry. “When we started out, the fund-raising market was in such bad shape,” says Jesse Serventi, one of the co-founders. The leverage available through the SBIC program “was a great way for us to get into the business,” he says.

Banks are so interested in the funds that in some cases, investors don’t even need the leverage. Valesco Commerce Street Capital LP just closed a $69 million fund with 53 community banks, as well as some individual investors. While it has an SBIC license and follows the program’s guidelines, Valesco won’t actually tap government funds. That’s because “banks are awash with liquidity, and need something with a current return,” says Eric Rosiak, vice president with the fund-management team at Valesco. (By not using the leverage, the company can skip the bond-interest payments and funnel returns directly to investors.)

Besides the financial returns, and the diversification that subordinated debt can add to bank portfolios, banks are also interested in the possible referrals they can garner through such funds. “Every company we invest in needs a banking relationship for deposits,” says Rosiak.

How to Click with an SBIC
So what does it take for a company to shake some money loose from an SBIC?

In most cases, the funds are looking for established, healthy companies that are on the precipice of a major event: an acquisition, an ownership transition, or some type of expansion. They may also be willing to finance a leveraged dividend or a refinancing transition, says Bronska.

Rosiak says Valesco is looking for companies with $10 million to $100 million in revenues, and $2 million to $10 million in EBITDA, plus “a business you can understand, like manufacturing, distribution, business services, or health care.” Ironwood has similar focus and criteria, though it looks for firms with up to about $200 million in revenues and $3 million to $15 million in EBITDA. (Generally, the SBIC program defines a company as “small” when its net worth is $18.0 million or less and its average aftertax net income for the prior two years does not exceed $6.0 million, according to its website.) That being said, however, the focus of firms can vary widely in terms of industry, geography, and the type of investment they want to make. Some may simply offer debt; others may want some equity or even a full buyout, says Bronska, depending on the balance of their portfolio and their cash-flow needs.

On balance, though, working with an SBIC is not much different than working with any other private-equity firm or mezzanine lender. Says Ironwood’s Reich: “A CFO would have to be really, really observant to notice any difference between us and a traditional private-equity investor.” In fact, many don’t advertise their SBIC status, so that “CFOs may be working with them but not know it,” says the SBA’s Greene.

And whatever the terms, finance professionals say that SBIC investments can help companies in a variety of ways, not the least of which is by giving CFOs the happy prospect of better terms in the future. “As the business has grown,” American Sensor Technologies’s Eldredge points out, “we’re finding traditional banks are coming in at much more favorable interest rates and with less dilution to shares.”