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Description of the Small Business Investment Company Debenture Program

Author: Christopher A. Rossi

January 2019
Description of the Small Business Investment Company Debenture Program

A Small Business Investment Company (SBIC) is a privately owned and operated company that makes long-term investments in American small businesses and is licensed by the United States Small Business Administration (SBA).

The principal reason for a firm to become licensed as an SBIC is access to financing (Leverage) provided by SBA. In addition, banks and Federal savings associations (as well as their holding companies) have the ability to own or to invest in SBICs and thereby to own indirectly more than 5 percent of the voting stock of a small business,1 and can receive Community Reinvestment Act credit for SBIC investments. Banks and their holding companies are permitted to invest in SBICs under the regulations implementing the “Volcker Rule” pursuant to the Dodd-Frank Act. They also receive exemptions from certain capital charge regulations and lending “affiliation” rules under the Gramm-Leach-Bliley Act. A business seeking a U.S. Government contract that is a set aside for small businesses does not lose its status as a small business by reason of a control investment by an SBIC. Many Business Development Companies (BDCs) also have formed SBIC “subsidiaries” as part of their business strategies.

This document provides a summary description of the SBIC Debenture program, SBA Leverage in the form of Debentures and a general overview of SBA regulations and policies applicable to Debenture SBICs.

The U.S. Small Business Administration

SBA administers the SBIC Program through its Investment Division (which employs approximately 80 people). SBA is an independent Federal agency located at 409 Third Street, SW, Washington, DC 20006 (202.205.6510). Useful information about the SBIC Program is available on SBA’s website at www.sba.gov/INV or may be obtained by contacting Samuel J. Boyd, Jr. (202.205.7546).

SBIA

The SBIC industry is served by an active trade association, the Small Business Investor Alliance (SBIA), which is located at 1100 H Street, NW, Suite 1200, Washington, DC 20005 (202.628.5055), www.sbia.org. SBIA’s President is Brett Palmer. Harry Haskins, the long-term senior career SBA manager of the SBIC program, is SBIA’s Director of SBIC Relations. SBIA provides a variety of information and services to its members and represents the industry with SBA and on Capitol Hill. SBIA publishes regular updates and is a resource for information concerning the SBIC Program.

Development of SBIC Program

Established by the United States Congress in 1958 to stimulate long-term investment in American small businesses, the SBIC Program has evolved into a significant factor in financing smaller American businesses. From the SBIC Program's inception to December 31, 2017, SBICs have provided approximately $91.5 billion of funding in more than 178,175 financing to businesses,2 including well-known companies such as Amgen, Apple Computer, Costco, Federal Express, Intel, Tesla and Whole Foods.3

The SBIC Program has undergone significant changes since its creation in 1958. The original Program permitted only Debenture Leverage. The Small Business Equity Enhancement Act of 1992 drastically changed the SBIC Program. It created a new form of SBA Leverage known as “Participating Securities” (essentially preferred limited partnership interests in an SBIC); increased the amount of Leverage available to an SBIC to $90 million (which subsequently was indexed to reflect changes in the cost of living since March 31, 1993 and then modified in 2009 to be $150 million and again in 2018 to be $175 million); required minimum private capital of $10 million for SBICs using Participating Securities and $5 million for SBICs using Debentures; provided for stricter SBA licensing standards; and enacted other changes to make the program more consistent with the private venture capital industry. Unlike the Debenture Program (where SBA is a creditor of the SBIC), which requires an SBIC to make periodic interest payments, the Participating Securities Program required an SBIC to pay SBA a prioritized payment (preferred return) and a profit share when the SBIC realized profits. As a consequence, the Participating Securities Program was designed to permit investing in equity securities whether or not those securities had a current pay component. This new program resulted in a large expansion of the number of SBIC licenses granted.

Following the burst of the “technology bubble” in 2002, the Administration decided there no longer was a need for an equity SBIC program and that the existing Participating Securities Program would cause significant losses to SBA. Accordingly, SBA decided to terminate the Participating Securities Program and announced that beginning on October 1, 2004, it would not issue commitments to use Participating Securities Leverage or license new SBICs using that Leverage.

SBA officials continue to emphasize that they believe the Debenture Program is working well and they want to expand it. The governing law and regulations for the Debenture Program have undergone several revisions since 1994 that have further streamlined and improved the SBIC Program. SBA has continued its outreach to institutional investors, bank regulators and prospective applicants in order to enlarge the existing Debenture program and to create ways for SBICs to make certain kinds of equity investments without undermining the financial integrity of the Debenture Program.

As of September 30, 2018,4 there were 305 licensed SBICs with approximately $15.8 billion of private capital and $10.9 billion of outstanding SBA Leverage (of which $10.8 billion is Debenture Leverage and $18 million is Participating Securities Leverage). Of these SBICs: 227 use Debentures; 25 use Participating Securities; 47 do not use Leverage; and six are specialized SBICs.

During the 2018 Federal fiscal year (October 1 – September 30) ("Federal FY") ended September 30, 2018, SBA licensed a total of 25 SBICs with approximately $1.2 billion of private capital. Of those, 21 were Debenture SBICs and four were Unleveraged SBICs.

SBA Leverage

SBA currently provides financing (called “Leverage”) to SBICs in the form of “Debentures.” SBIC’s borrow Leverage by issuing Debentures. Debentures are unsecured ten-year loans issued by the SBIC that have interest only payable semi-annually. Most Debentures bear a temporary interest rate based on LIBOR until they are pooled and sold to the public. The interest rate (excluding the annual SBA “Charge” described below) on these Debentures is fixed when the SBA pools Debentures from various SBICs and sells them to the public, with the pooled Debentures having a 10-year maturity from the sale date. The interest rate recently has been between 33.8 and 78.5 basis points in excess of the interest rate on Treasury Notes with 10-year maturities (the “Treasury Note Rate”). In the most recent September 2018 pooling, the interest rate was 3.548 percent (excluding the annual SBA "Charge" described below). This interest rate represented a 0.590 percent premium to the Treasury Note Rate and reflected an increase from the 3.187 percent (excluding the annual SBA "Charge" described below) rate set in the March 2018 pooling and the 2.518 percent (excluding the annual SBA "Charge" described below) rate set in the September 2017 pooling. As of September 30, 2018, there were $10.8 billion of Debentures outstanding, plus $3.4 billion of undrawn commitments to issue Debentures.

LMI and Energy Saving Debentures

More than a decade ago SBA created “LMI Debentures” for use by SBICs making equity investments in Low and Moderate Income Zones (LMI Zones) or in companies with significant numbers of employees in LMI Zones that are more fully described below under the heading “LMI Debentures.” In addition, on April 19, 2012, SBA published final regulations authorizing a limited amount of so-called energy saving Debentures which would enable SBICs licensed after 2008 to acquire equity securities in energy saving qualified investments using Debentures. No Energy Saving Debentures have been issued.

Early Stage SBIC Initiative

On January 31, 2011, the Administration announced its “Start-Up America Initiative,” which, among other things, had as its purpose to promote high-growth entrepreneurship across the country with new programs to help encourage private sector investment in startups and small firms. As part of this initiative, the SBA published final regulations on April 27, 2012 that established a new type of SBIC called an “Early Stage SBIC.” By their own terms, these regulations provided that the Early Stage Program would terminate on September 30, 2016. On September 19, 2016, SBA published a “Notice of Proposed Rulemaking” which proposed various changes to the Early Stage Program. The proposed rule reflected SBA’s intent to continue licensing and providing SBA-guaranteed leverage to Early Stage SBICs beyond the initial five-year term previously announced and proposed regulatory changes. However, on September 28, 2017, SBA announced that it was not going to renew the Early Stage Program or finalize the proposed rule. In its memorandum announcing the non-renewal of the Early Stage Program, SBA encouraged venture capital fund managers to apply for a license as a non-leveraged SBIC (i.e., an SBIC that does not utilize SBA debenture leverage).5

SBA licensed only five Early Stage SBIC’s during the Early Stage Program’s existence. SBA is no longer issuing leverage commitments to these Early Stage SBICs. However, they may continue to draw on their existing leverage commitments, subject to SBA regulations and policies.

Impact Investment Program

As part of the Start-Up American Program, the SBA also approved the creation of an Impact Investment Fund Program and set aside an aggregate of $1 billion of Debenture Leverage to be distributed over five years, beginning with Federal FY 2011. On September 25, 2014, SBA announced policy changes for this program, including an extension of the program past the original five year period and an intention to commit on average $200 million per year to Impact SBICs. On February 2, 2016, SBA published a proposed rule which would create a new class of SBIC’s called “Impact SBICs.” However, on September 28, 2017, SBA announced the termination of the Impact Investment Program. In its memorandum terminating the Impact Investment Program, SBA stated that, although it is terminating the Impact Investment Program, it remains committed to licensing qualified applicants which intend to finance small businesses located in underserved arears or employ an investment strategy focused on social, environmental, and/or economic impact.

Accordingly, since November 1, 2017, SBA has not accepted Management Assessment Questionnaires for applicants seeking to be licensed under the Impact Investment Program. Fund managers who submitted Management Assessment Questionnaires before September 28, 2017 were given an opportunity to convert to a standard SBIC applicant by providing written notice to SBA no later than October 28, 2017. Fund managers with existing green light letters from SBA authorizing them to submit an application for an SBIC under the Impact Investment Program are permitted to submit the license application consistent with the requirements contained in the green light letter. If any such manager is approved as an Impact SBIC, then it must operate under the Impact SBIC policy guidance under which it is licensed. 

Licensed SBICs that are operating under the Impact Investment Fund Program are required to continue operations under the Impact SBIC policy guidance under which they were licensed and, if they were approved to issue Debentures, SBA will continue its practice of approving leverage commitments and draws based upon SBA’s regulations and credit policies that are applicable to all SBICs.

Business Development Companies

A significant number of the publicly traded BDCs have SBIC “subsidiaries” using Debentures. A BDC owned SBIC is generally able to use up to $175 million of Debentures on a 2:1 ratio to the amount of capital contributed to the SBIC. BDCs also may form more than one SBIC and thereby use up to $350 million of Debentures at one time. Formation of a second SBIC is subject to SBA policies that generally apply to the formation of second funds (requiring successful operations of the first fund for at least two years, among other requirements). SBIC subsidiaries of BDCs, like other SBICs, are required to have a limited life, typically with a five-year investment period followed by a five-year harvest period, and may not be formed with perpetual existence.

Reserving and Drawing Leverage

SBICs obtain Leverage by reserving a “Leverage Commitment” and then drawing down Leverage that Commitment. Leverage Commitments may be obtained at the time of licensing for an amount up to one tier6 of Leverage (subject to availability) and thereafter as needed for an amount of up to two tiers of Leverage,7 but not more than twice in any Federal FY. When a Leverage Commitment is issued, the SBIC pays a “one time” commitment fee that is 1 percent of the amount of the Leverage Commitment. A Leverage Commitment expires on September 30 of the fourth Federal FY following the fiscal year of its issuance.

SBICs may apply twice each month to draw down Leverage Commitments. SBA’s approval of a draw request is good for 58 days, and an SBA can make a draw against the approval on one day’s notice. A newly licensed SBIC is permitted to draw only “one-half tier” of Leverage before SBA’s first regulatory examination (generally 6-10 months after licensure).

Debentures that will be pooled use an interim credit facility provided by the Federal Home Loan Bank of Chicago. At the time of each disbursement for these pooled Debentures, fees totaling 2.425 percent are deducted from the amount the SBIC receives (a 2 percent “user” fee payable to SBA, 37.5 basis points of underwriting fees and 5 basis points as an administrative fee to the Selling Agent). The SBIC pays an interim interest rate on Debenture Leverage of LIBOR plus 30 basis points and the amount of SBA’s “Charge” described below. In March and September of each year, all Debenture Leverage issued since the prior pooling is pooled by SBA and sold to the public in the form of Trust Certificates and a new interest rate for all such Debenture Leverage is established and fixed until the Leverage is repaid.

Typical Use of Leverage

A management team may hold a closing and form its fund at any time before or after it files its formal SBIC application.8 However, it may not obtain Leverage until it receives its license, a process that currently is taking about 6-12 months from the date that SBA accepts a filed license application for processing.9 After the license application is accepted by SBA for processing, many applicants draw their private capital to pay organization expenses and management fees and to make investments. In any event, an SBIC is required to have drawn at least $2.5 million of private investors’ capital prior to licensing. Once licensed, most SBICs fund their operations solely by using SBA Leverage until the ratio of outstanding Leverage to paid-in capital from private investors (called “Leverageable Capital”) reaches two-to-one, and they then coordinate capital calls from private investors with the use of Leverage to maintain a two-to-one Leverage-to-drawn Private Capital ratio.10 SBICs are permitted to borrow money from banks or other unaffiliated third parties prior to their initial Leverage, but SBA requires such borrowings to be repaid when Leverage is first drawn.

Leverage Availability

A single SBIC may use up to $175 million of Debentures and the total amount of Debentures that may be outstanding among a group of commonly controlled SBICs is limited to an aggregate of $350 million.11 The amount of Leverage Commitments available to an SBIC is its Regulatory Capital multiplied by the tiers of Leverage that SBA has approved for the SBIC.

SBA obtains funds enabling it to supply Leverage for pooled Debentures by guarantying payment of Trust Certificates that are purchased by traditional purchasers of government-guaranteed notes. SBA then invests the proceeds in SBICs in the form of Debentures. SBA Guaranteed Trust Certificates for Debentures are sold in March and September of each year. SBA obtains funds enabling it to supply Leverage for Debentures that are not pooled (including LMI Debentures and Early Stage SBIC Debentures) by guarantying loans made by the Federal Home Loan Bank of Chicago.

The amount of Leverage Commitments that may be issued each year is subject to the amount authorized by Congress. In recent years, Congress has enacted authorized levels in three-year cycles. For Federal FY 2019, $4 billion of Leverage Commitments is expected to be available. Leverage Commitments issued by SBA each year have been well below the amounts authorized by Congress. During the past five (5) Federal FYs, SBA issued a total of $12.098 billion of Leverage Commitments as depicted in the following chart:

Federal FY Leverage Commitments Issued by SBA
2014 $2.549 billion
2015 $2.553 billion
2016 $2.514 billion
2017 $1.960 billion
2018 $2.522 billion

 

SBICs drew a total of $10.581 billion of Debenture Leverage during the past five Federal FYs in the amounts depicted in the follow chart:

Federal FY Leverage Drawn by SBICs
2014 $2.065 billion
2015 $2.337 billion
2016 $2.158 billion
2017 $1.902 billion
2018 $2.119 billion

 

The Trust Certificates representing an interest in the pooled Debentures are sold with the assistance of investment bankers (who receive a 37.5 basis point fee) to institutional purchasers of government-guaranteed, fixed rate notes with 10-year maturities. The interest rate on Trust Certificates is a premium over the 10-year Treasury Note Rate. The premium has been as high as 2.273 percent in the pooling in September 2008. Since then the premium has decreased dramatically and, during the last five years, has been less than 1 percent. The premium over the 10-year Treasury Note Rate for each of the last ten (10) poolings is depicted in the following chart:    

Pooling Date  10 Year
Treasury Rate
Premium Total Interest Rate (excluding SBA Charge)
March 2014 2.684% 0.507% 3.191%
September 2014 2.591% 0.424% 3.51%
March 2015 2.059% 0.458% 2.517%
September 2015 2.170% 0.659% 2.829%
March 2016 1.996% 0.541% 2.507%
September 2016 1.713% 0.338% 2.051%
March 2017 2.430% 0.415% 2.845%
September 2017 2.202% 0.316% 2.518%
March 2018 2.812% 0.375% 3.187%
September 2018 2.958% 0.590% 3.548%


Historically, the amount of Leverage Commitments that SBA could issue each year was subject to annual Congressional appropriation of an amount necessary to cover anticipated losses on the Leverage issued. Thus, the amount of Congressional appropriation and the rate of loss anticipated on the issued Leverage (referred to as the “Subsidy Rate”) determined the actual amount of Leverage that would be available each year. This typically resulted in significantly less Leverage being available than the level “authorized” by Congress. Beginning on September 1, 1996, SBA charged a 1.00 percent annual “Charge” on Leverage it provided to SBICs, causing significant reductions in required Congressional appropriations needed to support increasing amounts of available Leverage. The amount of the “Charge” is determined in the fiscal year in which a Leverage Commitment is issued and applies to all Leverage issued pursuant to that Commitment. The Subsidy Rate was substantially reduced in the case of Debentures to less than 1.00 percent with the result that no appropriations were required to support their issuance beginning in Federal FY 2000.

In December 2000 legislation was enacted requiring SBA to set the amount of the Charge it imposed on Commitments issued each fiscal year at the rate necessary so that the sum of all fees charged (including 1 percent commitment fees, 2 percent user fees, the annual “Charge” and anticipated profit distributions) would equal the amount of anticipated losses. The Charge for Leverage Commitments issued between Federal FY 2006 and Federal FY 2018 varied from a low of 0.285 percent, for Federal FY 2010 to a high of 0.94 percent for Federal FY 2006. The Charge for Leverage Commitments issued in Federal FYs 2014, 2015, 2016, 2017 and 2018 was 0.355 percent, 0.742 percent, 0.672 percent, 0.374 percent and 0.222 percent, respectively. The Charge for Leverage Commitments issued during Federal FY 2019 is 0.094 percent, an all-time low.

SBA’s website contains historical information concerning the SBIC Program, including the amount and pricing of Leverage committed and issued since the SBIC Program was restructured in 1994.

Summary of Calculation of Interest Rate Charged on Conventional Pooled Debentures

The rate of interest payable by a conventional SBIC on pooled Debentures is the sum of the following:

1. The interest rate of Treasury Notes with 10-year maturities at the time the Trust Certificates are pooled and sold

2. The premium required by the purchasers of the Trust Certificates above the 10-year Treasury Note Rate, and

3. The annual Charge payable to SBA at the rate applicable in the fiscal year in which the Commitment was issued.

Thus, for example, the interest rate for Debentures issued in the September 2018 pooling pursuant to a Leverage Commitment issued during Federal FY 2017 was:

2.958%   10 Year Treasury Rate
0.590%   Premium required by Trust Certificate purchasers
3.548%   Trust Certificate Rate
0.374%   SBA Charge for Debenture Commitment issued in Federal FY 2017
3.922%   Total Interest Rate


Repayment of Debenture Leverage

Debentures that have 10-year maturities from the date of pooling, are not amortized prior to maturity, and bear interest payable semi-annually.12 Debentures are unsecured, and the General Partner of the SBIC is generally not liable for their repayment. Beginning with the September 2006 issuance, Debentures may be prepaid without penalty, but a Debenture must be repaid in whole. Repayment of Debentures is subordinate to repayment of loans from non-Associate lenders up to the lesser of $10 million or twice the amount of the SBIC’s Regulatory Capital.13 SBA is able to issue Debentures with maturities shorter than 10 years, but has not done so since 1991.

Unrelated Business Taxable Income Exemption

Prior to October 2004, certain tax-exempt entities that invested in SBICs were subject to recognition of unrelated business taxable income (UBTI) as a result of the issuance of Debentures. Tax legislation adopted in October 2004 exempts tax-exempt investors from UBTI that otherwise would be caused by the issuance of Debentures by SBICs licensed after enactment of the legislation, but only if no tax-exempt investor (other than a governmental unit) owns more than 25 percent of the capital or profits interest of the SBIC and all tax-exempt investors (including governmental units, other than any agency or instrumentality of the United States) own less than 50 percent of the capital and profits interest of the SBIC.

Distributions by Debenture SBICs

An SBIC using Debentures makes distributions among its Partners as provided in the SBIC’s limited partnership or operating agreement. The sources of those distributions are limited as follows:

1. Distributions from positive Retained Earnings Available for Distribution, so-called “READ.” An SBIC has READ if it has positive net realized cumulative retained earnings, that is the cumulative earnings after all expenses and realized and unrealized depreciation of investments have been deducted. An SBIC may distribute an amount equal to READ prior to repayment of its outstanding Debentures. Note that SBA determines whether distributions have been made in excess of READ as of the end of each calendar year.

2. In addition to distributions from READ described in paragraph one, except as provided in paragraph three below, until all Debentures have been repaid in full, an SBIC may make distributions in any calendar year up to two percent of its Regulatory Capital.14

3. After an SBIC has substantially completed making new investments, it generally files a “wind-up” plan with SBA. If SBA feels secure about repayment of outstanding Debentures, SBA may permit some repayment of Regulatory Capital prior to the repayment in full of all outstanding Debentures. SBA generally only gives that approval when the SBIC has previously made significant repayments of Debentures, the remaining portfolio is performing well and SBA feels reasonably well assured that outstanding Debentures will be repaid in full. With respect to funds available for distribution, an SBIC will seek to negotiate with SBA the proportion of those funds that will be used to repay Debentures and to make distributions constituting a return of Regulatory Capital. While sometimes this proportion is 1:1, an SBIC cannot reliably predict what arrangement, if any, SBA may be willing to accept.

SBICs are permitted to make distributions before the end of a fiscal year. In situations where an SBIC made a distribution mid-year from READ that then existed, but at the end of the year the SBIC did not have READ for the year (for example, if the SBIC wrote off an investment after mid-year), SBA has taken the position that the SBIC’s distribution was improper and that event of default occurred under the Debenture Leverage. In such a case, the SBIC would be given a specified period of time to cure the default, not less than fifteen days. The failure to cure could result in SBA declaring all Debentures immediately due and payable and seeking the appointment of SBA or its designee as a receiver.

Unlike conventional Debentures which are permitted to make distributions to its investors from READ before Debentures are repaid, an Early Stage SBIC must make distributions to SBA concurrently with the making of any distributions to its investors. The amount that an Early Stage SBIC must distribute to SBA is determined by a formula based on the degree of Capital Impairment,15 a Leverage Ratio and amounts previously distributed to SBA.

Just in Time Financing

The SBIC Program permits the funds from investors and SBA Leverage to be taken down by the Partnership in “lock step,” thereby delaying investor capital calls and potentially increasing investor returns. An SBIC using Debentures is required to have total Regulatory Cap

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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