Background
Small Business Investment Companies are privately owned investment funds that are licensed and regulated by the U.S. Small Business Administration ("SBA"). The SBIC program is a private-sector led partnership with the U.S. government. Established under the Small Business Investment Company Act of 1958, SBICs have been a significant contributor to job creation in the U.S. over their history by making profitable investments in thousands of small businesses that form the backbone of the U.S. economy. In fact, small businesses account for nearly all of the new jobs created in the U.S. since 1991 and represent over 99% of all U.S. employers. Investments by SBICs have fostered the growth of companies such as Federal Express, Intel, Callaway Golf, America Online and Outback Steakhouse.
SBICs are generally organized and operated like any other venture capital, mezzanine or private equity fund. There are, however, a few notable exceptions. Unlike traditional funds, SBICs receive up to approximately two-thirds of their total capital from the SBA. In return, an SBIC must invest in "Small Businesses" as defined by the SBA, abide by a body of regulations and submit to annual regulatory and operational examinations. An applicant for a SBIC license must raise a minimum amount of private capital, $5 million or more, normally provided by banks, high net worth individuals and other institutions as limited partners. It is this private capital that is "leveraged" up to 2:1 or (less frequently) 3:1 with SBA funds, provided the applicant successfully completes the rigorous SBA licensing and audit processes. The SBA leverage is provided at below-market rates which increases the returns to the limited partners.
CRA Credit
The four federal bank regulatory agencies, OCC, OTS, FDIC and the Fed, began in 1993 an effort to develop new joint CRA regulations. This process culminated in May, 1995, with a joint rule that was phased in over a two-year period.
In July of 1997 CRA underwent a major revision when the Investment Test was added to the existing Lending and Service Tests. The various federal bank regulatory agencies individually and through the Federal Financial Institutions Examination Council ("FFIEC") established bank investments in SBICs as a "safe harbor" for satisfying the Investment Test. Since that time an increasing volume of capital has flowed into SBICs from banks, and the number of banks investing in SBICs has increased dramatically. All banks with total assets of $250 million or more are subject to the Investment Test.
An investment in an SBIC operating in a bank's CRA Assessment Area is specifically cited in the Interagency Interpretive Questions and Answers Regarding Community Reinvestment for the joint rule as an investment that will be presumed by the agencies to be a "qualified investment" for CRA purposes. The agencies have further stated that a bank can receive full credit for an investment in a SBIC that serves a broader regional area, provided it includes the bank's assessment area. The Investment Test accounts for about 25% of the overall CRA rating. A bank's CRA rating must be taken into consideration by regulators when a bank applies for approval of an activity relating to deposit-taking facilities, and by the Federal Home Loan Bank when a bank requests an advance. Banks are authorized to invest in or own SBICs by the Bank Holding Company Act, which permits a bank to invest up to 5% of its Tier 1 capital in SBICs.
Attractive Returns
SBICs provide banks with an attractive alternative to other investments routinely used by banks to meet the Investment Test - e.g., grants, pools of mortgages made in low and moderate income areas, qualified tax benefit transactions, etc.- since SBICs routinely produce returns in the mid-teens and above. According to the SBA's SBIC Program Statistical Package, January 2001, the average annual realized rate of return to investors for all SBICs has been approximately 21% since 1996. While investing exclusively in SBICs to meet the Investment Test may not be prudent, including SBIC investments with other investments can provide better diversification and higher returns than most banks are currently realizing.
Commercial Lending Opportunities
Probably the most overlooked and possibly the most valuable benefit available to a bank by investing in an SBIC is the impact it can have on the bank's commercial lending activities. Investing in an SBIC that operates within a bank's market area provides an excellent opportunity to establish a referral relationship with another lender/investor that pursues many of the same types of companies to which the bank has an interest in lending. Since SBICs invest in the form of equity and subordinated debt, they do not compete with banks. In fact, SBICs often seek banks that are interested in providing senior secured debt to the companies in which the SBICs invest. Likewise, banks often find themselves in a lending situation where an existing borrower needs additional capital below the bank loan to enable the bank to continue to increase its lending to the company to support its growth. Having an SBIC with which the bank is familiar, whose interests are aligned with the bank and which operates within the bank's market area is a competitive advantage when seeking to meet the needs of a client and to retain a valuable relationship.
Summary
Once the domain of only the largest banks, investing in SBICs has become common practice for many smaller community banks. And although more banks are increasingly investing in SBICs, there remains a large number that are unaware of the CRA credit available to them, and still others that do not fully appreciate the broader benefits that an investment in an SBIC can provide. A confluence of events has occurred over the past few years to make SBIC investments worthy of serious consideration for all financial institutions. A better understanding of the regulatory benefits of SBIC investments, growing competitive pressures, and the very favorable economic and community development impact that SBICs provide should cause more banks to allocate a meaningful amount of capital to profitable investments in SBICs.
