On October 18, 2022, the US Small Business Administration (the SBA) proposed a wide range of regulatory changes to the rules governing the small business investment company (SBIC) program (the Proposal).1 The full text of the Proposal is available here.
This Legal Alert is one of a series of alerts that will be published to track the proposed changes and summarize the provisions of the final rule adopted by the SBA and their effective date. The Proposal impacts existing SBICs and the SBIC license application process, including the creation of a new type of debenture program for equity-focused funds (Accrual SBICs). This Legal Alert focuses on certain key regulatory changes impacting existing SBICs, including the following:
I. Definition of “total leverage commitment"
The SBA proposes to approve the “total leverage commitment” for the life of the SBIC at the time of licensing, subject to SBA regulations, rather than requiring the SBIC to apply for multiple leverage commitments following licensing. The SBA argues that this change will reduce the burden of submitting separate commitment requests after the fund has been licensed, and will reduce uncertainty regarding the SBA’s leverage commitment.
As discussed in the SBIA Comment Letter,2 as drafted, an interpretation of this change would suggests applicants would be required to have secured all of their projected capital before proceeding to the “green light” stage of the license approval process. The change does not align with the reality of capital raising for many funds. Based on industry feedback, this provision will likely require further attention from the SBA. Depending on the SBA’s response to the comments received, this proposed change may be revised before the new definition of “total leverage commitment” is adopted.
II. Use of credit lines
Under the current SBIC regulations, leveraged SBICs must seek SBA approval to obtain secured third-party debt. The Proposal creates a new “Qualified Line of Credit” exemption that would allow a leveraged SBIC to forego obtaining the SBA’s prior written approval if certain requirements are met:
- all borrowings under the line of credit must be secured by unfunded regulatory capital up to 100% of the amount of the borrowing and 90 days of interest;
- must be for the purposes of maintaining operating liquidity or providing funds for a particular financing of a small business;
- must be fully repaid within 90 days after the date they are drawn;
- must be limited to 20% of total unfunded binding commitments from institutional investors;
- the term of the line of credit must not exceed 12 months, but may be renewable so long as each renewal does not exceed 12 months; and
- must be fully paid off for at least 30 consecutive days during the SBIC’s fiscal year such that there is no outstanding third-party debt for at least 30 consecutive days.
The Proposal notes that in practice, these types of lines of credit are regularly approved by the SBA, and establishing this type of exemption will streamline access to lines of credit that tend to be authorized by the SBA without having to go through the pre-approval process.3 The SBIA Comment Letter recommends that the SBA amend the Proposal to create an additional exemption from an unsecured line of credit, which do not raise the same concerns as secured lines of credit.
III. Distributions and reductions in regulatory capital
Under current SBA regulations, a leveraged SBIC with outstanding debentures can make such distributions only from retained earnings available for distribution (READ), which consists of the SBIC’s cumulative realized profits, less unrealized losses on investments. Alternatively, a leveraged SBIC can make distributions as a reduction in the SBIC’s regulatory capital but it may not return more than 2% of its regulatory capital to investors in any fiscal year without the SBA’s prior approval. An unleveraged SBIC is permitted to make distributions without regard to this limitation if it notifies the SBA of any reduction in regulatory capital within 30 days and meet the required minimum capital requirements. In the Proposal, the SBA raises several concerns with the current practice, including instances where leveraged SBICs have made a distribution, then subsequently written down an asset that would have reduced READ. Additionally, the Proposal highlights the risk of Licensees distributing profits without repaying the SBA debentures, resulting in potential losses to the SBA.
The Proposal provides separate distribution requirements based on three categories of SBICs:
- Unleveraged SBICs: No changes to the current requirements.
- Leveraged SBICs licensed before October 1, 2023, and leveraged SBICs wholly owned by business development companies (BDCs): No substantive changes to the current requirements, but the SBIC must consider whether there have been any “material adverse changes” to its portfolio.
- Leveraged SBICs licensed on or after October 1, 2023 not wholly owned by BDCs and Accrual Funds: SBICs would follow a distribution waterfall that repays the SBA the principal balance on outstanding leverage on at least a pro rata basis with private investors. By requiring repayments on a pro rata basis when READ distributions are made, a 10-year debenture would instead become a 3- to 5-year debenture, depending on when the SBIC begins to make payments to limited partners. Accordingly, this would reduce the capital available for reinvestment in other small businesses by requiring an SBIC that falls into this category to prematurely pay back its debenture base. In light of the negative industry feedback on this provision, the SBA is likely to revise or reconsider this proposed provision.
IV. SBIC reporting requirements
The Proposal includes the following changes to the SBIC reporting requirements:
a. Portfolio reporting changes
The Proposal would require SBICs to submit a portfolio financing report on SBA Form 1031 within 30 calendar days of the end of the calendar quarter following the closing date of a financing, rather than within 30 days of the closing date of a financing.
b. Valuation reporting
The SBA proposes to change the valuation reporting timeline from semi-annually to quarterly for leveraged SBICs. The Proposal also expands the timeframe for quarterly valuations, including material adverse changes to 45 calendar days following the closing of each quarter (rather than within 30 days).
c. Annual reporting changes
The Proposal includes changes to the substantive information required by SBA Form 468. The current regulations require an assessment of the economic impact of each financing, including details about the impact of the financing on revenues of the business, taxes paid by the business and its employees, as well as full-time equivalent jobs created or retained by the financing. The SBA proposes adding a category to SBA Form 468 that would report “total jobs created or retained” by a financing, which includes information about part-time jobs (whereas SBA Form 468 currently only requires full-time job data). The SBA would also request certain demographic information as to a portfolio company’s ownership, which would be reported on a voluntary basis.
d. Form 468 filing due date
The Proposal would change the deadline for submitting annual SBA Form 468 to within 90 calendar days following the end of the fiscal year, instead of before the last day of the third month following the end of the fiscal year as is currently required.
e. Form 1031 filing due date
The Proposal would change the deadline for submitting a portfolio financing reporting on Form 1031 to within 30 calendar days of the end of the calendar year quarter, instead of before the last day of the third month following the end of the fiscal year as is currently required.
In addition to the changes above, the SBA is working on upgrades to the SBA Connect system and exploring options to more effectively gather and report performance data about the SBIC program.
V. Valuation policies
The Proposal would allow unleveraged SBICs to adopt a valuation policy in accordance with GAAP, which would continue to be approved by the SBA. The SBA is re-evaluating this requirement for leveraged SBICs, and working with its valuation contractor to evaluate potential changes to the SBA’s Valuation Guidelines to become GAAP compliant.
VI. Revisions to fee structures
The SBA has proposed changes to the following fee structures:
a. Leverage fees and annual charges
The Proposal would establish a minimum “annual charge” (not to exceed 1.38%) on leverage commitments issued each federal fiscal year at the rate to address long-term variances in losses, which generally fluctuate on a yearly basis. The SBA proposes to set the minimum “annual charge” to 0.50%.
a. Examination fees
Currently, the SBA charges a minimum base fee of 0.024% of assets at cost, which is capped by a maximum base fee. The Proposal would streamline this formula to $10,000 + 0.035% of the SBIC’s total leverage commitment. For existing SBICs, this structure would result in a fee of $10,000 + 0.025% of the total of the SBIC’s outstanding leverage, plus the SBA’s undrawn commitment amount. Under the Proposal, an unleveraged SBIC would pay a flat fee depending on the unleveraged SBIC’s assets at cost as follows: (1) $10,000 if the SBIC has less than $50 million in assets; or (2) $20,000 if the SBIC has more than $50 million in assets.
VII. What’s next?
The Proposal issued by the SBA involves many changes to the SBIC program, and will have a significant impact on the operation of SBICs. The comment period for the Proposal closed on December 19, 2022. We expect that this Proposal is the first wave of changes to the SBIC regulations, and the SBA will likely seek another round of comments soliciting further input on the Proposal.
Once the SBA issues a final rule, the SBA will also need to issue an updated Standard Operating Procedure (SOP) to include provisions explaining how the SBA will operate in light of the new regulations. Although the SOP does not technically have the force of law, agencies occasionally open a public comment period for major changes to an SOP. If the SBA provides a public comment period for changes to the SOP, industry participants would have another opportunity to clarify how the new rules will impact SBICs and potential applicants.
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1 Small Business Investment Company Investment Diversification and Growth, 87 Fed. Reg. 63436 (Oct. 19, 2022) (to be codified at 13 C.F.R. pts. 107 and 121).
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