The U.S. Small Business Administration (SBA) finalized a rule to modernize the Small Business Investment Company (SBIC) Program on July 17, 2023. Part of President Biden’s Investing in America agenda, the new SBIC Investment Diversification and Growth (IDG) rule seeks to “unlock unrealized potential and strengthen, diversify, and expand our network of SBIC licensed private funds to address capital deficiencies in underserved small businesses, start-ups, and critical U.S. industries impacting our nation’s security,” according to the SBA press release. The final rule becomes effective on August 17, 2023.

Background

The SBIC Program, established during the Eisenhower Administration, allows SBICs to invest or lend private capital, plus funds borrowed with an SBA guarantee, to make equity and/or debt investments in small businesses and start-ups. The primary benefits of the program for lenders are SBA guarantees and affiliation exemptions for the fund’s other investments. The effort to modernize the SBIC Program is part of President Biden’s Investing in America agenda, which seeks to mobilize historic levels of private sector investment, bring manufacturing back to America, and create new, good-paying jobs.

Historically, the SBIC public-private partnerships contributed to advances in semiconductors, personal computers, and electric vehicles by seeding and scaling “some of the most innovative and successful businesses in the world,” according to SBA Administrator Guzman. The SBIC Program also helps small businesses bridge capital gaps to sustain operations and build resilient businesses.

The new IDG rule addresses structural aspects of the SBIC Program that limited the flow of equity and growth-oriented debt investments from SBIC-licensed funds to small businesses and start-ups operating in underserved communities, capital-intensive industries, and technology areas critical to U.S. national security and economic development.

Highlights of the IDG Rule

• Accrual SBICs. The IDG rule introduces a new debenture instrument to the program portfolio called an “Accrual Debenture.” This instrument permits cash flows of longer duration and/or equity-oriented investment funds, with funds licensed under this financial instrument called an “Accrual SBIC” and eligible for 1.25x tiers of leverage. A typical traditional SBIC investment is made over a three-year period. In contrast, Accrual SBICs accrue interest over a ten-year term. The SBA does not participate in the profits of Accrual SBICs, instead the SBA receives accrued interest and principal upon the distribution event.
• Reinvestor SBICs. The new rule introduces a new type of SBIC called a “Reinvestor SBIC” based on a fund-of-funds model. These SBICs invest equity in underlying funds with an underserved focus (such as disadvantaged businesses, and rural, low-, and moderate-income areas) that, in turn, invest directly in small businesses and start-ups. The rule leaves the term “underserved” intentionally broad to maintain flexibility and agility in aligning with evolving market conditions. Applicants are required to provide a justification in their business plan describing how a particular geographic, industry, or market segment is underserved. Fund-of-funds Reinvestor SBICs will utilize the Accrual Debenture instrument and be eligible for 2x tiers of leverage.
• Improved Program Access. The new rule reduces the financial burden for new program applicants by modifying licensing fees. The rule also permits a more diversified group of investment teams to participate, with a wider range of investment strategies, by broadening track record and eligibility requirements of the fund managers. For instance, the final rule creates an exception for Traditional Investment Companies to own more than 70% of a licensee’s Regulatory Capital and Leveragaeable Capital (generally, no affiliate may own more than 70%), as defined by the SBA. Non-profit entities may now serve as management companies of a licensee, but with the usual 70% limit on Regulatory and Leverageable Capital ownership imposed.
• Affiliation Clarity. The rule clarifies that equity investment by an SBIC licensee does not establish affiliation with the SBIC or its other investments. This is significant particularly for firms that pursue set-aside government contracts. This final rule carves out an exception under 13 CFR 121.103(5)(vi) for Traditional Investment Companies and private funds exempt from registration under section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. The rule clarifies that the exceptions apply to Accrual SBICs. As a result, the portfolio companies of an SBIC licensee are considered “unaffiliated” under SBA regulations unless affiliation is triggered by another relationship.
• Stronger Controls. The rule implements several changes to improve SBA risk management. The enhanced controls include: (1) a codified formal watchlist of potential performance or compliance risks; (2) improved monitoring of investment performance through enhanced reporting requirements; and (3) establishing sufficient SBA loss reserves by phasing in a 40-basis point annual charge floor.
• Reducing Administrative Friction. The rule seeks to reduce friction for participants and investors by: (1) indicating at the time of conditional (“Green Light”) approval the extent of SBA’s intended financial commitment; (2) permitting non-leveraged licensees to submit Financial Accounting Standards Board GAAP compliant valuations; (3) removing the need for SBA pre-approval of a capital call line; and (4) granting a safe harbor for eligible follow-on funding of a portfolio company through a non-SBIC vehicle managed by the principals of the SBIC without prior SBA approval.
• Expediting Subsequent Funds. The rule introduces a risk-controlled process to expedite licensing of subsequent funds to existing program participants.

Implications for Investors and Small Business Owners

Both investors and small business owners are likely to benefit from the new SBIC rule. Investors looking to fund innovative small businesses through a public-private partnership are likely to find the new SBIC rule provides easier access and reduces administrative friction. Small business contractors looking to bridge funding gaps are likely to find the rule helps provide much needed access to private equity.

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