A middle-market oasis

There's another game in town, and it isn't a bailout. Fifty years after it was launched, the U.S. Small Business Administration's debenture program is enjoying a quiet renaissance.

When the Small Business Investment Co. program, or SBIC, was created in 1958, its goal was to bridge the funding gap between businesses and financing sources and spur job creation, boost the tax base and funnel liquidity in the market -- all relevant in today's economy. Buyout shops bereft of leveraged financing have been effectively marginalized, while portfolio companies face a cash crunch. For the middle market, at least, SBIC resembles an oasis of liquidity.

Stephen Fields, something of an SBIC specialist at law firm McCarter & English LLP, realized as much one day in mid-January, when he took three phone calls from three SBIC licensees: one from a buyout executive, another from a business development company officer, a third from an official of a bank-owned mezzanine fund. Each asked Fields about doing a second SBIC fund.

Fields, a managing partner at the firm's New York office who has handled about 50 SBIC license applications, knew the timing of the calls wasn't coincidental. Absent liquidity in capital markets, the SBIC program, warts and all, looks quite attractive, he says.

Unlike the equity program that the Bush administration phased out in 2004, SBIC's debenture program has money -- to the tune of $3 billion, the amount Congress is expected to authorize for fiscal year 2009. That seems Lilliputian against the woes of the economy when compared with the amounts of the Troubled Asset Relief Program and the stimulus package. But, Fields argues, it "gets cash out into the marketplace and helps create jobs."

The SBA manages $8.5 billion in outstanding leverage and commitments, supported by $9 billion in private capital that 345 partnerships have raised. Recently, interest in the program has picked up, with 16 new applicants in the last fiscal year, more than double the previous year's. "Anecdotally, we're seeing a significant upturn in new applications, says Harry Haskins, a longtime SBA administrator. Kristi Craig, senior investment officer, agrees: "People are definitely looking at SBICs more seriously."

Historically, many companies that have since made it big -- Apple Computer Corp., Federal Express Corp., Outback Steakhouse and Sun Microsystems Inc. -- can look to their humble beginnings as SBICs. The program has had its ups and downs as liquidity ebbs and flows. The SBA does not track a profit component as it did with the equity program, but Haskins says the debentures program has shown "steady performance."

The SBA licenses private investment funds, which get $2 in SBA-guaranteed "leverage" for every $1 of private capital, in return for lending money to cash flow companies. The leverage ceiling in 2009 is $137 million, which means the SBIC has to raise just $68 million from third parties. A bill in Congress hopes to raise the ceiling to $150 million and to more than $200 million for a fund family.

The SBIC issues a 10-year, interest-only debenture, and the principal is pooled and securitized by investment banks. When drawn down, interest is tied to the 10-year Treasury rate (2.87% as of Jan. 30) plus 1%, payable every six months. A lender can then extend credit to a company at a maximum interest rate of 14% per annum, or 19% if an investor chooses not to invest in equity.

Other incentives: A private equity fund may "drop down" a certain portion of a bigger partnership fund dedicated to an SBIC. Moreover, an SBIC can now invest in control situations and set up a one-stop shop.

But certain rules apply. Like any lender, the SBA screens the managers and looks for a track record. An SBIC must also lend up to 75% of total capital as debt securities. "It comes with certain restrictions and management hurdles, but it's been very beneficial to us," says Charles McCusker, managing partner at Baltimore-based Patriot Capital. Patriot is now on its second SBA-backed fund, which closed last July with $180 million. It has a typical SBIC profile, investing between $3 million and $15 million in both subordinated debt and equity in businesses valued at between $15 million and $100 million.

As challenging as it may seem to do business with the government, investors appear willing to suffer. As Fields puts it, "The economics are compelling enough, especially in this economy."