Statement of Lee W. Mercer, President of NASBIC, before U.S. House of Representatives Committee on Small Business, February 26, 2003

NASBIC President Lee Mercer testifying at the February 26, 2003, House Small Business Committee hearing on the Administration's FY 2004 SBIC program budget proposal.

Chairman Manzullo, Representative Velázquez, members of the Committee:

On behalf of the National Association of Small Business Investment Companies, I appreciate the opportunity to testify today concerning the Administration's FY 2004 SBIC program budget proposal. I am pleased to report that the budget has the unqualified support of the SBIC industry. We urge the Committee to support the SBIC budget proposal as submitted.

Discussion Of The President's Proposed FY 2004 Budget For The SBIC Program

The budget would make $4 billion in Participating Security leverage and $3 billion in Debenture leverage available to SBICs for investing (together with their required private capital) in U.S small businesses. SBICs are an important part of our national economic recovery. SBA estimates that SBICs currently account for 60% of all venture capital investments—by number of investments. For comparison, in 1997 the number was 38%. The increase is likely to continue to grow in the face of the substantial and continuing contraction in overall venture capital. To illustrate, the number of all annual venture capital investment transactions has dropped by 60% since the high water mark of FY 2000, but the number of SBIC investment transactions has dropped by just 14% over the same period. This data underscores the important countercyclical nature of the SBIC program and the role it will play in our national economic recovery.

As has been the case since FY 2000 for the Debenture program and since FY 2002 in the Participating Security program, the FY 2004 budget provides that the leverage will require no appropriations to establish the subsidy reserves required by the Budget Act. Rather, the budget provides that the leverage subsidy reserves will be supported 100% by fees and interest paid to the government by Debenture SBICs and by fees, prioritized payments, and profit distributions paid to the government by Participating Security SBICs.

For the Debenture program, §303(b) of the Small Business Investment Act (SBIA) provides that one of the fees is annual interest to be paid directly to SBA for leverage drawn with respect to an applicable year's leverage authority. The interest rate varies from year-to-year as required to keep the subsidy rate at "zero" for Debenture appropriation purposes; provided, however, that the rate may not exceed 1.0% per annum. For Debenture leverage drawn with FY 2004 authority, that rate required to maintain the zero subsidy rate will be 0.855% per annum, down slightly from the FY 2003 rate of 0.887% per annum. No change in the law will be required.

SBIA §303(g)(2) provides the per annum counterpart for the Participating Security program. The section provides that a prioritized payment rate of not to exceed 1.38% per annum on any outstanding leverage related to the annual leverage authority in question shall be paid directly to SBA's account to keep the subsidy rate at "zero" for Participating Security appropriation purposes. For leverage related to FY 2003 authority, the required rate is 1.311% per annum. For FY 2004 leverage authority the required rate will be 1.454% per annum, 0.074% greater than current statutory authority. Thus, for implementation of the President's budget as submitted, the authority of SBIA §303(g)(2) must be increased legislatively by 0.074% at a minimum.

The reason the §303(g)(2) rate must be increased this year has nothing to do with assumption of increased losses in the program. Rather, it is because the profit sharing rate that Participating Security SBICs must pay SBA falls as the 10-year Treasury bond rate falls. At current projections for the 10-year rate, the profit share rate is at its lowest point. In essence, all that is happening this year is a reduction in one rate element and a related increase in another.

We suggest increasing the §303(g)(2) "not to exceed rate" to 1.5% per annum as part of the reauthorization process later in the year. That is the same level we suggested in FY 2002. It is well within the ability of SBICs to pay given current market conditions and would not in any way increase the amount paid by small businesses for Participating Security SBIC financing. The latter are set by market conditions; there is no direct correlation between the cost of leverage to a Participating Security SBIC and the amount it can charge a small business. Total annual cost of leverage has been much higher historically than it is today. The estimated total cost of Participating Security leverage for the next year is approximately 6.5% per annum. This compares to the average for the life of the program of 7.84% per annum. Participating Security SBICs using FY 2004 leverage will be well positioned to contribute to the economic revival so important to our country.

Reauthorization And The Importance Of The SBIC Program

In addition to working with the Committee on the suggested change in §303(g)(2), we look forward to working on the reauthorization of the SBIC program that is required this year. In addition to setting maximum permissible leverage levels for the reauthorization period, we believe we will be able to suggest to the Committee one or two changes in the law that will strengthen the program for all stakeholders. At this time we are working with SBA to further define the portions of the law that might be changed to secure the desired goal. The SBIC program is of great importance at this time and deserves our very best legislative effort.

At a time when the U.S. economy can use all the financial help it can get, SBICs are proving their value as steady and reliable sources of venture capital for America's small business entrepreneurs. For the fiscal year ended September 30, 2002, SBICs invested $2.7 billion in 1,979 U.S small businesses. While down 40% from the previous year, the total compares with a drop of 54% in all venture capital dollars invested for the period. The biggest drop in SBIC dollars invested was in those made by unleveraged bank SBICs-a 63% drop compared to only a 16% drop in investments made by leveraged funds. Banks SBIC investments have fallen both because of economic conditions and because banks can now make venture capital investments out of funds established under Gramm-Leach-Bliley authority. Finally, and of the greatest importance, while SBIC dollars invested fell 40%, the number of companies financed dropped only by 12% (from 2,254 to 1,979), indicating that much of the dollar fall can be attributed to lower valuations of companies securing financing. Given the major contraction in the economy, a fall of just 12% in the number of companies supported by SBICs was a positive result.

What will FY 2003 results show? An extrapolation from investment data through January 2003 indicates that dollars invested will remain level or increase slightly, but that there will be a substantial increase in the number of companies receiving financing. Of course, all projections at this time are clouded by the uncertainty related to the situation in Iraq. What can be said with certainty, however, is that the program is strong and that there is continued growing interest in the program by experienced venture capital management teams. That bodes well for the program and, of greater importance, for the small businesses they will finance.

SBICs continued to be a significant source of capital for new businesses, with 48% of all FY 2002 investments made in companies less than three years old. The average size of investments by all SBICs was less than $1 million mark while investments by non-SBIC funds averaged approximately $9 million for the same period. These numbers speak to the importance of SBIC capital to the great numbers of younger, smaller, less capital-intensive companies that become important parts of the economic foundations of their respective communities, particularly in areas that are traditionally underserved by non-SBIC venture capital firms. In this regard, SBICs invest in virtually every state—48 of 50 in FY'02—and are an important source of capital for businesses located in Low- and Moderate-Income (LMI) areas as defined by the government. In FY'02, LMI investments by SBICs totaled $725 million—27% of all SBIC FY'02 investments. The 27% total was up from 22% in FY 2001—a percentage increase of 23% for LMI businesses.

In terms of employment, based on reports to SBA, average employment at SBIC-financed companies in FY'02 was 157. The median number of employees was 29. Based on the average, SBIC-financed companies employed approximately 310,000 individuals in FY'02. With growing capital resources, SBICs are ready to build on that number in the years ahead.

At year-end FY'02, 442 SBICs were managing $20.1 billion in capital resources, up 7% from $18.8 billion at year-end FY 2001. The increase was significant given the contraction in all other sources of venture capital. During FY'02, private investors committed $800 million in new private capital to the 41 new SBICs licensed in FY 2002. The backlog of current license applications at SBA and the rate at which new applications are being received make it likely that as many as 50 new funds will be licensed in FY 2003. This will ensure the continued flow of critical venture capital to the fast growing U.S. small businesses that are the foundation of U.S. job creation and economic growth.

With the jarring economic contraction we have experienced over the past three years, some losses in the SBIC program are to be expected. Economic business cycles apply to SBICs just as they do to all other business endeavors. However, the SBIC program remains strong. The SBIC program is designed to stimulate the flow of scarce venture capital to U.S. small businesses in a way that, over time, produces revenue neutral results for the government in connection with the augmentation of private capital by government-guaranteed capital. Using a complex model, the Office of Management and Budget (OMB) sets "reserves" that must be set aside each year to meet potential out-year losses associated with the program. While there is no "lock box" for the annual reserve amounts, they are made up of fees, interest, prioritized returns, and profit shares paid directly to the government by SBICs and, when required, annual appropriations. The balance of these "reserves" for the period FY'94-FY'02 was approximately $360 million at year-end FY'02. As more SBICs are licensed, more funds are being added to reserves in FY'03. The program is in a strong position to weather the current economic cycle over time while continuing as an important source of capital for starting and expanding U.S. small businesses.

Suggested Legislation To Increase Private Capital Investment In Debenture SBICs

We ask your continued support for legislation that would exclude Debenture leverage from the type of "Acquisition Indebtedness" that automatically creates Unrelated Business Taxable Income (UBTI) for tax-exempt institutional investors that might be inclined to invest in Debenture SBICs. These investors include pension funds, charitable foundations, and university endowment funds. UBTI is subject to filing requirements and taxation and creates an almost total disincentive for tax-exempt investors that might otherwise invest in one or more Debenture funds. The exemption would provide Debenture SBICs with access to substantial sources of potential private capital that are not available to them at present. Representatives Jim Ramstad (R-MN) and Earl Pomeroy (D-ND) have again filed the required legislation in the House—H.R. 739. The legislation is identical to that filed last year with a "scoring" of just $1.0 million per year in lost tax revenue over the next ten years. According to Thomson Financial / Venture Economics of Newark, New Jersey, tax-exempt institutional investors accounted for approximately 65% of all capital committed to venture capital funds in 2001. Virtually none of it was committed to Debenture SBICs. Passage of H.R. 739 would give Debenture SBICs and the small businesses that depend on Debenture financing a fair chance of securing some of the capital these tax-exempt investors are willing to invest in venture capital funds.

The Debenture SBIC program was designed to enable Debenture SBICs to make loans to small businesses that are generally subordinate to, and may be the basis for, more senior credit facilities from commercial banks. As such, these subordinated loans are often critical to the survival of the small businesses that secure them. Such loans are particularly suited for family-owned businesses that may never reach the growth required to "go public," or, for companies whose owners may never want to give up equity in (or control of) their companies by the sale of large blocks of stock. These companies are often found in the heartland of America, not the "hot" locations that typically attract media attention. Nonetheless, these companies are important to America's economic wellbeing in general and the health of their local communities in particular. They are often primary employers in the areas in which they are located.

UBTI is created automatically by Debenture SBICs because the government-guaranteed capital used to augment private capital in the Debenture program is borrowed capital. It is structured that way by the SBIA. The Internal Revenue Code treats the borrowed capital as "Acquisition Indebtedness," indebtedness that triggers UBTI. This serves as a roadblock for Debenture SBICs and should not apply in the context of the SBIC program. The congressional intent of the SBIA is: "to improve and stimulate the national economy in general and the small business segment thereof in particular by establishing a program to stimulate and supplement the flow of private equity capital and long-term loans which small-business concerns need for the sound financing of their business operations and for their growth, expansion, and modernization ...provided, however, that this policy shall be carried out in such a manner as to insure the maximum participation of private financing sources." Section 102 of the Act, emphasis added. UBTI rules effectively put 65% of private capital "off limits." To advance the intent of the SBIA, it is reasonable that Congress exclude Debenture leverage from the definition of "Acquisition Indebtedness"-thus removing a major fundraising hurdle for Debenture SBICs and UBTI any income received by a tax-exempt organization that is derived from an investment in an SBIC.

We believe there is an excellent chance for this important legislation to be included in the economic stimulus tax bill that Congress may pass this year. We urge the Committee to work with Messrs. Ramstad and Pomeroy and the Committee on Ways and Means to secure that result.

Thank you again for your consideration our views. We look forward to working with you again this year to further improve the SBIC program and its ability to help meet the venture capital requirements of America's small business entrepreneurs.