Statement of Lee W. Mercer, President of NASBIC, before the U.S. Senate Committee on Small Business May 1, 2001

NASBIC President Lee W. Mercer, second from right, testifies at May 1, 2001, Senate Small Business Committee hearing on SBA's Funding Priorities for FY 2002.

Chairman Bond, Senator Kerry, members of the Committee:

The National Association of Small Business Investment Companies appreciates the opportunity to testify today with respect to the Administration's proposed FY 2002 budget for the SBIC program. As indicated by the attached compilation of FY 2000 statistics, the SBIC program continues to be one of the most successful of the government's small business programs.

The budget proposal calls for an increase in fees to bring the estimated subsidy rate for the SBIC program to zero, rendering unnecessary any appropriations to cover possible government-guaranteed capital (or leverage) losses projected by OMB by reference to its subsidy rate model. The increase in fees would apply to Participating Security SBICs only, inasmuch as the fees paid by Debenture SBICs are already sufficient to render the subsidy rate zero in that program.

The fee increase proposed by the budget is 37.6 basis points per year on outstanding leverage. Imposing the fee would require legislation raising the 1.0% per year maximum permitted prioritized payment rate paid directly to the Government, as found in Section 303(g)(2), to at least a maximum of 1.376%. Subject to certain reservations, NASBIC supports that increase.

At first reading, the increase seems substantial. However, the fee that would be increased is but one of several fees paid by Participating Security SBICs for the government-guaranteed leverage that makes the program attractive to private sector investment professionals and investors who are the foundation of the SBIC program. In context, the proposed increase is not substantial.

1. The amortized values of one-time leverage charges. These are a 1.0% leverage commitment fee, a 2.0% leverage draw fee, and a 0.5% underwriting fee (for the sale of government-guaranteed securities that generate the funds for leverage). The total of 3.5% is amortized over 7 years, the period that leverage is generally estimated to be outstanding. Discounting cost-of-money considerations, that equals 0.5% per year.



2. An annual percentage rate set by the public markets when the government-guaranteed securities are sold. The February 2001 Participating Security pool rate was 6.64%.



3. An annual percentage rate on outstanding leverage paid directly to the U.S. Government. The rate is set by the Small Business Investment Act. The current rate is 1.0% per year. The President's proposal would change that rate to 1.376% for FY 2002 leverage.

Although no one enjoys fee increases, the proposed increase would not adversely affect either Participating Security SBICs or small businesses to which they provide equity financing. In fact, in FY 2000, the SBIC program's most successful year to date, the total annual rate rose as high as 9.517% for the $455 million in leverage financed in February 2000. The Administration's budget proposal is not unreasonable and, if implemented correctly, should dramatically increase the amount of equity capital that will be available for U.S. small businesses.

Increasing the amount of FY 2002 leverage available to Participating Security SBICs is critical to the SBIC program and small businesses relying on SBICs for equity financing. The table below provides our projected Participating Security leverage requirements through FY 2002 for existing Participating Security SBICs and those funds that are estimated to receive Participating Security licenses over the next twelve months. The estimate, $3.5 billion, is conservative: it includes only 50% of the prospective SBICs that have already had their Management Assessment Questionnaires approved by SBA. Further the number of new Participating Security licensees is only 80% of the average number of Participating Security SBICs licensed per year by SBA in FY 2000 and FY 2001. The estimates are based on the standard SBIC model of one part private capital and two parts government guaranteed capital.

As stated, the estimate of required Participating Security leverage availability is conservative. Participating Security SBICs have used virtually all leverage made available to them over the past few years and commitments for new leverage are now being rationed to some degree by SBA. Failure to make the total of $3.5 billion available would have a negative impact on the program. Private investors and private management teams, the foundation of the SBIC program, would necessarily begin to question whether the government was pulling back from its commitment to the growth of the program. At a time when individual private investors, the foundation of the SBIC program, are reducing their investments in venture capital funds overall, growth in the SBIC program will be particularly important to U.S. small businesses. The Senate Small Business Committee has been the primary leader with respect to SBIC program growth over the past five years and we hope the Committee will continue that leadership by ensuring that $3.5 billion in Participating Security leverage is available in FY 2002.

Given current budgetary constraints, we believe that it would be almost impossible for Congress to make the required leverage available without fee increases. We are not unmindful of, and greatly appreciate, the amendment to the budget resolution authored by Senator Kerry and supported by Senator Bond and the rest of the Committee that would restore cuts in SBA program funding proposed in the President's budget. However, at best we might hope for level funding in the SBIC program. The FY 2001 subsidy appropriation was $26.2 million. Due to vagaries in OMB's subsidy model that can produce increases in subsidy rate projections when the Federal funds rate is falling, such as at present, the FY 2002 Participating Security subsidy rate will increase from 1.31% to 1.87 percent. It is an increase unrelated to any negative performance projections, but an increase nonetheless. Applying the new rate to an appropriation of $26.2 million would make only $1.4 billion in Participating Security leverage available without an increase in fees. Thus, we see increased fees as a necessity to secure the growth we believe is required for the program, even if those fees might be something less than proposed.

As we have said, our support of the President's budget proposal is conditional. One of our concerns, related directly to amounts available for appropriations, is the number of personnel and other resources available to SBA for running the Investment Division, the unit responsible for managing the SBIC program. In fact, we believe that the greatest danger to the SBIC program at present is not the increase in fees proposed for Participating Security SBICs, but lack of adequate personnel and required expense resources for the Investment Division. It may seem strange to some that a regulated industry would ask for more regulators, but that is the case. Lack of adequate personnel has a direct impact on the ability of SBA to process SBIC license applications and on SBA's ability to conduct necessary SBIC compliance examinations on a regular basis. Expeditious processing of license applications and regular examinations, certainly of leveraged SBICs, are necessary to the continued health and success of the program.

Since the close of FY 1993, the number of SBICs has increased from 280 to 411, an increase of 47%. The amount of outstanding and committed government-guaranteed leverage has increased from $860 million to $6.4 billion, an increase of 644%. During this same period, the Investment Division's staff has actually dropped from 93 to 90, a 3% drop. The total budget for the division has increased from $6.2 million to approximately $7.7 million, but the increase averages just over 3% per year to pay increases in salaries and other expenses. The Investment Division has shown considerable ability during this period to meet the substantial increases in its workload and responsibility by increasing productivity. However, it is NASBIC's feeling that the limits of what may be accomplished through productivity increases may have been reached. We urge both this Committee and the Administration to address what we see as a requirement for more resources in the Investment Division. Although not directly related, we hope that our agreement to support the President's budget, whether eventually adopted in whole or in part, will have a positive impact on resources that will be made available to the Investment Division.

Our second concern is that the leverage available to SBICs in FY 2002 be the maximum authorized by the Small Business Investment Act. As amended by Congress last year, the authorized program levels for FY 2002 are $2.5 billion for Debentures and $3.5 billion for Participating Securities. The budget proposal offers somewhat conflicting language. We believe that the conflict relates more to a misunderstanding as to the normal course when subsidy rates fall to zero than to an intention to amend through the appropriations process the Small Business Committee stipulated authorization levels that Congress approved last year. With the Debenture subsidy rate already at zero and the Participating Security rate moving to zero, at least under the Administration's proposal, we ask the Committee to ensure that no artificial limits be put on the authorization limits through the appropriations process.

We believe the Committee should address one additional issue concerning fees and subsidy rates. We understand that OMB, in connection with its preparation of the FY 2002 budget, has re-estimated the reserves required to meet estimated losses associated with the Debenture program from FY 1992 through FY 2000 and the Participating Security program from its inception in FY 1994 through FY 2000. The foundation of those reserves is made up of the fees paid by SBICs and the subsidy appropriations made by Congress for those years. We understand that as a result of the re-estimate that OMB has determined that the reserve accounts had a cumulative total of approximately $390 million more than required to meet anticipated losses. Apparently, that amount has now been "released" to the Treasury for general funding of the government. If correct, SBICs and taxpayers were overcharged by $390 million over the past nine years. During that period, Congress appropriated approximately $257 million to cover all SBIC subsidy reserves, including those of the SSBIC program. The re-estimate indicates not only that those appropriations were unnecessary, but that approximately $133 million of the fees paid by SBICs may have been unnecessary to protect the Government's interests.

We appreciate the fact that estimating losses in the context of the SBIC program is an inexact science, but the magnitude of the "over-estimation" appears to be so large as to raise serious questions in our minds as to the basis for current subsidy rates, particularly that for the Participating Security program. Of the $390 million in "released" reserves, we understand $334 million is attributable to the Participating Security program. Respecting the fact that mathematical models can sometimes yield counter-intuitive results, now that we have learned of the over-estimation of prior years, we question seriously how the Participating Security subsidy rate can jump from 1.31% to 1.87%, a 43% increase, in the same year that the re-estimation has occurred. Our reluctance to accept OMB's estimate is further supported by the fact that OMB made a substantial error in calculating the Debenture subsidy rate in its initial FY 2001 budget submission. It was only after NASBIC raised the issue that OMB corrected its mistake. Thus, while we have said that we can support an increase in Participating Security program fees to achieve the program growth we believe is necessary, we ask that the Committee question the Administration closely concerning the increase in the subsidy rate that makes most of the fee increase necessary.

In anticipation of the requirement for legislation that would increase fees paid by Participating Security SBICs, legislation we hope will originate in this committee, we ask you to consider two additional legislative proposals that will improve the SBIC program. The first suggestion is that Section 312 of the Small Business Investment Act, dealing with potential conflicts of interest in SBIC investments be amended to eliminate the absolute requirement that notice of potential conflicts of interest include, in addition to other requirements imposed by SBA, "disclosure in the locality most directly affected by the transaction."

SBA maintains primary jurisdiction over transactions with potential conflicts of interest and may refuse to grant a waiver for the transaction to go forward if SBA believes the potential conflict has not been addressed satisfactorily. SBA publishes notices of potential conflicts of interest in the Federal Register so that the public has notice of any potential conflicts and the opportunity to respond. However, SBA has interpreted the locality disclosure clause in the Act to mean that notice of a potential conflict must also be published in a paper in the appropriate jurisdiction, with a copy mailed to SBA. To the best of our knowledge, no individual has ever contacted SBA as a result of such a publication in a "local" paper. The result has been a duplicative process that imposes a cost, in terms of both time and money, on both SBA from a regulatory standpoint and SBICs and small businesses from an investment transaction standpoint.

We believe that the requirement of the statute is unnecessary. Without the locality clause Section 312 would read as follows:

"For the purpose of controlling conflicts of interest which may be detrimental to small business concerns, to small business investment companies, to the shareholders, partners, or members of either, or to the purposes of this Act, the Administration shall adopt regulations to govern transactions with any officer, director, shareholder, partner, or member of any small business investment company, or with any person or concern, in which any interest, direct or indirect, financial or otherwise, is held by any officer, director, shareholder, partner, or member of (1) any small business investment company, or (2) any person or concern with an interest, direct or indirect, financial or otherwise, in any small business investment company. Such regulations shall include appropriate requirements for public disclosure necessary to the purposes of this section."

We believe that the amended statute would still give SBA all the authority required to address potential conflict of interest situations without requiring publication that SBA may deem unnecessary. We also believe that SBA supports this proposed amendment.

The second legislative proposal we ask the Committee to consider and support is an amendment to Section 512(b) of the Internal Revenue Code that would exempt income received by tax-exempt institutional investors from SBICs they have invested in from treatment as Unrelated Business Taxable Income (UBTI). UBTI is subject to filing requirements and taxation. The exemption will provide Debenture SBICs with a substantial source of potential private capital that is not available to them at present, capital that is available to Participating Security SBICs and other equity based venture capital funds. Debenture SBICs make subordinated loans to those small businesses with cash flows to sufficient to support them. Entrepreneurs often prefer debt financing inasmuch as they are able to retain a greater portion of the equity in their companies than would be possible with a straight equity investment.

The proposed amendment would not open a new area of tax-exempt activity to organizations that are currently engaging in the same and paying taxes on their investment gains. Under current law, tax-exempt organizations can and do invest in venture capital funds, including Participating Security SBICs, without incurring the requirement of preparing and filing tax returns and paying taxes on investment gains. According to Thomson Financial / Venture Economics of Newark, New Jersey, tax-exempt institutional investors such as endowments, foundations, and pension funds control 61% of the funds invested in venture capital funds. The percent is 66% if the category is expanded to include all private equity funds. Although the percent of their investment funds allocated to the class of investments represented by venture capital funds is small, the total funds controlled by tax-exempt institutional investors are so great that the small percent allocated to venture capital represents 61% of the market.

The vagaries of the tax law are such that a Debenture SBIC creates UBTI (actually a sub-category of UBTI called "Unrelated Debt-Financed Income") by virtue of the fact that the leverage used by Debenture SBICs is raised by issuing debt securities—as opposed to equity securities used by Participating Security SBICs. As a result, Debenture SBICs find it almost impossible to raise private capital from tax-exempt institutional investors. The following is the statement of Keith R. Fox, the founder and managing partner of Exeter Venture Partners. It illustrates how UBTI can have a negative impact on SBIC fundraising.

"The first Exeter fund was a non-SBIC and did not generate any UBTI. It attracted several pension funds and foundations. Our next fund was a Debenture SBIC, which generated UBTI. All the tax-exempt investors dropped out. Our third fund was a Participating Security SBIC, which did not generate UBTI. It had two tax-exempt investors representing 20% of the capital. Our fourth fund was a Debenture / Participating Security hybrid fund, which generated UBTI. All the tax-exempt investors dropped out. Although there may have been other reasons, UBTI was a major determining factor."

A more recent example is that of InvestAmerica Investment Advisors of Cedar Rapids, Iowa. David Schroder, President of InvestAmerica is trying to raise capital for a new SBIC and has hit a substantial UBTI roadblock. He has written me as follows:

        "A month ago I was explaining to various congressional members that UBTI could potentially reduce funding for our fund raising. I am now facing an actual funding reduction that could prove disastrous for our new fund.

        "A state pension fund is balking at the prospect of UBTI and may not invest. This may reduce our fund raising by 50% and result in a reduction of our investment capacity by approximately $22,500,000. This will be a significant reduction of the capital that we will be able to invest in rural states that already are faced with a need for our type of capital.

        "The need to exempt tax-exempt funds from UBTI when investing in Debenture SBICs has become painfully real to us. Please help us secure this exemption which will in turn help to create more capital for SBICs."

The express congressional policy of the Small Business Investment Act 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. Private capital held by tax-exempt organizations represents the large majority of private capital potentially available to SBICs for investing in domestic small businesses. The UBTI provisions of Section 512 of the Internal Revenue Code effectively close off access of Debenture SBICs to that private capital. To advance the express policy of the Small Business Investment Act, it is reasonable that Congress exclude from the definition of UBTI any income received by a tax-exempt organization that is derived from an investment in an SBIC. This exclusion would cost little if any in lost tax revenue since tax-exempt investors wishing to invest in venture capital funds may do so without fear of generating UBTI so long as they do not invest in Debenture SBICs.

We hope upon consideration, the Committee will support our proposed amendment and work with the Finance Committee to the end that will see the amendment part of the tax bill that Congress will pass this year. With Senators Kerry and Snowe holding uniquely relevant positions on both this committee and the Finance Committee we believe that with this committee's support there is a good opportunity to have the proposal included in the tax bill.

Thank you again for your consideration. We look forward to working with you again this year to further improve the SBIC program and its ability to help America's small businesses.