Statement of Lee W. Mercer, President of NASBIC, before the U.S. House of Representatives Committee on Small Business May 16, 2001

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 2002 SBIC program budget proposal. 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 finance programs.

The budget proposal calls for an increase in Participating Security SBIC fees to bring the estimated subsidy rate for that program to zero, rendering unnecessary any appropriations to cover possible losses by the government with respect to guaranteed leverage used to augment SBIC private capital. The increase would apply to Participating Security SBICs only. Fees paid by Debenture SBICs are already sufficient to render the subsidy rate zero in that program.

The increase proposed by the budget is 37.6 basis points per year on outstanding FY'02 leverage. Imposition would require legislation raising the 1.0% per year maximum permitted prioritized payment rate paid directly to the Government (§303(g)(2) of the Small Business Investment Act) to at least a maximum of 1.376%. With certain reservations, NASBIC supports the fee increase.

At first reading, the increase seems substantial. However, the fee to 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.

The total annual rate that SBICs pay for leverage is made up of three major components:

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, the rate 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 paid by Participating Security licensees rose to 9.517% for the $455 million in leverage financed in February 2000. The proposal is not unreasonable and, if implemented correctly, should dramatically increase the amount of equity capital that will be available for 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 projected Participating Security leverage requirements through FY 2002 for existing Participating Security SBICs and those funds that we estimate will receive Participating Security licenses over the next twelve months. The estimate, $3.5 billion, is conservative: it includes only 50% of the prospective Participating Security SBICs that have already had their Management Assessment Questionnaires approved by SBA. Further, the projected number of new 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 House Small Business Committee has been a 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. At best we might hope for level funding in the SBIC program. The FY 2001 subsidy appropriation was $26.2 million. Due to variables 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 projected negative management performance, 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. The full $3.5 billion would require $65 million in appropriations—a 148% increase. Thus, we see increased fees as a necessity to secure the growth we believe is required for the Participating Security SBIC program. We hope to work with your committee to secure legislation that is required to achieve this result.

NASBIC Concerns With Respect to the Budget Proposal

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—hardly sufficient to keep pace with the growth of the program. 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 Administration's budget proposal speaks in terms of lesser amounts. 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 authorization levels set by the Small Business Committees and approved by Congress last year. With the Debenture subsidy rate already at zero and the Participating Security rate moving to zero, we ask the Committee to ensure that no artificial limits be put on the previously approved authorization levels 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 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 possible SBIC program losses 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, we understand $334 million is attributable to the Participating Security program. Now that we have learned of the over-estimation in prior years, we question 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 concern 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 this regard, we support the request made by the Chairmen and Ranking Minority Members of both the House and Senate Small Business Committees for a General Accounting Office report on subsidy rates in SBA's 7(a) program. We believe that report may have some applicability to the SBIC program as well.

Suggested SBIC Legislation

• Paperwork Reduction in Potential Conflict of Interest Situations

In anticipation of the requirement for legislation that would increase fees paid by Participating Security SBICs, legislation we hope this committee will support, we ask you to consider two additional legislative proposals that will improve the SBIC program. First, we suggest that Section 312 of the Small Business Investment Act, dealing with potential conflicts of interest be amended to eliminate the 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 any 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, the locality disclosure clause in the Act requires also 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 the "locality publication" 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."

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

• UBTI Exemption for Tax-Exempt Organizations Investing in SBICs

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 would provide Debenture SBICs with access to substantial sources of potential private capital that are not available to them at present, capital sources that are available to Participating Security SBICs and other equity based venture capital funds. The amendment we suggest would add the following as Internal Revenue Code §512(b)(18):

"(18) Special rule for investment in Small Business Investment Companies. There shall be excluded all income attributable to an investment in a small business investment company operating under the provisions of the Small Business Investment Act of 1958. This paragraph shall apply to a small business investment company formed as a limited liability company, a partnership, or a corporation."

Without the exemption, UBTI rules make it virtually impossible for Debenture SBICs to raise private capital from tax-exempt institutional investors. The reason is not that tax-exempt institutional investors do not invest in venture capital funds. Indeed, according to Thomson Financial / Venture Economics of Newark, New Jersey, these institutional investors provide approximately 60% of the capital invested in venture capital funds each year. However, the vagaries of the tax law are such that virtually all of this money is invested in equity oriented venture capital funds, funds that do not raise any of their capital by way of borrowing and that do not structure their investments as loans as opposed to stock purchases. Investments in equity-oriented funds do not create UBTI for tax-exempt investors.

The following are examples of how UBTI rules can have a negative impact on Debenture SBIC fundraising. The first is a statement by Keith R. Fox, founder and managing partner of Exeter Venture Partners.

"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 Debenture 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."

These results make no sense in the context of the government's SBIC Debenture program. As with Participating Security funds, in return for agreeing to invest only in U.S. small businesses that meet small business size standards, Debenture SBICs can augment their private capital with government-guaranteed capital. For Debenture SBICs that government-guaranteed capital comes in the form of a loan, the proceeds of which must be used primarily for loans to the small businesses SBICs finance. The 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 lose 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 tax rules that serve as roadblocks for Debenture SBIC managers trying to provide the above loans have no place in the context of the SBIC program. 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. 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.

There should be no revenue loss to the government if an exemption from UBTI consequences is provided for tax-exempt institutional investors investing in SBICs. Tax-exempt investors allocate only a finite percentage of their capital to the class of investments represented by venture capital funds. The government is receiving little if any tax revenue attributable to Debenture SBIC UBTI at present since tax-exempt investors invest their allocated amounts in equity-oriented funds that do not produce UBTI. Allowing Debenture SBICs to compete for such funds on even terms with other venture capital funds would not cause tax-exempt investors to increase the amount of capital allocated to that class of investments. The change would simply remove the UBTI roadblock that prevents tax-exempt institutional investors from allocating a small but important portion of their venture funds to Debenture SBICs that the government has already deemed worthy of support.

Notwithstanding our belief that there would be no revenue loss to the government, we understand that the Joint Committee on Taxation did estimate revenue loss in connection with a 1992-1993 attempt to secure the same exemption. The loss was estimated to be $12 million over five years. The amount was inconsequential then, as it would be now, when compared to the benefits that would accrue as Debenture SBICs increased the amount of capital available to U.S. small businesses for difficult to obtain loans. Debt financing is as important in the development of growing small businesses as is equity financing. A minimal loss should not be a hurdle that would prevent Congress from supporting a well-justified amendment to the tax code. We hope that, upon consideration, the Committee will support our proposed amendment and work with the Ways and Means Committee to provide the exemption we have suggested.

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 America's small businesses.