Statement of Lee W. Mercer, President of NASBIC, before the United States House of Representatives Committee on Small Business
March 1, 2000

Mr. Chairman, Ms. Velázquez, and members of the Committee:

A. Introduction.

My name is Lee Mercer. I am President of the National Association of Small Business Investment Companies (NASBIC), the nonprofit association that has represented the SBIC industry since 1958, the year Congress passed the Small Business Investment Act establishing the SBIC program. NASBIC works with Congress to provide the information you need to draft legislation that governs the SBIC program and with SBA to help develop reasonable operating regulations. NASBIC also produces educational programs and publications designed to help SBIC managers and others in the venture capital industry gain the knowledge and skills they require to invest successfully in small private businesses. In this regard, NASBIC members also agree to adhere to a code of ethics and fair trade practices promulgated by NASBIC. Finally, NASBIC works with the news media and private sector information providers to help ensure that the information published about the SBIC program is as complete and accurate as possible.

B. NASBIC Supports the Administration's FY 2001 SBIC Budget.

On behalf of the SBIC industry, I appreciate the opportunity to offer our views on the SBIC portion of the FY 2001 budget that has been proposed by the Administration. We support the Administration's budget as we understand the same has been amended by the testimony of Small Business Administration Administrator Aida Alvarez. Our understanding is that the budget proposes making the following amounts available to SBICs in FY 2001 to augment their private capital for small business investment purposes:

• For Participating Securities: $2 billion at an appropriations cost of $26.2 million given the reduction in the Participating Security subsidy rate from 1.8% to 1.31%. That amount would be subject not only to the appropriation, but also to authorization of at least $2 billion in the SBIC program reauthorization legislation that this Committee will soon address. Our suggestions regarding authorization levels are set out below.
  
  
• For Debentures: an amount to set by the SBIC program authorization legislation referenced above since the Debenture subsidy rate continues to remain at zero. During FY 2000, the amount of Debenture leverage available is $800 million.

C. NASBIC Suggested Reauthorization Levels.

Since the Debenture subsidy rate will remain at zero for FY 2001, the amount of Debenture leverage available in FY 2001 will be governed by the SBIC program reauthorization legislation that Congress must pass this year. This leads me to our suggestions for program authorization levels for Fiscal Years 2001 - 2003. They are set out below.

The suggested growth in the Participating Security authorization levels is in keeping with the growth slope of the program for the past four years. The suggested levels for Debentures are cannot be justified alone by reference to current use of Debenture authority. Rather, we suggest the new levels for two reasons. First, last Spring Congress amended the Small Business Investment Act in a manner that for the first time will make debt investments that also involve royalty agreements attractive vehicles for SBIC investments in small businesses. SBA has yet to issue implementing regulations. However, when it does, we believe that thousands of businesses that heretofore would not have attracted SBIC financing will be able to do so. We urge SBA to issue its regulations soon.

The second reason for the suggested Debenture levels relates to a new "zero coupon" debenture that will be available from SBA in the near future. It is intended for use by SBICs investing in small businesses located in Low—and Moderate—Income (LMI) areas. With no interest due until at least five years, Debenture SBICs will be able to make many more equity investments than they can at present—subject to LMI regulation requirements. Since equity investing is the most popular form of SBIC investing at present, the potential exists for the new Debentures to stimulate renewed interest in Debenture leverage. Thus, the new authority and flexibility that will soon be available to Debenture SBICs leads us to suggest keeping authorization levels relatively high over the next three years.

D. NASBIC Legislative Proposals.

As this Committee considers reauthorization legislation, we also urge the consideration of four program proposals. Three proposals will bring program rules into balance with current operating norms in venture capital investing and reduce overhead time and expense at SBA. The forth would make permanent the authority of SBA to reduce fees paid by SBICs when subsidy rates fall below zero, as they will for the Debenture program in FY 2001. The proposals and their rationales are set out as attachments to this testimony.

E. SBIC Program Statistics.

In addition to our legislative proposals, I have attached a one-page recitation of some of the most important FY 1999 SBIC program statistics. Taken from SBA data, the statistics give the basic and most important facts with respect to the role of the SBIC program in supporting America's small businesses. The SBIC program is a model partnership between government and the private sector to meet a critical national requirement. It is an unqualified success in building small businesses. Congress has heard for years about how Apple, Intel, Federal Express, and Callaway Golf, to name but four well-known examples, received some of their early financing from SBICs. In fact, in Table 22 of its Fiscal Year 1999 SBIC Program statistical package, SBA lists 122 well-known companies that received early financing from SBICs. I have attached that list of companies to my testimony. However, a list tells only the result. It does not give the details of how a particular SBIC helped a particular small business flourish. NASBIC attempts to fill in some of that information for various small companies that have received SBIC financing. As we complete our research with respect to any company that has received SBIC financing, we post it in the "Success Stories" section of our Internet site at www.nasbic.org. We have developed 50 stories to date and encourage you to review them. They tell the real story of the SBIC program.

F. Conclusion.

In conclusion, the SBIC program is well conceived and producing the results that were intended by the legislation. This Committee and Congress have moved quickly and effectively in passing legislation that has improved the SBIC program and made it safer and sounder from the Government's perspective and more effective in providing capital to worthy small businesses. We believe the SBIC program is in the best overall shape of its history and we at NASBIC and the SBIC managers that NASBIC represents are proud to be part of it. The millions of jobs that have been created by the program over the years represent a return on investment that is the envy of all who have studied the program. We believe there is even more to be done in the future and the Administration's proposed FY 2001 budget set appropriate levels in that regard. We look forward to working with the Committee this year and in the years to come to ensure the SBIC program is always in the best position to attain its full potential.

NASBIC Proposed Amendments to the Small Business Investment Act

1. Issue: The definition of long-term as found in Section 102 of the Act.
   
   Proposal: Amend Section 103 of the Act by adding the following new definition:
   
   (17) the term "long-term" when used in connection with private equity capital or loan funds invested in small-business concerns and smaller enterprises pursuant to this act shall mean any period of time equal to or greater than one calendar year.
   
   Rationale:
   
   
   • SBA has construed the term "long-term" as found in Section 102 of the Act to mean a period of time equal to a minimum of five years for all SBIC investments other than those made in "Disadvantage Businesses." For the latter, the minimum period is four years.
     
     
   • This interpretation is overly restrictive and does not allow SBICs and small businesses to fashion investment agreements that are flexible enough to meet the needs of both parties in accordance with the dictates of the commercial marketplace.
     
     
   • SBA's interpretation finds no counterpart in any other area of business commerce. To the contrary, Generally Accepted Accounting Principles (GAAP) define "long-term" as any period of time greater than one year in duration. Likewise, tax law defines "long-term" for capital gains purposes as a period greater than one year. The proposed amendment would make SBIC law consistent with GAAP and tax law.
     
     
   • SBA has recognized that its position is overly restrictive by allowing SBICs that invest in small businesses located in Low and Moderate Income (LMI) areas to structure their investments for periods equal to or greater than one year. Since SBA has stated that companies located in LMI areas are likely to be the least sophisticated in terms of management and perhaps most in need of patient capital there remains no valid reason for maintaining the current SBA definition.
     
     
   • The Gramm-Leach-Bliley bank modernization act—which for the first time gives banks authority to conduct venture capital operations without an SBIC license—places no restrictions on the period of time for investments. The proposed amendment would be consistent with the new bank law and would serve as an important incentive for banks to retain their SBIC operations-to the benefit of small U.S. businesses seeking financing. Without the amendment, many banks may choose to operate all their venture capital operations outside the SBIC program-to the detriment of small U.S. businesses served by the SBIC program.
   
   
2. Issue: The meaning of Section 103(5)(A)(i) as it pertains to control of a small business.
   
   Proposal: Amend Section 103(5)(A)(i) of the Act to read as follows:
   
   (i) shall not cause a business concern to be deemed not independently owned and operated regardless of the allocation of control to be exercised during the investment period in accordance with the investment agreement between the parties;
   
   Rationale:
   
   
   • SBA regulations prohibit an SBIC from owning a controlling interest in the voting stock of a small business or otherwise exercising control of the small business.
     
     
   • SBA regulations provide five broad exceptions for taking "temporary control," including the occasion of an SBIC investment in a small business located in an LMI area. The temporary control can last for up to five years—the average life of an SBIC investment.
     
     
   • The regulations cause inordinate waste of time and resources for both SBA and SBICs in administering the same. Substantial time is spent in each SBA examination of an SBIC determining whether or not the SBIC is in compliance with the control regulations.
     
     
   • SBA's position is does not recognize the realities of venture capital investing wherein there is often substantial difference between the value of the small business seeking financing and the value of the investment to be made by the SBIC or group of SBICs. SBA's position does not allow the parties to an SBIC investment to structure the investment in the way that may be most reasonable and acceptable from both operating and market perspectives without going through unnecessary "exception" procedures.
     
     
   • The purpose of the Act is "to improve and stimulate the national economy and the small business segment thereof in particular...." The focus is on economic growth through job creation. The purpose is not to guarantee control to a senior management team.
     
     
   • Section 103(5)(A)(i) of the Act explicitly states that an investment by an SBIC "shall not cause a business concern to be not independently owned and operated," SBA has no basis in law for prohibiting control in the context of an SBIC investment.
     
     
   • SBA has no good rationale for allowing an SBIC to take control of a small business located in an LMI area while prohibiting control in other SBIC investments. Since SBA has stated that companies located in LMI areas are likely to be the least sophisticated in terms of management ability, the prohibition on control cannot be justified in terms of protecting the small business receiving SBIC financing from possible predatory practices.
     
     
   • The Gramm-Leach-Bliley bank modernization act—which now grants banks authority to conduct venture capital operations without an SBIC license—does not prohibit control. To the contrary, it explicitly permits control during the investment period. The proposed amendment would be consistent with the new bank law and would serve as an incentive for banks to retain their SBIC operations-to the benefit of U.S. small businesses.
   
   
3. Issue: The one percent in annual interest and prioritized payments paid to and retained by the Administration may no longer be required to help support subsidy rates.
   
   Proposal: Amend Sections 303(b) and 303(g)(2) of the Act as follows:
   
   303(b): Such debentures may be issued for a term not to exceed fifteen years and shall bear interest at a rate not less than a rate determined by the Secretary of Treasury taking into consideration the current average market yield on outstanding marketable obligations of the United States with remaining periods to maturity comparable to the average maturities on such debentures, adjusted to the nearest one-eighth of one percent, plus an addition charge of not more than 1 percent per annum which shall be paid to and retained by the Administration, but only to the extent that the 1 percent or a portion thereof is required to offset all or a portion of a positive subsidy rate for debentures as determined by the Administration for the year in question.
   
   303(g)(2): Prioritized payments on participating securities shall be preferred and cumulative and payable out of retained earnings available for distribution, as defined by the Administration, of the issuing company at a rate determined by the Secretary of Treasury taking into consideration the current average market yield on outstanding marketable obligations of the United States with remaining periods to maturity comparable to the average maturities on such securities, adjusted to the nearest one-eighth of one percent, plus an addition charge of not more than 1 percent per annum which shall be paid to and retained by the Administration, but only to the extent that the 1 percent or a portion thereof is required to offset all or a portion of a positive subsidy rate for participating securities as determined by the Administration for the year in question.
   
   Rationale:
   
   
   • The additional 1 percent interest obligation was imposed on SBICs in 1996 in order to reduce the Administration's appropriated cost, as determined by the Administration's model, of supporting the SBIC program.
     
     
   • At least part of the 1 percent in additional interest is no longer required in the Debenture program to keep the subsidy rate at zero. The same may soon be true for the Participating Security program as well.
     
     
   • Changing the law as proposed would allow the Administration to adjust the additional interest and prioritized payment rates annually based on annual subsidy rate calculations. This is similar to the approach already in place for the SBA's 504 loan program.
   
   
4. Issue: The ability of a qualifying SBIC to make a quarterly tax distribution any time during the applicable calendar quarter.
   
   Proposal: Amend the fourth sentence of Section 303(g)(8) of the Act to read as follows:
   
   "A company may also elect to make a distribution under this paragraph at the end of any time during a calendar quarter based on a quarterly an estimate of the maximum tax liability for that quarter."
   
   Rationale:
   
   
   • The proposed amendment is technical in nature and will have no substantive impact on the SBIC program. However, it will save time and expense for both SBA and SBICs by eliminating duplicative filings and inefficient use of SBA resources.
     
     
   • Under current law, SBICs may make prioritized payment distributions, profit distributions, and other optional distributions (e.g., distributions of capital on any date with prior SBA approval. Tax distributions, however, may only be made at the end of calendar year quarters.
     
     
   • The practical impact of this restriction is that SBICs are forced to either delay otherwise permitted interim distributions (that would include tax distributions) to the end of a quarter or split their distributions into two distributions-tax distributions (made at the end of a quarter) and all other distributions (made at any time during a quarter).
     
     
   • Postponing an entire distribution to the end of a quarter has negative cash flow and internal rate of return (IRR) implications for SBICs. Consequently, most SBICs will opt to split their distributions.
     
     
   • Splitting distributions requires the preparation, submission, and SBA review of two sets of documents when one would otherwise suffice. This results in inefficient use of both SBA and SBIC time and resources.