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Fair Share?

Venture fund operators cry foul over the SBA's bid to get a greater share of their investment profits.

In an effort to stop losing money in its equity-investment program, the SBA is seeking a larger stake in the profits generated by the venture funds it licenses. The agency's goal isn't to make money but to break even. Under existing rules, it provides two-thirds of the capital for Small Business Investment Companies, or SBICs, but receives a much smaller percentage of their profits. The SBA has asked Congress to increase its share to 33.3 percent, up significantly from its current take of about 10 percent. The change would affect funds started after September 30, 2004.

Fund managers argue that such a drastic change in the program's economics will dissuade private investors from putting up capital to start an SBIC. Critics maintain that private investors, who already take a back seat to the SBA in recovering investment losses, are unlikely to accept other unattractive terms, particularly a sizable decrease in their own share of profits. "The [SBIC] industry believes that would represent far too risky an investment for private investors for the potential gain they would get from investing in those SBICs," says Lee Mercer, president of the National Association of Small Business Investment Companies (NASBIC).

SBIC equity funds generally operate like any other venture fund. But unlike traditional funds, an SBIC uses its own capital, plus funds borrowed from the federal government (via the SBA), to provide equity capital to small companies. Not only do they tend to be more risk-tolerant than banks or regular venture funds, SBICs typically target young companies not ready for a traditional venture investment.

In recent years, the SBIC program has attracted mainstream investors having difficulty raising capital for venture-backed investments. Through the SBA, an SBIC can obtain up to three times the amount of private capital it raises, which means that a $10 million private capital investment could create a $30 million fund. There were 198 SBA-backed equity funds worth $11.6 billion in total capital as of October 1, 2003, according to the NASBIC. Twenty-six of those funds had been licensed in the previous 12-month period.

The SBA is optimistic there will be continued investor interest, because the proposal is just one potential program adjustment. Says Jeffrey Pierson, the SBA's associate administrator for investment, "I think it would be in the government's best interest to seek additional changes in the interest of simplifying and streamlining the program."

For its part, the SBA has worked to strengthen the program in other ways, including tighter licensing requirements. In addition, it has developed a new portfolio risk model to identify funds having difficulty. "Now it's time to start looking at the deal terms between the [general partners], the [limited partners] and ourselves to see what kind of stable relationship we can build in over time," Pierson says. "In our view, the math doesn't work anymore with respect to the equity program."

Mercer disagrees with the SBA's assertion that it will continue losing money without the proposed overhaul, arguing that the equity program's 10-year track record is insufficient to make accurate predictions about long-term performance. "The government has looked at a very short period of time to say 'We believe this is how the program will work over time.' But that is a very abnormal cycle that we've just been through," he stresses.

Professor David Brophy, director of the Center for Venture Capital and Private Equity Finance at the University of Michigan in Ann Arbor, maintains that any redistribution of profits would probably turn off some potential investors. "The problem is that the SBA is a special limited partner in a limited partnership, and they get paid first-they have all of these preferences going-and when that percentage is considered modest, then that's fine. [Private investors] could tolerate that.

"There are non-trivial costs involved in being an SBIC," he continues. "It's a substantial regulatory burden that has to be sustained. So when you net it all out, and there's somebody standing in front of you who is getting a third and who is a comprehensive regulator, some of these [private investors] might not be too thrilled about it."


Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.

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This article was originally published in the January 2004 print edition of Entrepreneur with the headline: Fair Share?.

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