Top considerations for managing Small Business Investment Companies

This transcript was auto generated and may contain inaccuracies. Please refer to the original webinar recording for the most complete and accurate information.

Cynthia Krus: Good afternoon and welcome. I'm Cynthia Krus, a partner at Eversheds Sutherland. Thank you for joining us today for our webinar. We'll be taking a practical look at managing an SBIC after the licensing process is complete. If you weren't able to join our webinar earlier this month on the SBIC licensing process, the recording and the transcript are available on our website.

Interest in the SBIC program remains strong, and many platforms—especially those with existing investment vehicles or BDC affiliates—are focusing on understanding the operational steps that come next. Today, I'm joined by my colleagues, Sara and Paige, who will walk us through our top ten questions on obtaining SBA leverage and key leverage terms, portfolio investment requirements and limitations, and important operational and compliance considerations for SBICs.

Our goal is to provide practical guidance on issues we see most often with newly licensed funds. So, let's start off with obtaining leverage and key leverage terms. What is the process like for obtaining a leverage commitment from the SBA? Actually getting the money?

Paige Spraker: The most important part! After the SBIC is licensed, the next step is to submit a commitment application to request leverage in order to make investments. During the commitment application process, and even now as we will discuss during the final license application process, the SBIC requests a total amount of funding to be provided by the SBA, which is based on the SBIC’s regulatory capital.

The total intended leverage commitment is what’s disclosed to the SBA as what the SBIC views is the amount of leverage the SBIC expects to use over the life of the fund, whereas the commitment application process typically involves requesting smaller portions of that total intended leverage commitment. In our experience, the SBA expects SBICs to request incremental portions of that total leverage over time rather than submitting a commitment application for the entire amount at the outset.

In terms of timing, the SBA will consider a commitment application at the final licensing stage, which can help speed up the process so SBICs have debentures available to make investments once they’re operational. As part of the commitment application process, there’s legal documentation, bank information, and other administrative items the SBA needs in order to fund debenture requests. The commitment application process also involves an investment plan.

It’s helpful to make sure the amount of leverage you’re requesting at any given time aligns with the investment plan you provide to the SBA, showing that you have the business opportunity to spend the money they are providing to you.

Krus: So you can do that simultaneously? So that once you get your license, you’re ready to go?

Spraker: That’s right. During the final license application stage, the SBA will concurrently consider your commitment application so you have debentures available to draw down on once you’re ready to start investing.

Krus: And that commitment is just the SBA’s commitment for the debentures. When you actually want to draw down, that’s a separate process?

Spraker: Exactly. In terms of timing, the debenture requests themselves come after the SBA guarantees that commitment. The SBA accepts those drawdown requests twice per month, so it’s a bit more of a cyclical timing than the commitment application itself. There are clearer deadlines for when you submit those debenture draw requests.

Krus: When can you access the money, and how soon?

Spraker: In terms of timing, once the commitment application is granted, those debenture requests can be submitted on that twice per month cycle. Practically speaking, SBICs are limited to half a tier of leverage until they’re examined by the SBA. In our experience, it’s helpful for SBIC clients to proactively request an SBA examination early so they can move beyond that hurdle and access the full amount of leverage that they are able to obtain over the life of the SBIC fund.

Krus: And when you do a drawdown, you need to have a reason for accessing the money? But if a transaction doesn’t go through, you don’t have to time that, you can keep that money?

Spraker: Exactly, that’s right. When you draw down on the funds, the SBA looks for concrete examples of investment opportunities. They want details, including whether it’s an initial or follow-on investment. So they are very focused on making sure there are actual investment opportunities in your pipeline. But as you mentioned, if it falls through, you won’t necessarily be faulted. But they are looking for that detail at the outset when accepting and approving those draw requests.

Krus: What are the terms of the leverage the SBA is providing today?

Sara Nasseri: I’ll focus on the standard debenture program, which is the traditional SBIC fund – debt funds primarily making debt investments.

There are leverage limits. I won’t go into the $150 million leverage limit, but to the extent there is a family of funds with an SBIC, two or more, limited to $350. Your ability to draw on your leverage is limited by that $350 cap.

In terms of interest rate, the standard debenture is a ten-year term, is unsecured, and interest is payable on a semiannual basis. The interest rate is set through a pooling process on a six-month basis every March and September and is based on the ten-year Treasury rate plus a market spread. The most recent, all in, was about 4.532%, so Treasury rate plus a five basis point spread on top of that.

In addition to the interest payment, there’s an annual charge that’s based on the leverage commitment date. Once you get your leverage commitment, the annual charge is based on that date. As of FYE2026, the annual charge is 25 basis points.

With respect to prepayment fees, to the extent you prepay the debentures after year six, there will not be any prepayment penalties. But if it is prepaid after the first year, there is a 5% fee, and each year it goes down by 1%.

Krus: And you mentioned the pooling, how does that dovetail if you are taking down on a just in time basis? Do you look back to the previous interest rates during that gap in time?

Nasseri: Exactly right. There is a temporary interest rate that you are using at that point, until there is a pooling. If you are in May, you would use that temporary rate at a look back basis. And on the September pooling day you would adjust as needed.

Krus: Are there additional leverage considerations for SBICs that are part of a larger platform?

Nasseri: Where an SBIC is wholly owned by a parent fund such as a BDC, the SBA focuses on the collectability of leverage commitments. Over time, the SBA has developed standards or rules over time to ensure that. So what they are looking for, assuming you are going for the full 87.5 leverage, for the BDC, for example, is to have six times of that total funded capacity, so that gets you around $525 million.

What they are looking for is the BDC will be typically limited to a single tier of leverage until its regulatory capital is paid in. They are looking to ensure that the BDC parent would be able to cover the debentures for the SBIC subsidiary.

Krus: The percentages, those have moved around a bit depending on what the environment is like?

Nasseri: It has. I should mention that there is a separate clause that the SBA has discretion to ensure that there is sufficient liquidity. We have seen it, in some instances, depending on the financial operations of the BDC, we’ve seen them request more leverage, and some less. So a private BDC or non-traded BDC, without an inflow of capital, would be able to satisfy this requirement. But there are various considerations you would have to think through.

Krus: The SBA wants to be satisfied that you will have the financing in place, whether that’s debt or equity. You will spend quite a bit of time during the application process, but it’s also ongoing. Moving on to portfolio investment limitations, Paige, what is the definition of a small business? Remember, everything you put into the SBIC has to be a small business.

Spraker: The definition of small business is businesses that have a tangible net worth of less than $24 million and average after-tax income for the prior two years of less than $8 million. SBICs may also rely on a separate industry size classification standard if those tests are not met by the particular business. And that test is based on the number of employees, or the average annual receipts for whatever industry that business is operating in. The SBA publishes that information.

In addition, at least 25% of the SBIC’s invested funds must be invested in what the SBA calls smaller enterprises, which are companies with net worth of less than $6 million and average after-tax income for the prior two years of less than $2 million.

One important distinction between these two definitions that the SBA, in our experience, has focused on in exams. Which is that small businesses, or everything that is in the SBIC’s portfolio, relies on tangible net worth, while the smaller enterprise test relies only on net worth. It’s important to think through these details when keeping records for the various investments that the SBIC makes, because it is something that the SBA has become more focused on in recent years.

And when factoring in these different calculations for small businesses, there are a couple things we see trip people up. One is affiliation. Both of these size tests take into account not only the business itself but also its affiliates. That definition is very broad, it focuses on not just whether another entity controls that business, but whether they have the ability to. So if there is any other entity that has the ability to control the business in question, even if that control is not exercised, the SBA will view that as an affiliate relationship, which can lead to some unexpectedly large businesses, in cases where you may not think the portfolio company would fail the definition. For example, if the small business is owned by a private equity firm, that is a time where we see this issue come up a lot.

Another consideration in terms of calculating small business is even if the business satisfies the size criteria, it might not necessarily be a good fit for the SBIC. We’ve seen the SBA ask questions about why a business had negative average annual receipts. So even though it technically satisfied the definition of small business, it might not have been the type of business that the SBA was hoping the SBIC would invest in.

And then the tangible net worth vs. net worth distinction is another obstacle that comes up in making these calculations.

Krus: When doing these calculations, you’ve got to be careful if you’ve got any kind of complex securities, good will. To the extent a business you are trying to qualify, you’ve got to spend some time looking at those financials and that you are comfortable. Going on, what are some other limitations beyond the small business definition?

Nasseri: Before I get into describing those various limitations, this is one area that really highlights the benefits of making sure the organization has some sort of investment checklist or compliance mechanism in place to make sure the deal team is tracking and confirming that it is truly an investment that is eligible for an SBIC.

There are several types of business the SBA would view as ineligible. I won’t touch on all of them, but I will highlight the ones that come up more frequently, but also keep in mind there are some limited exceptions.

The first is re-lenders and re-investors. This is referring to businesses whose primary business activity is purchasing debt obligations, for example, or long term leasing of equipment, for example. One exception that the SBA recently adopted is to allow for equity capital investments in re-lenders that are disadvantaged businesses. A few years ago, this was a major focus and the SBA was very mission-oriented. The definition of disadvantaged businesses is very vague, and is primarily focused on ensuring that the business is owned or controlled by individuals that are deemed to be hampered by social or economic disadvantage, again, very vague. It is a limited exception that we don’t see utilized often.

The second example of an ineligible investment is passive businesses. So, the SBA is not looking for the SBIC to make investments in companies that don’t have actual operations or employees that are effectively doing the day to day obligations of the company. There are two key exceptions that are often utilized. The first one being if you set up an investment through an SPV, as long as the proceeds of that investment go through to a small business, that is permitted. The SBA used to limit this to two tiers of SPVs, but they recently removed that limitation, and as long as the proceeds are flowing through to a small business that is appropriate. In addition, for an SBIC that is wholly owned by a BDC that is regulated as a regulated investment company, the SBA does permit equity tax blockers be put in place to prevent any bad income flowing through to the BDC. This was a very recent change, up until vey recently that was not permitted and often times resulted the SBIC not being able to participate in equity tags or co-investments.

Moving on, one other requirement is foreign businesses. Once again, the SBA is focused on small businesses in the United States. So you would want to carefully look at where the business operations are, where are the employees sitting.

Krus: Are there overline limits as well?

Nasseri: Yes, the SBA is also looking that you do not invest more than 10% of your total capital in any single company. So, what does that mean? That means you are looking at your private capital plus your total amount of projected leverage. Assuming you are going for the full 87.5 leverage commitment (two tiers of leverage), you are talking 30% of your private capital. They want to ensure some level of diversification in the portfolio. That is one thing you would need to look at at the outset as well.

Krus: And if you have two SBICs, you would have to aggregate those? So if you have a family of SBICs you need to be very careful about that. Let’s move on to some other operational and compliance considerations. What is the reporting the SBA requires?

Nasseri: You will have an annual audit, that is separately provided to the SBA. There are valuation reports as well.

The valuation, the SBA has very specific valuation guidelines that they expect to be followed here. To the extent that you are an SBIC that is wholly owned by a BDC parent or another parent fund, there will be instances where your valuation of a single investment at the SBIC level is going to be different than what would be presented at the fund level. There effectively would be two sets of books for the SBIC and the parent fund.

In addition, you will need to present a report with respect to each financing that discloses how you complied with the small business test. And separately, the SBA does do examinations. There has been a big push. And in recent remarks, they have made a comment that they are striving to do exams on an annual basis.

Krus: So some of that paperwork you are required as a fund to keep yourself, some of it gets submitted. The paperwork that goes into the application is very heavy, as you get further down, it becomes much lighter and is much more of a regulatory environment where you get examined and that’s where they do deeper dives. Is that the way to look at it?

Nasseri: Right. In terms of the actual reporting, it is lighter. And given that the forms are a little archaic, there are oftentimes third-party vendors that are engaged to assist in inputting the information into the specific forms. But a much lighter load after you’ve completed the MAC.

Krus: The SBA has its own accounting and reporting rules, which are not GAAP. Paige, can SBICs co-invest with their affiliates across the platform or with other funds?

Spraker: Practically speaking, there are two types of associate-related transactions that the SBA is focused on. The first is financings with an associate, so what we would think of as typical co-investments. And they’re also concerned with financing an associate itself.

The general principle governing both of these types of transactions is that the SBICs can’t make investments that would create a conflict of interest. And in the SBA’s view, investments with an associate do not create a conflict of interest if the investment is made between the SBIC and the associate on the same terms and at the same time, in addition to on the same conditions. So outside of those cases, the SBIC would need the SBA’s prior written approval to engage in that co-investment. Practically speaking, that means that the co-investments just aren’t feasible if they can’t be done on the same terms and the same times because the timing of the closing of the investment can’t necessarily be slowed down to make sure that the SBIC can make it through the pre-approval process in time, especially when there are other features of the transaction that might be outside the control of the SBIC and its associate. These types of investments really highlight the importance of having a strong relationship with your analyst, being able to get their attention to something quickly and get feedback is a helpful way to get through any prior approval process. In our experience, it is helpful if there is one person who can be the center of communication between the analyst and the SBIC management team. So in instances where you need a quick answer, that puts you in the best position if you are in a pinch.

In terms of the second type of conflict of interest transactions that the SBA is concerned with, the SBA is also focused on instances where the SBIC might be providing financings to a business that is itself an associate of the SBIC. This is only permissible in certain circumstances with prior SBA approval. We often see this come up when an associate of the SBIC has made a previous investment in a business and because of the SBA’s lookback rules, that business ends up maintaining its status as an associate of the SBIC, even after the associate that might be on the same platform as the SBIC has divested itself of its interest in that business. So, the business in question could still be considered an associate of the SBIC if it has been a few months since the associate divested itself. In our experience, it’s very important to nail down these details at the outset of the investment, and carefully consider the associate definition, especially the look back rules, when considering a financing.

Krus: If you are part of a BDC-type platform or a regulated platform where you have exemptive relief from the SEC, does that allow you to forgo the SBA rules?

Spraker: It does not unfortunately, it is just another layer of consideration in these types of transactions, and does not separately guarantee that you would be able to make investments between the SBIC and its associates.

Krus: Sara, we are up to number nine. Are there other scenarios where the SBIC will need sign off from the SBA?

Nasseri: There are a few.

The first one being a change in principal. To the extent a new principal is being added to the investment committee, or an individual has departed, that is going to require prior SBA approval. Again, the SBA is going to require the same level of detail and information that previously was provided in the MAC. A letter will need to be included to provide additional details of the change of management as well.

In addition - a change in ownership. So, if 10% or more of the licensee has been sold but there is no change of control. This would require SBA prior approval. If you fit into this definition, it would constitute some sort of letter to the SBA. The key here is to highlight that there is no change in control and highlight the facts of the transaction. 

And the last one being a change of control. If there is a change of control, that would be a very detailed, deep dive. As you know, going through the MAC application, the SBA is vetting your management team. To the extent there is a change in control that is going to result in a change of management, that is going to be a very detailed extensive review by the SBA.

Just like in life, the most important thing to do here, is to be good communicators with your SBA analyst. Have an open channel of communication with your analyst. You want to make sure you are communicating to your analyst before it becomes public and well in advance. When we see large M&A transactions that involve a change of ownership of the SBIC this is a closing condition that could take some time.

Krus: Just to go back for a second to the principals. You must always have two principals, if you don’t, that can create some issues on taking down additional leverage. The actual approval for a new principal is the same as when you go through the licensing… the background check, the fingerprints. It is not a quick process. To the extent there is a change going on, being prepared ahead of time is our best guidance, as it can take quite a bit of time. So, we talked about getting the money into the SBIC, how do you get the money out? Are there any limitations on how much money you can take out?

Spraker: In terms of the wind down process, the SBA is focused on that exact question. What is your plan to pay back the debentures, and other details like your liquidation timeframe for each investment and anticipated proceeds. And depending on how early you’re paying back the debentures, there are different form requirements for what the SBA will expect in terms of the information you are providing them on timing, your other investments that are expected to mature at that time, things of that nature. The wind down process is almost as equally as involved as operating the SBIC more generally. It’s very helpful to have a clean line of communication with your analyst so they can convey their expectations. The format of the wind down plan is not necessarily as formulaic as other aspects of operating an SBIC, so it’s another aspect where communication with your analyst is very important, so you are providing the correct information when they expect it.

Krus: One of the things to keep in mind is that the SBA is not a bank. They are not going to want you to be paying back the debentures, this is a long-term relationship. On the distributions, it’s not a wind down, but if you are just distributing back up the dividends, you have to meet the retest, so there are certain limitations around that.

As a new licensee, you should consider joining the SBIA, which is an association of SBICs. If you want to keep up to date with what’s going on in the SBIC world, they are a great resource. I’d recommend looking into that membership. They are great to work with.

I’d also augment the importance of your analyst. You’d like to make them your best friend. So that when you have an issue, you know who they are and can give them sufficient time to react. You really want one person talking to the SBA, and I’d recommend that person be one of your principals. I know that getting time is not always the easiest; you want to make sure that whoever is speaking with the SBA understands the program and the rules.

Sara and Paige, thank you for all of your insights. And to our audience, thank you for joining us. We hope today’s discussion provided helpful, practical guidance on managing an SBIC—from navigating leverage commitments and draw processes to understanding portfolio investment limitations and key operational requirements.
If you have questions about how these considerations apply to your organization, please feel free to reach out to any of us. We also encourage you to stay tuned for future programs as we continue to unpack key issues for SBICs. Thank you again for joining us, and we look forward to connecting with you soon.