Western Independent Bankers Small Business Investment Companies Offer

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Western Independent Bankers

June/July 2004

Issue Focus: Changing Profitability Drivers

Small Business Investment Companies Offer

Big Benefits To Community Banks

By Jonathan D. Joseph and Sean P. Mahoney

As traditional bank products are becoming commoditized, small business banking, where many community banks see their growth, is becoming increasingly competitive. To compete in this arena many banks find it necessary to offer a complete suite of small business banking products from deposit accounts to loans, and, with a small business investment company (SBIC), equity funding. Business deposit and loan products have long been community bank staples, but SBICs have also been used by large banks—Bank of America and Union Bank of California are good examples—to make equity investments in small businesses. Community banks could also benefit from making equity investments through SBICs by forming an SBIC either alone or as part of a consortium of community banks.

SBICs Can Enhance Community Bank Profitability

SBICs can enhance profitability of community banks in at least two ways. First, SBICs give community banks a valuable banking product (

i.e.

equity funding) for small businesses that may not meet the bank’s lending standards.

This, in turn, allows community banks to build solid banking relationships with small businesses in the early stages, paving the way for more lucrative lending and banking relationships as businesses mature. Second, the investment in the SBIC itself can also enhance the bank’s profitability. SBICs, like other private equity investment funds, can generate strong returns, albeit over a period of time while assuming considerable risks. If a consortium of banks owns the SBIC, the SBIC can obtain leverage, or low cost debt financing from the SBA, which can significantly increase the return on the equity capital of the SBIC. Moreover, a consortium-owned SBIC permits banks to spread risks through better diversification.

What is an SBIC?

An SBIC is a professionally managed private equity fund that invests in small businesses. Over the years, SBICs have provided funding to approximately 90,000 businesses, including well-known companies such as Callaway

Golf, Apple Computer, Federal Express, Cray Computers, and Outback Steakhouse.

There are two main varieties of SBICs: leveraged and unleveraged. A leveraged SBIC is permitted to borrow up to twice the amount of the SBIC’s capital from the SBA at favorable rates. An unleveraged SBIC does not borrow from the SBA and is subject to fewer restrictions. Unlike a leveraged SBIC, an unleveraged SBIC can be a wholly owned subsidiary of a bank.

What is Needed To Form an SBIC?

SBICs generally require minimum capitalization of five to ten million dollars, depending upon the type of SBA leverage, if any, sought. Capitalization rarely prevents a bank or group of banks from forming an SBIC. Rather, the biggest obstacle to a bank (or a consortium of banks) forming an SBIC is obtaining the services of qualified professional managers to make investment decisions for the SBIC. The SBA considers the quality of the investment managers one of the most important factors in determining whether to license an SBIC. Thus, banks interested in forming SBICs should consider retaining the services of an experienced venture capitalist to provide investment management services to the SBIC.

What is the Legal Authority for a Bank Investment in an SBIC?

National banks are permitted to invest in SBICs under the National Bank Act and OCC regulations. Many states also give banks explicit authority to invest in SBICs, although sometimes applications are required. Absent explicit authority, banks in most states can otherwise invest in SBICs under parity or super parity statutes. Because SBICs are permissible investments for national banks, they do not raise issues for state-chartered, non-member banks under the Federal Deposit Insurance Corporation Improvement Act and Part 362 of the FDIC’s regulations.

Although state-chartered, non-member banks may also invest in private equity funds with FDIC approval under Part

362 (in addition to state approvals), SBICs may be a better vehicle for equity investments for three main reasons.

1[1]

First, unlike other permissible equity investments, there is no capital deduction for an investment in an SBIC in an amount up to fifteen percent of the bank’s tier one capital. Second, a state-chartered bank could own one hundred percent of an unleveraged SBIC, while it may not be permitted by the FDIC to own a controlling interest in a non-

SBIC private equity fund. Third, banks receive positive Community Reinvestment Act consideration for investments in SBICs.

Conclusion

In designing a suite of small business banking products, community banks should consider the need for small business equity financing in their communities. The ability to offer equity financing to small businesses may be one more factor that differentiates among many capable small business banks.

Jon

Joseph is a partner in the San Francisco office of Kirkpatrick & Lockhart LLP. He specializes in corporate finance, mergers and acquisitions, venture capital and regulatory matters and can be reached at

[email protected]

.

Sean

Mahoney is an associate in the Boston office of Kirkpatrick & Lockhart, LLP. His practice is focused in the areas of corporate law and financial services regulation and can be reached at

[email protected]

.

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