Small Business Administration Channels Billions to Wall Street Firms
Ever since President Eisenhower approved its creation in 1953, the Small Business Administration has stood in the popular imagination as a lender to mom-and-pop stores and scrappy entrepreneurs chasing the American dream.
In fact, the agency is increasingly providing billions to Wall Street firms that reap big returns on loans and other investments while taxpayers shoulder the risk of bad bets, records show.
Since 2007, the SBA has guaranteed $14 billion in financing to boutique investment firms. And over the past year, it has pushed its Small Business Investment Company (SBIC) program closer to its permitted $4 billion ceiling each year, according to government officials and records tracked by OpenTheBooks, a nonprofit that collects public-spending data.
Mark Walsh, who left the private sector in December 2015 to oversee the program, defends it by saying, “What we are is incredibly affordable debt and everybody should know about it.”
Certainly it is affordable to the investment firms that draw on federally backed lines of credit as finance intermediaries. The firms pay the government roughly 3 to 3.5 percent, making the arrangement among the cheapest commercial loans available.
If the firms realize their expected double-digit returns on that money, by lending to or investing in other businesses, they pocket the profits. But when the investments go south – and no lender has a perfect record – taxpayers are on the hook for the losses.
SBIC champions say the approach provides capital to small businesses like tech start-ups that blossom and create jobs. Yet as new business creation hits a 40-year low, it’s unclear what impact the program has, especially given the fraction of venture capital that $4 billion a year represents.
The SBA rebuffed RealClearInvestigations’ requests to review its audits of SBIC financing -- public records the feds are required to produce every 12 or 18 months for each licensed SBIC borrower. A request under the Freedom of Information Act is pending.
Opaque as it seems, the growing program is becoming a larger part of the SBA’s overall budget, which now tops $10 billion a year.
President-elect Donald Trump’s pick to head the SBA – former wrestling impresario Linda McMahon – has declined to comment before her confirmation hearings. But she is a critic of swelling government, and in 2012 favored President Obama’s proposal to merge the SBA with other agencies.
Other SBA critics aren’t hard to find, including those focused on the SBIC program, which they see as a kind of hedge fund welfare.
“I’d feel better if the government was totally out of the loan business,” said former Republican Sen. Tom Coburn of Oklahoma, long a hawk on reining in federal spending. “Do you think everyone uses their best judgment, spending someone else’s money?”
“There’s no reason for the SBIC to be providing capital to private equity funds,” said Tom McWilliams, a managing partner at Court Square Capital Partners who once helped run SBIC operations at Citibank. “There’s plenty of capital out there for good ideas. What aren’t are a lot of good ideas.”
The SBIC program is very different from the SBA’s more traditional efforts, which backstop private loans to businesses ranging from Quiznos sandwich shops to golf courses. Instead, the SBIC program offers millions in public dollars -- $2 for every $1 raised privately -- to closed-end funds and private equity and venture capital firms whose directors include Ivy League MBAs and veterans from Goldman Sachs or other Wall Street powerhouses.
Bankers not normally associated with government largesse are tapping big sums through the investment-company program. These include $100 million made available to Boathouse Capital, which takes its name from the row of clubhouses along the Schuylkill River in Philadelphia; and $225 million to Hercules Capital, a publicly traded company worth more than $1 billion and headquartered near Silicon Valley.
The SBA describes the program, which was launched in 1958 but has grown dramatically in recent years, as a “fund of funds.”
Roughly 300 professional investment companies hold an SBIC license. The SBA says these private licensees “use their own capital plus funds borrowed with an SBA guarantee to make equity and debt investments in qualifying small businesses.”
It has a flexible definition of “small business,” though; one requirement stipulates “a tangible net worth of no more than $19.5 million, and an average of $6.5 million in net income over the previous two years at the time of investment.” But there are alternative criteria too.
SBIC-licensed firms can receive a line of credit for a maximum of $150 million, although some firms, like Hercules, hold more than one SBIC license and can tap up to $350 million.
Between 2011 and 2015, firms in the investment-company program pumped more than $21 billion into small businesses through private funds leveraged by taxpayer lines of credit, the SBA says.
Walsh said SBIC companies pay 1 percent on the line of credit when drawn, and another 2 percent when they pay the money back. In addition, a charge is levied each year based on the sum remaining in the guaranteed pool, which can push the total return to taxpayers over the 3.5 percent interest rate threshold.
The SBA’s description notes the investments made with the money can include buying stock, an ownership position of up to 10 percent in a company and cash loans. And these government-backed bets can themselves be sold to other investors, Walsh said.
The size and nature of bets in the investment-company program can be hard to gauge without access to SBA audit records. On their websites, major participating companies do not list precise figures or differentiate between their SBIC investments and others.
Mark Harris, chief financial officer at Hercules Capital, one of the biggest SBIC players, described it as an ideal way for the government to boost fledgling businesses that might otherwise founder. While Harris conceded businesses in their infancy are perhaps the riskiest sort of investment, he noted that even eventual behemoths start from scratch. Without tapping into the expertise and track record of firms like Hercules, he said, the government would not be able to determine the best and most effective allocation of money to help such small enterprises.
“The program in and of itself is phenomenal,” Harris said. “It’s going to really great American companies, and, in the process, we are creating value, creating jobs, and mostly it’s being done with [SBIC] debt.”
He declined to offer individual examples, saying it “wouldn’t be appropriate” to disclose such “non-public information.” On its website, the SBA boasts that the program played a role in some helping some of America's most familiar businesses, from Apple to Staples, but it provides no details.
New Mountain Finance,* a publicly traded firm with the SBIC’s largest line of credit at $150 million in 2014-2015, said it makes loans to “mid-size companies” with its SBIC funds. New Mountain seeks a return of around 10 percent on those investments, according to Joy Xu, a vice president with New Mountain Capital. It has usually hit that target since getting its SBIC license in 2014, Xu said.
The websites of several SBICs that have received $100 million or more show their core businesses can involve sophisticated investments like mezzanine debt, which allows a creditor to take an equity stake in a borrower in case of default. Professionals seek a return of between 13 percent and 25 percent on these instruments, according to New York University’s Stern School of Business and professionals.
In addition, SBIC licensees can sell the loans downstream to others.
“That’s the case with all loan guarantee programs,” said Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University and a longtime libertarian critic of government largesse and corporate welfare. “That near-0 percent part of the loan is sold on the secondary market and they are making a killing on it.”
Although making double-digit returns with money committed by taxpayers grates on critics, Xu noted the government program, as the creditor, isn’t functioning any differently than a commercial bank. A commercial bank does not retroactively change the terms if a borrower profits off a loan, she said.
She added that SBIC rates, while very competitive, are not much cheaper than other sources of money. Furthermore, the federal program’s claims as a creditor take precedence over a firm’s other creditors, reducing some of the public’s risk, according to Harris and Xu.
Still, the federal government is shouldering considerable risk since, according to the SBIC itself, much of the capital in the program flows to companies that were unable to secure similar financing in the private marketplace.
Walsh acknowledged that “no one bats 1.000.” In response to RealClearInvestigations’ questions, an SBA spokeswoman said the SBIC program has cost taxpayers $1.6 billion in losses during the last 10 years, although a considerable portion of that came in an SBIC program that has been discontinued.
The licensed funds that fail to keep up with payments can be put into federal receivership, as has happened 54 times in the past decade, the SBA said. It is those complete failures, not a bad loan here or there in a portfolio, that cost the public money.
That’s a low rate in a risky field, Walsh said, and a testament to the careful policing of the program.
“We don’t cost the taxpayers anything,” Walsh asserted. “If people think this makes the fat cats fatter, it does not. I make the government money.”
Despite that rosy picture, the SBA rebuffed RealClearInvestigations’ request to review its inspection reports.
“I am curious…why do you want to see exam records?” Walsh wrote in an e-mail. “The loss ratios from our SBIC program are the envy of the industry, and our liquidations and recovery efforts are so effective that we remain a zero-subsidy program.”
Offering further justification for the SBIC, Walsh argued that the private sector is neither perfectly efficient nor willing to make money available in less well-off parts of the country. “Sixty-six percent of venture capital in this country is raised and spent in 25 ZIP codes,” he said. “We get it into other ZIP codes and I think we do a pretty good job.”
But the core issue to many critics is not the fine details of the program or its size.
“Politicians shouldn’t tilt the scales with cronyism or distort the market with agency programs like the SBIC: It’s welfare for the wealthy,” said Adam Andrzejewski, founder and CEO of OpenTheBooks, whose honorary chairman is former Sen. Coburn.
“In America, we should never demonize success, but we shouldn’t ask taxpayers to subsidize it, either.”
*Correction: March 4, 2017, 11:51 AM Eastern
An earlier version of this article mischaracterized New Mountain Capital. It is a private-equity firm, not a publicly traded company. An affiliate of New Mountain is the investment adviser for New Mountain Finance Corporation, a publicly traded business development company.