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SBIC Revival: Why Interest From Banks Is Way Up, As The Volcker Rule Looms

A decade of waning interest in small business investment companies is quickly reversing course among banks big and small.

One reason is that SBICs - essentially pooled investment funds that can get matching money from the Small Business Administration - are exempt from the restrictions on equity investments imposed by the Volcker Rule, as well as the Bank Holding Company Act.

Such regulations are particularly burdensome for banks at a time when they are eager to get close to innovative technology startups that could disrupt how business gets done.

If a bank wants more than a small equity stake in a company that offers financial services - say, a mobile payments provider - the only practical approach now is to form an SBIC and invest through it, several bankers and lawyers say. The regulatory hassle makes trying to invest in any other way all but impossible.

But the Volcker Rule workaround is hardly the only impetus for the sudden surge in the popularity of SBICs. The potential for outsize returns in a low-interest rate environment, the chance to spur economic growth and job creation, and the bonus of Community Reinvestment Act credit are all part of the lure.

So is the opportunity to connect with promising middle market businesses, any of which might become a lucrative bank customer, says Tim Rafalovich, a senior vice president at Wells Fargo who oversees its investments in SBICs.

"Each SBIC invests in roughly 25 companies," Rafalovich says. "Every one of those 25 companies needs somebody to handle their insurance, deposits, their foreign exchange. So we stand a better chance of getting that business if we're invested in these funds that engage with these companies first."

The relationships can expand well beyond the basics. One of Wells Fargo's SBIC investments supplied senior debt funding to R360, a Houston-based oilfield waste disposal company. Later, the private equity firm Blue Sage Capital tapped Wells Fargo as an adviser on the 2012 sale of R360 for $1.34 billion. Then, Wells Fargo provided a term loan facility to the acquirer, Waste Connections, to finance the purchase.

SBICs can act like divining rods for banks' corporate lending efforts. Instead of finding potable water though, SBIC fund managers find revenue streams for banks in the form of the double-digit interest payments from corporate borrowers.

The SBA, which oversees the SBIC program, does not track the number of participating banks or the amount they invest. But those familiar with the sector say activity from banks is on the rise. Some are returning to SBICs after years away. Others who have been active all along say they are increasing their investments.

At least one big bank is creating its own SBIC so it can make strategic equity investments in startups that it views as being disruptive to the banking sector. The bank - which asked not to be named because its SBA approval is pending - wants to get more intimately involved with fintech innovators that threaten traditional banks' revenue from services like payments.

Several other banks also say they're turning to SBICs, primarily to avoid restrictive regulations. The pending Volcker Rule in the Dodd-Frank Act seeks to limit a bank's investment in private equity and venture funds to no more than 3% of each fund. It also says a bank's total ownership in all such private funds must not exceed 3% of the bank's total Tier 1 capital. (The rule is slated to take effect in July 2015.) Another complicating factor is the Bank Holding Company Act, which prohibits acquiring more than 5% of the voting shares of a nonbank company that engages in activities closely related to banking.

None of these restrictions apply to bank investments through SBICs, however. An exception on SBICs was written directly into the Volcker Rule to keep banks unshackled from lending to small businesses.

Though banks still have a cap on how much money they can put into SBICs, it's less onerous than the other regulatory limits; a bank can invest up to 5% of all of its capital and surplus.

"There has been great interest by banks since the Volcker Rule came into existence of returning to SBICs," says Michael B. Staebler, a partner at Pepper Hamilton. He has helped set up more than 210 SBICs over the past four decades and says several banks have taken steps in recent months to start their own SBICs, including a regional bank that is new to these types of investments.

 

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How SBICs Get Started

Besides banks, investors in SBICs often include insurance companies, endowments, pension funds, family offices, wealthy individuals, hedge funds and private equity firms.

Fund managers, called general partners, first get SBA approval to operate an SBIC, then raise money from the investors, called limited partners. The SBA usually then kicks in two to three times the amount of the private capital raised.

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