Banks have rediscovered an innovative weapon in their battle with nonbank financial companies: direct equity investments in small businesses.
A growing number of banks are forming and pouring cash into a once- troubled vehicle known as a small-business investment company, or SBIC. Such private venture capital firms are licensed and regulated through a revamped Small Business Administration program.
Among the banks that have launched these venture capital firms: Salt Lake City-based Zions Bancorp, Bowling Green, Ky.-based Trans Financial Corp., and New Orleans-based Hibernia Corp.
"Venture capital is a very profitable use of a bank's resources," said Don A. Christensen, the SBA's assistant administrator for investment. "Banks can't (make equity investments) any other way."
The banks' venture capital units engage in a high-risk, often high- reward business of financing fledgling firms with little capital. That approach is at odds with banks' lending departments, which shun start-ups.
The 69 small-business investment companies affiliated with banks make up less than a quarter of the total but provide more than two thirds of the $4.5 billion now invested through such units, according to the SBA.
The growth in SBICs comes as banks are emphasizing small-business and attempting to transform themselves from loan-and-deposit institutions into diversified financial services companies.
That parallels several shifts in small-business finance: entrepreneurs building their business with equity rather than bank debt, a financial market receptive to new stock offerings, and the SBA cleanup of the ailing program in the early 1990s.
Competing with a booming number of venture capital firms, banks found that investing in an expanding business is one of the best ways to ensure a relationship with the firm once it is grown.
"We saw a need for more early-stage money for new businesses," said Harris Simmons, chief executive officer of Zions Bancorp.
"We've seen some very substantial returns, and some ventures that didn't work out," said Mr. Simmons, whose bank started the SBIC in 1994 to invest in high-tech companies.
One of Zions' early successes was a company that designed software for Internet sales that was eventually bought by America Online. The bank now has $8 million worth of investments in SBICs, and their return usually tops 20%.
Investors in such units typically expect their return on investment to beat the success stories. But, demonstrating their inherent risk , the average return was 13% in 1990, and last year it dipped to 8%, according to the SBA.
Many of the banks that have entered the business in the past two years wanted to build a relationship with a firm that usually would not qualify for a loan so that they could profit from the company's expansion.
"The only way we could establish a relationship with them as they grew was through the SBIC," said Todd Stevens, manager of Zions' venture capital fund.
The Bank Holding Company Act prohibits banks from owning more than 5% of the voting stock of another business; but through small-business investment companies, banks can hold up to 49%.
Under revamped laws that took effect in 1994, banks can invest no more than 5% of their capital in the subsidiary SBICs.
About 15% of all the venture capital money in the United States comes from SBICs, according to Lee W. Mercer, president of the National Association of Small Business Investment Companies.
Of course, banks have easier access to capital than individual SBIC operators, who must raise the required $5 million in capital on their own.
Mr. Mercer said banks and nonbanks have been attracted to venture capital financing because of the high profit potential realized in recent years.
"Small business has been leading the country in terms of tremendous job growth, and the stock market has been favorable to new issues," he said.
Mr. Mercer predicts 40 to 50 new SBICs will gain SBA approval within the next year, bringing the total money invested through SBICs to about $6 billion.
The units can leverage SBA-guaranteed funds or use only their own capital. Almost all the 69 bank-affiliated small-business investment companies invest funds that aren't leveraged with SBA guarantees.
The firms have been incubators for corporate giants such as Federal Express and Apple Computers. They also invested in losers such as a waste disposal company that never got a state permit.
When the economy slumped in the late '80s and early '90s, many fledgling business stalled - and 159 SBICs that owed the SBA more than $476 million went into liquidation proceedings.
After the problems subsided, Congress retooled the regulations to reduce the SBA's exposure to losses in the investment program.
Congress raised the minimum amount of capital needed to form a small-business investment company to $5 million, increased auditing standards, and required the units' managers to have venture capital experience.
After the new regulations took effect, 16 banks formed SBICs, and the amount of capital in the those affiliated with banks doubled to reach $3.1 billion.
"They cleaned up a lot of regulations and tightened things up that needed to be tightened," Mr. Collins said. "But this is still a high-risk business, and some percent of the SBICs will fail."