Of all the provisions in the massive financial reform package passed by Congress, the Volcker Rule arguably poses the largest threat to big banks' profits.
But the industry's loss might end up being small businesses' gain. The Volcker Rule places strict limits on how much banks can invest in private-equity and hedge funds, but it provides an exemption for "investments designed to primarily promote the public welfare"—including small business investment companies. Industry observers say the upshot could be a surge of bank investments in SBICs that would then trickle down to the very small businesses that are struggling to get bank loans these days.
The legislation still hadn't been signed as of early July and, at this point, bankers are too steamed about the idea of the Volcker Rule to be giving much thought to upping their stakes in SBICs. No banks contacted would comment for this story.
But Paul Stock, executive vice president at the North Carolina Bankers Association, says he expects interest to pick up as the reality of the rule sets in. "I think that when the dust settles, SBICs will be more appealing," Stock says.
SBICs are privately owned firms licensed by the Small Business Administration that invest in small businesses. Once SBICs raise enough money on their own, they can apply for low-interest loans from the SBA equal to up to two times the amount collected from private sources.
For years, the program was considered to be underutilized because investment groups could reach their fundraising targets without any help from the SBA. In the fiscal year that ended Sept. 30, 2009, only $700 million of the $3 billion available though the SBA program had been tapped.
But investment groups have shown more interest in the program of late as they've struggled to raise private capital. At the end of May there were already 31 new SBIC applications in the current fiscal year, compared to 29 new applications in the last fiscal year. One newcomer is Fifth Street Capital Corp, which received an SBIC license in February. Bernie Berman, president of the 10-year-old firm, based in White Plains, N.Y., says he applied for license in late 2008 when "the credit market seized up and it was hard to find financing from traditional sources."
Congress has also played a role in making SBICs more attractive to investors. As part as the economic stimulus package passed last year, Congress increased the SBA leverage limit to $150 million for any one fund and $225 million for any family of funds. Previously, the maximum leverage limit was $137.1 million for any fund. The stimulus package also changed the maximum that any one fund could invest in a company from 20 percent to 30 percent.
Banks are active investors in SBICs, partly because they get Community Reinvestment Act credit, but also because the investments can help banks provide customers with more financing options, says Sean Greene, the SBA's associate administrator for investments.
Michael Staebler, a partner at Pepper Hamilton LLP and head of its SBIC practice group, says that since President Obama indicated his support of the Volcker Rule, more banks have expressed interest in investing in or setting up their own SBICs. Before investment restrictions were lifted under the Gramm-Leach-Blilely Act, about 100 banks owned their own SBICs, he says.
"I think there is going to be lots of interest in both investing in and setting up SBICs," Staebler says. "A lot of banks had used SBICs for years in the '70s and '80s and will do so again."
Plexus Capital, a North Carolina-based SBIC that received a license for its second fund in January, works closely with several banks. Kel Landis, a principal at Plexus, says that 50 percent of the investments in its first fund and 20 percent in its second came from banks, and he expects those figures will rise once the Volcker Rule takes effect.
Landis says bank investments are vital to the success of his funds. In 26 of the 27 deals in its first fund's portfolio, banks provided long-term loans while Plexus was providing the capital for growth. "We are not competition to banks," says Landis. "We are complementary capital to banks."