Banks Turn to SBICs for Higher Returns
October 11, 2012
At a time when banks are struggling to find quality loans, a decades-old government-supported program that lets them indirectly invest in small businesses is looking increasingly attractive.
Small business investment companies, or SBICs, as they are known, offer a better proposition for banks today in part due to recent changes in the regulatory landscape, according to industry and government officials. Specifically, an economic stimulus measure passed by Congress in 2009 made the program more enticing to banks and other investors, and a provision in the so-called Volcker Rule is expected to spur even more activity.
"I would say there certainly is increased interest," said Kristi Craig, a senior vice president at the Small Business Investor Alliance, a trade group for the investment companies. "It hasn't been a 15-fold increase, but it's been significant."
The U.S. Small Business Administration, which licenses small business investment companies, does not keep aggregate data on how much money banks have invested in the firms. But other sources confirm that many banks are looking to get up to speed on the opportunities available.
To educate banks about the program, the Office of the Comptroller of the Currency last month released a 24-page report that lays out what they need to know about the investments. That followed an online seminar hosted by the agency in February that attracted hundreds of bankers.
The OCC's report states that as of July 31, there were 299 small business investment companies that had capital of $18.3 billion, both from private sources and from bonds backed by the Small Business Administration.
The companies invest in a wide range of small businesses, which must have a net worth of $18 million or less. Investments by the companies generally range from $1 million to $10 million per small business.
Last week's report notes that when banks invest in small business investment companies, they are eligible for credit under the Community Reinvestment Act. It also states that investments in the firms can yield higher returns as a result of the leverage provided by the government-guaranteed bonds — an appealing prospect for banks in an environment of narrow margins and tepid loan demand.
But those two aspects of the program have long been in place. What's changed for banks in the last few years?
Some in the industry point to the passage in 2010 of the Volcker Rule provision in the Dodd-Frank Act, which prohibits banks from investing in private equity funds, but provides a carve-out for small business investment companies. While the Volcker Rule has yet to be finalized, banks must prepare now for its enactment.
Bank investments in small business investment companies would continue to be allowed under the proposal from regulators on how to implement the Volcker Rule, said Brett Palmer, president of the Small Business Investor Alliance. "That is the one thing that is clear under the Volcker Rule," he said.
Another factor that may be driving investment from banks are regulatory changes that have allowed the companies to become licensed more quickly.
In addition, the 2009 stimulus law made a number of permanent changes to the structure of the companies — allowing them to raise more government-backed money and to invest more of their funds in individual small businesses.
It is not yet clear how new bank capital rules under the Basel III framework will treat investments in small business investment companies. Industry representatives are pushing for such investments to be treated as well as those made in community development financial institutions, another type of institution that was created by the government for public-policy reasons.
In a recent joint notice of proposed rulemaking, regulators sought public comment on whether the two types of institutions should get the same favorable treatment under Basel III. "It certainly shows some flexibility from the regulators," said Tim MacTaggart, a partner at Pepper Hamilton LLP.
A number of large banks — notably, TD Bank, Wells Fargo, and Bank of America — have long been significant investors in small business investment companies. But today, industry officials say, they are seeing more interest from community banks.
Kel Landis, a former banker who is now a partner at Plexus Capital, a small business investment company in North Carolina, said that 30% to 40% of the capital at his company comes from banks — from very small institutions to larger ones.
"We are augmenting and helping banks make more loans, and better structured loans," he said.
What is likely most attractive to banks is the possibility of double-digit returns on their investments. The OCC's analysis showed that leveraged funds originated between 1999 and 2005 had average internal rates of return ranging from 7.1% to 17.8%, though the analysis also found that leveraged funds originated in 1998 yielded negative returns.
Barry Wides, who is deputy comptroller for Community Affairs at the Office of the Comptroller of the Currency, expressed hope that the agency's efforts will bring greater awareness of the small business investment opportunities available to community banks. He noted that complex government programs like the one for small business investments can be intimidating to community banks.
"I think there's always a feeling that, 'Hmm, there's a lot of moving pieces,'" Wides said. "'I want to understand them in a way that I can move forward.'"