On July 18, 2023, the U.S. Small Business Administration (SBA) published a Final Rule to modernize the Small Business Investment Company (SBIC) Program as part of the President Biden's Investing in America Agenda. The Final Rule, which took effect on August 17, 2023, makes wide-ranging changes to the SBIC program with the goal of increasing access and diversifying funding for the small business, start-up, and emerging company ecosystem.
One of the most significant changes included in the Final Rule is the creation of a new Accrual Debenture Program. The Accrual Debenture Program was designed to align with the cash flows of equity-oriented investment funds to encourage investment in early stage U.S. small businesses and expands access to the SBIC Program for venture capital, growth capital, and buyout investment firms, unlocking the potential for increased capital investment in small businesses. For a full discussion of all changes to the SBIC program as a result of the Final Rule, please see our previous release available here.
Accrual Debenture Economic Terms
An SBIC that qualifies as an Accrual SBIC is eligible for leverage of up to 1.25 times its qualifying limited partner capital commitments using SBA guaranteed debentures. In contrast to the existing Standard Debentures which have a current interest pay component requiring interest payments semi-annually, Accrual Debentures will accrue interest over their 10-year term with principal and interest payable at maturity. Notwithstanding the stated leverage limit, the maximum amount an Accrual SBIC is permitted to borrow will be determined by aggregating total principal and ten years of accrued interest over the life of the debenture (with such imputed interest accrual to be debited against the maximum leverage commitment that such Accrual SBIC will be approved for).
For example, if an Accrual SBIC has $100 million in qualifying limited partner capital commitments, the total Accrual Debenture principal it may be approved for may be only $118 million if the forecast interest would accrue to approximately $57 million over a ten-year timeframe at a 4% interest rate, since higher amounts would result in SBA guaranteeing outstanding leverage amounts in excess of $175 million, which is the current statutory maximum for leverage available to a single SBIC.
When making distributions, Accrual SBICs will be required to follow to the below distribution waterfall:
First, payment of annual charges and accrued interest associated with outstanding leverage.
Second, repayment of outstanding leverage an amount equal to total distributions (including amounts in step one of the waterfall) multiplied by a fraction, the numerator of which is the total intended leverage commitment and the denominator is the sum of total intended leverage commitment and total private capital commitments (ie. maximum fund size, including leverage); if the amount of leverage repayable under step two is more than the total outstanding leverage of the Accrual SBIC, then the total payable to SBA will be the amount of such outstanding leverage.
Third, distributions to private investors of the remaining amount.
Qualifying for an Accrual Debenture SBIC
The Final Rule also made changes to the eligibility requirements for receiving an SBIC License with the goal of enabling a more diversified group of investment teams and a wider range of investment strategies to participate in the SBIC program. In evaluating the eligibility of an applicant, the SBA will consider management qualifications, demonstrated investment acumen, strategy and fit, and structure and economics. When considering management qualifications and investment experience, SBA will take into account, among other things, demonstrated investments skills and experience as a principal investor or a combination of investment skill and relevant industry operational experience, a record of active involvement in making and monitoring investments and assisting portfolio companies, and the proposed investment team's prior relevant industry investments as well as any supporting operating experience. SBA considers the totality of experience of the investment team of the applicant during the licensing process.
The modifications made to the SBIC Program are substantial, and the SBA will be providing further guidance and updated regulations pertaining to the Final Rule, as well as updated application materials and standard operating procedures.
Originally Published 17 August 2023
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