The Small Business Administration (the "SBA") published a final rule on July 18, 2023, implementing significant changes to reduce barriers to program participation and address Small Business Investment Company ("SBIC") diversification and growth. The final rule implements several significant changes, including (i) the addition of accrual debentures to the available SBIC debenture instruments and corresponding creation of an additional SBIC license, (ii) changes to required distribution waterfall structures, (iii) modification of certain key definitions, (iv) changes to ownership diversification requirements, (v) changes to minimum capital requirements and limitation thresholds on leverage, (vi) changes to the structure and amounts of application fees, (vii) implementation of a streamlined licensing for subsequent funds, (viii) additional of management team qualification requirements, (ix) changes to SBIC valuation policy requirements, (x) exclusion from the requirement to obtain prior SBA approval for certain capital call lines, (xi) changes to requirements for licensees to file financial statements, (xii) changes to restrictions on financing of certain small businesses, (xiii) clarification of SBA's policy with respect to restrictions on the ability of a small business to prepay loans and debt securities, (xiv) changes to timing of SBA's calculation of a licensee's capital impairment, and (xv) implementation of a watchlist program.

The full text of the final rule can be found here. The final rule will take effect on August 17, 2023. A new SOP is anticipated in September.

Establishment of Accrual Debenture Instrument and Accrual SBIC License

SBA's final rule establishes an "Accrual Debenture" instrument, to be issued to "Accrual SBICs" (Section 301(c) licensees that elect at the time of licensing to issue Accrual Debentures) and to "Reinvestor SBICs" (SBICs providing venture capital financing to disadvantaged businesses that are relenders or reinvestors; i.e., fund-of-funds).

Accrual Debentures will be issued at face value and accrue interest over a 10-year term. SBA will guarantee all principal and unpaid accrued interest. Accrual SBICs are eligible for 1.25x tiers of leverage, while Reinvestor SBICs are eligible for 2x tiers of leverage. To determine the maximum amount of leverage Accrual SBICs are permitted to have outstanding, SBA will aggregate the total principal leverage, plus ten years of accrued interest on such principal. For example, if an Accrual SBIC has $100 million in Regulatory Capital, 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, the current statutory maximum for Leverage available to a single Licensee.

SBIC applicants will be required to identify whether they intend to use Standard or Discount Debentures or if they intend to use the Accrual Debenture as an Accrual SBIC or Reinvestor SBIC. Approval to operate as an Accrual SBIC or Reinvestor SBIC is subject to SBA's investment due diligence, credit procedures, and statutory limitations. Reinvestor SBIC applicants must demonstrate an underserved need in their business plan.

Reinvestor SBICs can make Equity Capital Investments in underserved non-SBA leveraged limited partnerships, SBICs, or non-SBIC licensed funds, that:

  • finance businesses that meet SBA's small business size standards
  • are owned and controlled y U.S. citizens and/or entities headquartered in the United States, and
  • have at least 50 percent of employees based in the United States at the time of investment.

SBA's prior written approval is not required in connection with Reinvestor SBIC co-investments if an unaffiliated and unassociated third-party investor is contributing Equity Capital Investments to the portfolio concern alongside the Reinvestor SBIC. At least one substantial third-party investor, unaffiliated and unassociated with the Reinvestor SBIC, must be investing on the same terms as the Reinvestor SBIC. We anticipate SBA will issue additional guidance in the coming weeks and months to clarify the Accrual SBIC licensing application materials and procedure.

Changes to Required Distribution Waterfall Structures

Under the final rule, the following waterfall is required for Accrual SBICs and Reinvestor SBICs:

  • Payment of Annual Charges and accrued interest associated with Leverage. Interest will be paid to the bond holders based on the Leverage terms.
  • SBA's share is calculated as follows: SBA Share = Total Distributions x [Total Intended Leverage Commitment/(Total Intended Leverage Commitment + Total Private Capital Commitments)]
  • Repay SBA Leverage to bond holders in an amount no less than SBA's Share to the extent of outstanding Leverage.
  • Distribute to private investors the remaining amount.
  • Report the distribution to SBA on Form 468 submissions.

Non-leveraged licensees are permitted to distribute to their private investors without SBA prior approval as long as they retain sufficient regulatory capital to meet minimum capital requirements unless such amounts are in accordance with their SBA approved Wind-up Plan. If a non-leveraged Licensee does not have an SBA approved Wind-up Plan, they may make distributions, as long as such non-leveraged Licensees retain sufficient regulatory capital to meet minimum capital requirements. If a non-leveraged Licensee has an SBA-approved Wind-down Plan, their regulatory capital can drop below the minimum capital requirements if such amounts are in accordance with that plan.

Otherwise, there has been no change to distribution waterfall or READ requirements for standard debenture SBICs and unleveraged SBICs.

Modification of Certain Key Definitional Standards and Thresholds

  • Associate. Currently, an entity Institutional Investor whose ownership represents over 33% of the licensee's private capital is considered an ''Associate''. The new rule revises the threshold to 50%. Additionally, an entity Institutional Investor, as a limited partner in a partnership licensee, will not be considered an Associate solely because that entity's investment, including commitments, represents 10% or more but less than 50% of the licensee's private capital, provided that such investment also represents no more than 5% of the entity's net worth. This rule change onlyapplies to funds licensed after the rule is implemented.
  • Control Person. The definition of ''Control Person'' has been revised to clarify what constitutes a controlling relationship over an LP licensee with a government-sponsored non-profit management company relationship. Specifically, when over 30% of the private capital managed by the licensee comes from unaffiliated and unassociated entities (outside of their association as an investor in the licensee), the management company of the licensee is a government-sponsored non-profit entity and the general partner(s) of the licensee are bound by a fiduciary duty to the investors in the licensee, the management of the licensee can be determined to be free from outside control.
  • Leverage. The new rule amends the term "Leverage" to clarify that leverage and SBA's guarantee would apply to both the principal and unpaid accrued interest associated with the Accrual Debenture.
  • READ. The final rule adopts a modification to the definition of "Retained Earnings Available for Distribution'' to include the acronym ''READ'' and to clarify that READ distributions must be performed in accordance with the revised § 107.585.

Changes to Ownership Diversification Requirements

Current SBIC regulation requires SBIC ownership be ''sufficiently diversified from and unaffiliated with the ownership of the licensee in a manner that ensures independence and objectivity in the financial management and oversight of the investments and operations of the licensee.'' To ensure independence, ''no Person or group of Persons who are Affiliates of one another may own or control, directly or indirectly, more than 70% of your Regulatory Capital or your Leverageable Capital.'' As an exception to the diversification ownership requirement, SBA allows an investor that is a "Traditional Investment Company" (a term defined to own and control more than 70% of the licensee's regulatory capital).

The final rule amends current regulations to remove the ''indirectly'' requirement to provide greater clarification as to sources of Regulatory Capital available to an SBIC. Additionally, the final rule includes an exception from the diversification ownership requirements for non-profit entities.

Changes to Minimum Capital Requirements and Limitations on Leverage

Currently, SBICs (with the exception of Early Stage SBICs) are required to have regulatory capital of at least $5 million. The SBA has discretion in issuing licenses to an applicant with good cause and a minimum of only $3 million if the applicant:

  • meets its licensing standards with the exception of minimum capital;
  • has a viable business plan reasonably projecting profitable operations; and
  • has a reasonable timetable for achieving Regulatory Capital of at least $5 million.

Under the final rule, SBA clarifies that one example of ''good cause'' would be the applicant is headquartered in an Underlicensed State. If licensed, leveraged Licensees from Underlicensed States would be eligible for up to 1 tier of Leverage until they raise the $5 million minimum Regulatory Capital requirement. SBA notes that the ''good cause'' exception is not solely based on geography. Consistent with existing regulations, ''good cause'' factors may be applied in a non-exclusive manner based on criteria already specified in § 107.210.

Applicants headquartered in Underlicensed States with below median SBIC financing dollars will receive priority for licensing review. A list of the Underlicensed States will be provided by the SBA in a notice on the SBIC website. Once priority is established, the prioritized applicant will continue to receive priority throughout the licensing process.

The term ''Underlicensed State'' means a State in which the number of operating licensees per capita is fewer than the median number for all States. To determine the per capita per State, SBA will use the most recent resident population from the U.S. Census as of the date of the calculation. SBA will publish the list of Underlicensed States periodically on the SBIC website.

Changes to Application Fees, Leverage Fees, and Annual Charges

Under the new rule, initial licensing fees will be based on fund sequence (meaning the order of succession of the fund). First-time funds will be charged a fee of $5,000, second-time funds will be charged a fee of $10,000, third-time funds will be charged a fee of $15,000, and fourth-time funds and subsequent funds thereafter will be charged a licensing fee of $20,000.

Additionally, final licensing fees will be calculated by taking the final licensing base fee plus 1.25 basis points and multiplying by the Leverage dollar amount requested by the applicant. Final licensing base fees for first-time funds are $10,000, $15,000 for second-time funds, $25,000 for third-time funds, and $30,000 for fourth time funds and any fund thereafter.

SBA will determine the applicant's Fund Sequence based on the applicant's management team composition and experience as a team, including the business plan or strategy of the fund.

Additionally, SBA will implement new regulation(s) to set the minimum Annual Charge to .4 percent or 40 basis points (bps) which would be phased in over time, as follows:

  • FY24 – 10 bps
  • FY25 – 20 bps
  • FY26 – 25 bps
  • FY27 – 30 bps
  • FY28 – 35 bps
  • FY29 – 40 bps (capped floor)

SBA is implementing an applicant resubmission penalty of $10,000 for any applicant that has previously withdrawn or otherwise is not approved for a license that must be paid in addition to the Initial and Final Licensing Fees. Applicants can request SBA approval to waive the resubmission penalty fee that SBA may consider on a case-by-case basis.

Streamlined Licensing for Subsequent Funds

Under the new rule, SBIC applicants currently operating under an active Licensee will be eligible to submit a "Short-Form Subsequent Fund MAQ," where the following criteria are met:

  • Strategy and Fund Size – targeted Regulatory Capital to be raised is ≤133% the size of their most recent SBIC fund (inflation adjustments will be considered). Same asset class and investment strategy as most recent license.
  • Consistent LP – General Partnership (GP) Dynamics – no new limited partner will represent ≥33% of the Private Capital of the licensee upon reaching final close of a target fund size or hard cap. The two largest investors in terms of committed capital have verbally committed to invest in the new fund pending receipt of license. The most recent Limited Partnership Agreement of the active Licensee and all Side Letters will have no substantive changes for the applicant fund.
  • Investment Performance Stability – the most recent licensee net distributions to paid-in capital (DPI) and net total value to paid-in capital (TVPI) are at or above median vintage year and strategy performance benchmarks for the prior three quarters. The principals of the applicant are not managing a licensee in default or with high Capital Impairment (CIP).
  • Consistent or Reduced Leverage Management – the applicant is requesting a leverage to Private Capital ratio ≤the current or most recent SBIC licensee at target fund size or hard cap.
  • Firm Stability – subject to SBA's determination, no material changes to the broader firm, to include resignations, terminations, or retirements by members of the General Partnership, investment committee, broader investment team, or key finance and operations personnel that have a material adverse impact on the stability of the SBIC.
  • Promotions from Within – demonstration of a commercially reasonable effort of promoting internal investment team talent from within the firm/organization sponsoring the license.
  • Inclusive Equity – demonstration of a commercially reasonable effort of the appropriate/increased sharing of carry and/or management company economics with promoted talent or distribution of equitable or increasingly equitable economics among the partnership.
  • Clean Regulatory History
  • Federal Bureau of Investigation (FBI) and Internal Revenue Service (IRS) Background Check No Findings
  • No Outstanding or Unresolved Material Litigation Matters; and
  • No Outstanding Tax Liens.

Management teams applying for expedited subsequent fund licensing must already be operating one or more SBICs, be in good operational and regulatory compliance with SBA, and have two full years of operations from date of licensing of the most recently licensed SBIC (shorter if merited from prior experience). Financial performance and portfolio valuations demonstrating adequate coverage for any outstanding SBA leverage and a clean audit opinion from the SBIC's independent accountant must also be provided.

SBA has not given specifics with respect to the anticipated timeline for SBA to process Short-Form Subsequent MAQ applicants, nor when the Short-Form Subsequent MAQ application and corresponding instructions will be available but has noted that it is processing comments to the application and finalizing instructions. SBA's goal is to have the application materials available at the same time the final rule goes into effect.

Additional Management Team Qualification Requirements

SBA has added two additional management qualification requirements for SBICs: (i) relevant industry operational experience, which may be combined with investment skill, to demonstrate managerial capacity; and (ii) if applicable, experience managing a regulated business, including but not limited to an SBIC.

SBA has also added two new performance qualifications: (i) applicant's operating experience, combined with an investment team's experience to assess applicant's investment experience; and (ii) the applicant's past adherence to statutory and regulatory SBIC program requirements.

SBIC Valuation Policy Requirements

Under the new rule, SBA will require both valuations based on SBA Valuation guidelines as well as valuations reported to private investors in accordance with GAAP for leveraged licensees. SBICs licensed as non-Leveraged Licensees and SBICs that fully repay Leverage and seek no further Leverage may solely adopt a valuation policy in accordance with GAAP. SBA is also working with its valuation contractor to evaluate what changes to SBA's Valuation Guidelines would be necessary to make them GAAP compliant and the impact to SBA's monitoring and risk should SBA adopt GAAP compliant guidelines.

Additionally, SBA will require all Leveraged Licensees to increase reporting from semi-annually to quarterly, commensurate with the required quarterly reporting of the Form 468.

Exclusion from Requirement to Obtain Prior SBA Approval of Certain Capital Call Lines

Under the final rule, SBA will now exempt capital call lines from mandatory SBA approval if:

  • The line of credit is limited to 20% of total unfunded binding commitments from Institutional Investors.
  • The term of the line of credit does not exceed 12 months.
  • The line of credit is held by a federally regulated financial institution.
  • All borrowings under the line of credit:
    • Are only secured by unfunded Regulatory Capital up to 100% of the amount of the borrowing and 90 days of interest;
    • Are for the purpose of maintaining the SBIC's operating liquidity or providing funds for a particular Financing of a Small Business;
    • Are required to be fully repaid within 90 days after the date they are drawn; and
    • Are required to be paid off for at least 30 consecutive days during the SBIC's fiscal year such that the outstanding debt is zero for at least 30 consecutive days.

Changes to Requirements for Licensees to File Financial Statements with SBA

  • 468's. Portfolio valuations will follow a quarterly submission in which the Licensee must report the financing within 30 calendar days of the calendar year quarter following the closing date of the Financing. SBA will implement regulations adding information to help SBA determine net jobs created and total jobs created or retained, including identifying the number of jobs added due to a business acquisition versus growth in the business. SBA will also collect fund management contact information and optional demographic information.
  • 1031's. Portfolio Financing Reports on SBA Form 1031 will now be a quarterly submission filed within 30 calendar days of the calendar year quarter following the closing date of the Financing. For SBICs with a large number of 1031 filings, SBA permits Form 1041s for portfolio company financings to be disaggregated and submitted on a more frequent basis.
  • Valuations. Only Leveraged Licensees are required to report for quarterly reporting periods. Quarterly valuations are due 45 calendar days following the close of each quarter, instead of 30 days following the close of each quarter to allow Licensees additional time to prepare reports. All Licensees must report at least annually.

Changes to Restrictions on SBIC Financing of Certain Small Businesses

SBICs utilizing the Accrual Debenture (Accrual SBICs and Reinvestor SBICs) may make equity investments in certain underserved reinvestors that, in turn, make financings solely to Small Businesses which meet the Act size standards or the Small Business Act alternative size standards with at least 50% of employees in the United States at the time of investment. Reinvestor financing is limited to those that existing SBICs could generally finance.

The new regulations will include a safe harbor for financing a portfolio concern by an Associate when an outside third party participates in the equity financing of the Licensee's portfolio concern.

Clarification of SBA Policy with Respect to Restrictions on the Ability of a Small Business to Prepay Loans and Debt Securities

In the final rule, SBA clarifies the requirement to obtain prior SBA approval of restrictions on the ability of the Small Business to prepay other than the imposition of a reasonable prepayment penalty and states that, generally, SBA does not view a financing term that requires a portfolio concern to make prepayment distributions on a pro rata basis to all lenders in a transaction to be a prepayment restriction.

Licensee's Capital Impairment

SBA will now calculate the Licensee's CIP each quarter and notify the SBIC if they are capitally impaired.

Watchlist

The final rule formalizes SBA's SBIC Program Watchlist to proactively identify and manage risk. Actions which may result in Licensee being added to the Watchlist include (but are not limited to):

  • Bottom quartile performance relative to the other Licensee's stated benchmark for more than four consecutive quarters
    • Performance metrics include TVPI or DPI
  • Reporting failures defined in SBIC program policies and procedures

While on the Watchlist, Licensees will be required to file Form 1031 on a more frequent basis and may be requested to conduct portfolio review meetings with SBA.

Licensees will be notified when added to the Watchlist. Once the events that warranted Watchlist status are addressed to SBA's satisfaction, Licensees will be notified they are removed from the monitoring program.

Identification for the Watchlist will not result in enforcement action, but rather Licensees on the Watchlist will be required to engage in increased communication with SBA.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.