(This article appeared in SBIC Weekly as part of its Weekly Expert Author Series)
by Brad Whitman, Founding Partner, Renovus Capital
Why Private Equity Firms Were Slow to Embrace the SBIC
Historically, the Small Business Investment Company (SBIC) program has primarily attracted mezzanine debt funds. This trend partly reflected a Small Business Administration (SBA) that was focused on protecting the government’s capital, and was therefore reluctant to license buyout funds. But it also derived from the private equity community’s lack of appreciation for how the SBIC program can be used to support a buyout investment strategy. Many small buyout funds focused on the disadvantages of the SBIC program – the concentration limit, the current pay requirements, and the impairment rules – while ignoring the benefits of having ready access to low-cost leverage to do LBOs.
Current Economic Conditions Cause PE Firms to Reconsider
With institutional capital harder to raise than ever, buyout funds are now being forced to reevaluate this line of thinking as the SBIC program has increasingly become the best, if not the only way, for new, small-cap buyout funds to get into business.
When my two partners and I started Renovus Capital in January 2010, we turned to the SBIC program out of necessity since we saw no path to raising a $100 million-plus buyout fund without government matching funds. Having come from a traditional buyout fund, Leeds Equity Partners, we initially focused on the challenges of doing buyouts as an SBIC, and only, over time, have come to appreciate the program’s many advantages.
Enumerating and Tackling the SBIC Challenges
One: Covering SBIC Interest Payments
Among the challenges, the foremost is the need to generate current yield from portfolio companies in order to pay the interest expense on the SBA debentures.
There are a couple of solutions to this problem. One way is to build a portfolio that combines mezzanine debt investments with buyouts and rely upon the former to generate enough yield to cover all of the debenture interest expense. While this approach is certainly feasible, it does require a buyout fund to do a significant amount of mezzanine investing (assuming 2:1 interest coverage, perhaps as much as half the fund) and to delay making any buyout investments until at least a couple mezzanine deals have closed.
Case Study: Structure Scenario
At Renovus, we opted for the alternative route of doing buyouts without company-level leverage. For example, for our recent acquisition of Atomic Learning, the only third-party debt we took was a small revolver. We then invested our own capital as two-thirds debt, and one-third equity, with the former having a 14% cash coupon. Without third-party debt, the company generated sufficient free cash-flow to cover the 14% and this yield was more than sufficient to provide for 2:1 interest coverage on the SBA debentures.
Two: Concentration Problems – and Solutions
Foregoing third-party debt can, however, exacerbate one of the other drawbacks of the SBIC program, the concentration limit of 10%.
Many equity funds frequently invest 15% of the fund in an individual deal and when levered at 1.5:1 or 1:1, this has the effect of letting a $100 million fund do a $30-40 million transaction. Without third-party leverage, and with the SBIC concentration limit, this number shrinks to $10 million for an equivalent-sized SBIC fund.
As a result, SBIC buyout funds are more reliant on partners to do deals. But finding a partner can often be challenging in the current deal environment where many sponsors are looking more for a reason to say no – than to say yes.
In addition, traditional equity funds often resist partnering with an SBIC fund on a buyout because the latter ends up with some of its investment as debt which is senior to the equity provided by the traditional fund. As a result, SBIC buyout funds do need to invest the time and effort to develop relationships with potential partners, particularly with other SBIC buyout funds. For example, in the Atomic Learning transaction we partnered with another SBIC, Boathouse Capital.
Three: SBIC Valuation Rules and Asymmetric Risk
The final challenge to doing LBOs as an SBIC fund is the unfavorable nature of SBA’s valuation rules. Under SBIC valuation guidelines, equity investments cannot be written up for two years after closing unless there is a liquidity event.
In contrast, equity investments in companies where EBITDA declines after closing, have to be written down as part of the annual audit. As a result, SBIC funds that make equity investments face asymmetric risk. Their overall portfolio can grow combined EBITDA, but yet the SBIC valuation rules can result in an aggregate write down of this portfolio.
Mezzanine funds can largely avoid this issue because they generate gains through interest payments, which are recognized immediately, and they only have to write down their principal if portfolio company EBITDA declines significantly and wipes out the equity cushion beneath the mezzanine debt.
These valuations can matter significantly for an SBIC fund because of the potential for impairment. Net write downs are applied first to an SBIC fund’s private capital since the SBA capital is effectively senior leverage.
For example, a $100 million SBIC fund that suffers a 10% write down in its portfolio has actually suffered a 30% reduction in the value of its private capital. Moreover, all management fees, organizational costs, and broken deal expenses get charged against the private capital. As a result, an SBIC buyout fund can find itself over the impairment threshold (which can be as low as a 40% decline in private capital) even with a decent portfolio. Since crossing the impairment threshold can lead to loss of access to leverage, the asymmetric valuation guidelines pose a significant challenge for SBIC buyout funds.
No Easy Answer
This challenge defies an easy solution. Beyond simply doing good deals, there are a few ways that SBIC buyout funds can mitigate this risk.
Avoiding investments where EBITDA can decline meaningfully in Year 1 is critical, making turnarounds a difficult proposition for SBIC buyout funds, particularly in the early years of a fund.
Conservative capital structures at the portfolio company level also help by reducing the impact of EBITDA declines on equity valuations.
Finally, funds should find ways to generate income. Maximizing current yield on invested capital by eschewing third-party debt can provide significant income as can charging transaction and monitoring fees (while these fees are circular with the LPs effectively paying themselves, they still generate income to the fund for accounting purposes).
Case Study: Covering the Bases
In our recent Atomic Learning transaction we did all of these things: We bought a company with 80%+ recurring revenue, took no third-party debt, invested two-thirds of our capital as debt (with a 14% current coupon), and charged the maximum transaction and monitoring fees.
As can be seen, there are real challenges to doing LBOs as an SBIC fund. Yet none of these challenges is insurmountable – and all can be mitigated to a meaningful degree.
Next month, I will write about some of the advantages that an SBIC buyout fund has over its traditional equity fund competitors.
About the Author
Brad Whitman is a founding partner of Renovus Capital. Prior to this, Mr. Whitman was a Managing Director at Leeds Equity Partners, and was previously a Vice President with The Carlyle Group. Mr. Whitman began his career as an investment banker with Merrill Lynch Mergers & Acquisitions. Mr. Whitman is a summa cum laude graduate of Harvard University where he earned his B.A. in economics.
He can be reached by email at email@example.com, or by phone at (484) 416-0826.
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