Statement of Robert Finkel, President of Prism Capital, before U.S. House of Representatives Committee on Small Business, March 20, 2003

Robert Finkel, right, president of Prism Capital, a Chicago-based Small Business Investment Company, testifying at the March 20, 2003, House Small Business Committee hearing on reauthorization of SBA programs.

Chairman Manzullo, Ranking Member Velázquez, and members of the Committee:

It is an honor to be here to testify on behalf of the National Association of Small Business Investment Companies on important issues that the Small Business Committee will consider as it works on reauthorization of the Small Business Investment Company (SBIC) program. By way of introduction, my name is Robert Finkel. I am the founder and Managing Partner of the Prism Opportunity Fund, a Chicago, Illinois Participating Security SBIC with six professionals managing $50 million in capital assets. In addition to Chicago, we have offices in Seattle, Washington; Englewood, New Jersey; and Milwaukee, Wisconsin. We received our SBIC license for Prism Opportunity Fund in 1999 and I am happy to report that we have been given the green light by SBA to form our second SBIC. It will be a Debenture SBIC, Prism Mezzanine Fund, focusing on manufacturing and distribution companies in the Midwest. Before founding Prism, I had spent nine years in the private equity business with four of those as an investment manager at Wind Point Partners, also in Chicago. Before turning to investment management, I had been an investment banker specializing in mergers and acquisitions with Paine Webber.

At Prism, one of the two lines of investment opportunities we focus on is that of traditional manufacturing companies, of particular relevance given the focus of today's hearing. We look for small manufacturing companies that have potential for growth, whether internal or by way of acquisitions. The common denominator in all our investments is a driven, entrepreneurial management team coupled with a market-proven product, technology, or service. Prism is committed to backing exceptional entrepreneurs who have the vision, drive, and talent to be leaders within their industry. We understand the enormous effort required to create a successful business and stand ready to provide our portfolio companies with assistance in strategic planning, customer acquisition, business management, executive recruiting, and raising additional capital. We strive to provide entrepreneurs with all the tools they need to succeed.

At Prism, we are focused on long-term value creation for our limited partners, including SBA. We understand that growing an exceptional business is a lengthy, complex process with many unexpected twists in the road to success. Thus, we are a patient investor, investing with a horizon of between three and seven years depending on the requirements of the small businesses we invest in. We also invest with the mindset that growth requires additional capital and reserve for follow-on investments. We maintain an extensive network of contacts in the private equity community and can assist small companies by bringing additional investors into a transaction.

With that introduction, I turn to issues related to reauthorization of the SBIC program. I will summarize my testimony, but ask that the full written version be included in the record of this hearing. I want to particularly draw the Committee's attention to several points that I make at the close of my testimony that underscore the important role the SBIC program is playing in the current economic recovery that we all hope will take hold in America this year.

Reauthorization Period & Maximum Leverage Levels

Among other items, the Committee will address the period for which the reauthorization will apply and the maximum leverage levels that will be apply in each of the years for which the program is reauthorized. In this regard, we recommend that the program be reauthorized for three years as has been the general rule in the past.

As to maximum leverage levels, we support those proposed in the President's budget for FY 2004: $3.0 billion for Debenture leverage and $4.0 billion for Participating Security leverage. Those amounts should be sufficient to meet the requirements of existing SBICs and newly licensed SBICs that will rely on that authority to make investments. If the reauthorization period is three years, we suggest that authority be increased by $250 million in each of the programs in each of the additional years (FY 2005 and FY 2006) to which the reauthorization would apply. Thus, Debenture authority would increase to a maximum of $3.5 billion in FY 2006, Participating Security authority to $4.5 billion. Under current conditions, that authority should be sufficient to meet demand. What we hope we will never see is maximum authority serving as a cap that would keep new private capital from being invested in new SBICs.

For the Debenture program, §303(b) of the Small Business Investment Act (SBIA) provides that one of the fees is annual interest to be paid directly to SBA for leverage drawn with respect to an applicable year's leverage authority. The interest rate varies from year-to-year as required to keep the subsidy rate at "zero" for Debenture appropriation purposes; provided, however, that the rate may not exceed 1.0% per annum. For Debenture leverage to be drawn against FY 2004 authority, that rate required to maintain the zero subsidy rate will be 0.855% per annum, down slightly from the FY 2003 rate of 0.887% per annum. No change in the law will be required.

SBIA §303(g)(2) provides the per annum counterpart for the Participating Security program. The section provides that a prioritized payment rate of not to exceed 1.38% per annum on any outstanding leverage related to the annual leverage authority in question shall be paid directly to SBA's account to keep the subsidy rate at "zero" for Participating Security appropriation purposes. For leverage related to FY 2003 authority, the required rate is 1.311% per annum. For FY 2004 leverage authority the required rate will be 1.454% per annum, 0.074% greater than current statutory authority. Thus, for implementation of the President's budget as submitted, the authority of SBIA §303(g)(2) must be increased legislatively by 0.074% at a minimum.

The reason the §303(g)(2) rate must be increased this year has nothing to do with assumption of increased losses in the program. Rather, it is because the profit sharing rate that Participating Security SBICs must pay SBA falls as the 10-year Treasury bond rate falls. At current projections for the 10-year rate, the profit share rate is at its lowest point. In essence, all that is happening this year is a reduction in one rate element and a related increase in another.

We suggest increasing the §303(g)(2) "not to exceed rate" to 1.5% per annum as part of the reauthorization process later in the year. That is the same level we suggested in FY 2002. It is well within the ability of SBICs to pay given current market conditions and would not in any way increase the amount paid by small businesses for Participating Security SBIC financing. The latter are set by market conditions; there is no direct correlation between the cost of leverage to a Participating Security SBIC and the amount it can charge a small business. Total annual cost of leverage has been much higher historically than it is today. The estimated total cost of Participating Security leverage for the next year is approximately 6.5% per annum. This compares to the average for the life of the program of 7.84% per annum. Participating Security SBICs using FY 2004 leverage will be well positioned to contribute to the economic revival so important to our country.

Suggested Changes In The Small Business Investment Act Of 1958 That Will Increase Support Of Manufacturing Companies By SBICs

SBICs already provide significant support to manufacturing companies. In FY 2002, SBICs invested $737 million in 434 small U.S. manufacturing firms located in 41 states. That was 28% of all SBIC dollars invested in FY 2002 and 22% of all companies that received SBIC financing that year. SBA reports that 21,050 jobs were created and, using average employment numbers for SBIC-financed companies, over 68,000 manufacturing employees were supported by those investments. However, we believe there are several steps that would improve those numbers.

1. To make more funds available to invest in manufacturing companies we suggest a targeted change to SBIA §303. The changes would allow SBICs investing in small U.S. manufacturing companies to exceed current maximum leverage amounts set by the SBIA (currently $113.4 million) but would not permit them to exceed the maximum 3:1 leverage ratio contemplated by the SBIA. By keeping the maximum permissible leverage ratio no greater than that contemplated by the SBIA, the risk to the SBA would not be increased above that contemplated by the SBIA, although the exposure to any one SBIC or group of co-managed SBICs would be increased.
   
   Supporting capital-intensive manufacturing companies takes substantial capital resources. These might be held by a single SBIC or a group of co-managed SBICs. The SBIA limits the maximum amount of leverage available to any one SBIC or group of co-managed SBICs no matter how much private capital the SBIC has been able to raise. The current limit is $113.4 million. While the limit does increase annually by a percent equal to the increase in the Consumer Price Index, it is constraining for those SBICs that have substantial private capital under management—SBICs that would invest more in manufacturing companies but for the leverage limit. Providing a reasonable exception to the limit would increase investments by those SBICs with substantial private capital and a focus on manufacturing companies and would also stimulate the creation of new SBICs focused on investing in small U.S. manufacturing companies.
   
   Specifically, we suggest adding a new subparagraph to SBIA §303(b)(2):
   
   "(D) INVESTMENTS IN MANUFACTURING COMPANIES.—In calculating the outstanding leverage, whether represented by a debenture or participating security, of a licensed company for the purposes of subparagraph (A), the Administrator shall not include the amount of any leverage included in an investment made by the company in a small business concern or smaller enterprise that meets the definition of a manufacturing company under the industry classification system used by the U.S. Government; provided, however, that the total of leverage not included in the calculation shall not exceed 100% of the company's private capital and provided further that total leverage outstanding shall at no time exceed 300% of the private capital of the licensed company."
   
   In addition to the above, a conforming amendment to SBIA §303(b)(4)(A) is required to reflect the targeted exceptions to maximum leverage levels. Specifically, we suggest amending the section to read as follows:
   
   
   "(A) IN GENERAL—Except as provided in subparagraphs (B), (C), and (D), the aggregate amount of outstanding leverage issued to any company or companies that are commonly controlled (as determined by the Administrator) may not exceed $90,000,000 as annually adjusted for increases in the Consumer Price Index."
   
   
2. To give managers of very large SBICs the time they need to work with large portfolio companies and to reduce the risk that such managers invest in companies outside of their focus area, we suggest elimination of the mandatory requirement that those SBICs invest a substantial portion of their dollars in companies that are defined as smaller enterprises by the SBIA. The mandate is 20% of all investments made until the SBIC has used $90 million in leverage, and then 100% of any investments made with leverage exceeding $90 million. The impact of the law is to require larger SBICs to make many more investments than they would normally make under other controlling provisions of the SBIA (smaller enterprises generally require smaller amounts of capital) and to make them in companies that may not fit the investment focus and expertise of the SBICs involved. The result is that SBIC managers have less time to work with portfolio companies (particularly important in the U.S. manufacturing environment) and may have to invest in companies with profiles that do not match the expertise resident in the SBIC making the investment. This latter impact increases the risk of return to both the SBIC and the SBA.

   We propose exempting SBICs with private capital equal to or more than $50 million from the requirement of SBIA §303(d)(1). Only 14 of 353 leveraged SBICs (4.0%) meet this criterion at present. The average leveraged SBIC has approximately $20 million in private capital. The purpose is to encourage larger SBICs to focus on (specialize in) investing in larger businesses that still meet the SBIA definition of "small business concern." Capital-intensive manufacturing businesses will make up the large percent of such opportunities. SBICs that invest in companies that do not meet their investment profile increase the risk to both the SBICs and SBA, as SBA recognizes fully in its SBIC licensing and monitoring processes.

   Specifically, we suggest amending §303(d) to read as follows:

   "(d) INVESTMENTS IN SMALLER ENTERPRISES -
   
   
   (1) IN GENERAL - The Administrator shall require each licensee with private capital less than $50,000,000, as a condition of approval of an application for leverage, to certify in writing that not less than 20% of the licensee's aggregate dollar amount of financings will be provided to smaller enterprises.
   
   (2) MULTIPLE LICENSEES - Multiple licensees under common control (as determined by the Administrator) shall not be excused from the requirement of subsection (1) by the fact that combined private capital of any one or more of the commonly controlled licensees is equal to or exceeds $50,000,000."

   The suggestion would continue mandatory support for smaller enterprises by over 90 percent of SBICs, but would allow the few larger SBICs to focus on a smaller number of larger small businesses, although still a number meeting SBIA portfolio diversification requirements.

   Suggested Changes In The Small Business Investment Act Of 1958 That Will Increase Support Of Private Investors And The Ability Of SBICs To Raise Private Capital
   
   
3. To clarify congressional intent and to encourage more private investors, particularly institutional investors, to invest in the SBIC program, we suggest an amendment to SBIA §303(e), the section of the Act that deals with Capital Impairment. The section requires that SBA, as a condition of approving a request for leverage by any SBIC, make a determination that "the private capital of the licensee has not been impaired to such an extent that the issuance of additional leverage would create or otherwise contribute to an unreasonable risk of default or loss to the Federal Government." SBA has construed §303(e) as requiring not only that a finding of capital impairment (as defined by SBA) might preclude advancing additional leverage, but also that it is a violation of SBA promulgated regulations that can lead to imposition of operating restrictions, denial of the right to use remaining capital for investment purposes, and actual liquidation of the SBIC at the direction of and upon terms set by SBA—even in cases where there has been no other violation of the law or regulations and the SBIC has done nothing other than invest in accordance with the provisions of the business plan approved by SBA during the licensing process. Among the potential conditions that can be imposed is a requirement that the SBIC call any remaining private capital for the sole purpose of retiring outstanding leverage rather than supporting investments in small businesses.

   While capital impairment may be a permissible reason for rejecting a leverage request, we do not believe it was congressional intent that, absent other regulatory violations, it be a reason to shut down an SBIC or deny the use of private capital for investment purposes. Other than the reference to capita impairment in §303(e), there is no other reference to capital impairment in the SBIA. We believe the intent was to give SBA a tool to use to help judge whether or not it would advance more leverage to an SBIC, but not one that would permit SBA to punish the SBIC for simply having its capital eroded by investment losses. Those potential losses relate to investments in small businesses. While the money may not be returned to the SBIC, it nevertheless was put to its intended purpose. Whether or not the losses will be realized over time cannot be known only by looking at a value at mid-point in the life of an SBIC. SBIA §301(c)(3)(B)(iii) and §302(a)(3)(B) stress SBA's right to make the judgment during the licensing process and upon leverage requests as to whether or not to support an SBIC. However, we believe no section gives SBA the explicit authority to anticipate that an SBIC will be unable to meet its obligations with respect to leverage that has already been issued and to declare this unilateral anticipation a condition of default that justifies restricted operations or liquidation. Failure to pay Debenture interest, a prioritized payment due from a profitable PS fund, or the actual principal of a security when due are conditions of default that should (and do) permit SBA action, but SBA-defined arbitrary capital impairment ratios should be exclude from that list.

   In Participating Security SBICs, and in Debenture SBICs to a lesser degree, the very nature of investing can create significant conditions of capital impairment during the life of the fund. Depending on the type of investments made by a fund (e.g., start-up, later stage, technology, debt, or equity—all approved by SBA in the licensing process), capital impairment can be considerable in a fund that will ultimately prove to be very profitable. If SBA becomes the judge able to make a unilateral decision on when to shut down a fund in advance of the due date of outstanding securities, private investor support of the program will begin to erode since it will be seen as a repudiation of the venture capital model upon which the program is based and a transfer of investment decisions from the private fund managers to the SBA. Some funds will lose money. Bad things can and do happen to good people. However, SBA is an investor in hundreds of SBICs. Over time, dollar cost averaging will work to the advantage of SBA just as it does for institutional investors. Licensing requirements are strict, private capital is at risk first, and SBA can refuse to issue new leverage based on calculation of capital impairment. All of that is reasonable in the context of the program. However, if SBA severely restricts or liquidates SBICs in mid stream simply because of capital impairment ratios, private investors will have little reason to support the program, particularly the Participating Security program. This is particularly true if SBA couples restrictions with a call of private capital to pay itself rather than to see the money invested in the small businesses that make up the SBIC portfolio. Private investors can accept losing their money if it has been invested in small businesses. They cannot accept simply paying their capital directly to SBA.

   To clarify congressional intent, we suggest that SBIA §303(e) be amended to include a new subsection (3) which would read as follows:

   "(3) Notwithstanding the Administrator's right under subsection (2) to refuse to grant additional leverage to a licensee based on the degree to which the licensee's private capital has been impaired, that degree of impairment shall not be the basis, in whole or in part, for any action by the Administrator to restrict the operations of the licensee or to direct the use of the licensee's remaining capital to any purposes other than the investment purposes for which the licensee was licensed. This provision shall not prevent the Administrator from taking actions to restrict the operations of (or liquidate) a licensee for failure to comply with any other provision of the law or regulations promulgated by the Administrator under authority of this Act."

   We believe that the above clarification will make the SBIC program a very attractive program for institutional investors who, for the most part, have not invested heavily in SBICs. Coupled with what we hope will be passage of H.R. 739, the "Small Business Company Capital Access Act," the bill that will remove UBTI disincentives applicable to Debenture SBICs, we believe that the program will attract significant new sources of capital, capital destined to be put to work supporting U.S. small business entrepreneurs.

   Suggested Changes In The Small Business Investment Act Of 1958 That Will Strengthen SBA's Position With Respect To Leverage Advanced To Participating Security SBICs
   
   
4. Although we are still considering the issue in discussions with SBA, our belief is that the risk of loss to the government can be reduced by amending SBIA §303(g)(9). That section of the law governs both the percent of distributions made by Participating Security SBICs from income, after tax distributions and repayment accrued prioritized payments that may be due, that must be paid to SBA and how those distributions are to be characterized by SBA. The goal we share with SBA is to reduce the risk of loss to the government (thereby having a positive impact on the subsidy rate) without making the program less attractive to private investors who are the foundation of the SBIC program. We believe that SBA and the SBIC industry will agree on the language necessary to achieve the shared goal by mid- to late April. That should leave sufficient time for the Committee to consider the proposal for inclusion in the final reauthorization bill.

1. SBICs are an important part of our national economic recovery. SBA estimates that SBICs currently account for 60% of all venture capital investments—by number of investments. For comparison, in 1997 the number was 38%. The increase is likely to grow in the face of the substantial and continuing contraction in overall venture capital. To illustrate, the number of all annual venture capital investment transactions has dropped by 60% since the high water mark of FY 2000, but the number of SBIC investment transactions has dropped by just 14% over the same period. This underscores the countercyclical nature of the SBIC program and the role it will play in the recovery.



2. SBICs are proving their value as steady and reliable sources of venture capital for U.S. small business entrepreneurs. For the fiscal year ended September 30, 2002, SBICs invested $2.7 billion in 1,979 U.S small businesses. While down 40% from the previous year, the total compares with a drop of 54% in all venture capital dollars invested for the period. The biggest drop in SBIC dollars invested was in those made by unleveraged bank SBICs—a 63% drop compared to only a 16% drop in investments made by leveraged funds. Bank SBIC investments have fallen because of economic conditions and because banks can now make venture capital investments out of funds established under Gramm-Leach-Bliley authority. Finally, and of the greatest importance, while SBIC dollars invested fell 40%, the number of companies financed dropped only by 12% (from 2,254 to 1,979), indicating that much of the dollar fall can be attributed to lower valuations of companies securing financing. Given the major contraction in the economy, a fall of just 12% in the number of companies supported by SBICs was a positive result.



3. SBICs are a significant source of capital for new businesses, with 48% of all FY 2002 investments made in companies less than three years old.



4. The average size of investments by all SBICs was less than $1.0 million, while investments by non-SBIC funds averaged about $9.0 million for the same period.



5. SBICs invest in areas that are traditionally underserved by non-SBIC venture capital firms. SBICs invest in virtually every state—48 of 50 in FY'02—and are an important source of capital for businesses located in Low- and Moderate-Income (LMI) areas as defined by the government. In FY'02, LMI investments by SBICs totaled $725 million—27% of all SBIC FY'02 investments. The 27% total was up from 22% in FY 2001—a percentage increase of 23% for LMI businesses.



6. Regarding employment, average employment at SBIC-financed companies in FY'02 was 157. The median number of employees was 29. Based on the average, SBIC-financed companies employed approximately 310,000 individuals in FY'02. With growing capital resources, SBICs are ready to build on that number in the years ahead.



7. Currently 441 SBICs are managing $20.6 billion in capital resources, up 10% from $18.8 billion at year-end FY 2001. The increase is significant given the contraction in all other sources of venture capital. During FY'02, private investors committed $800 million in new private capital to the 41 new SBICs licensed in FY 2002. The backlog of current license applications at SBA and the rate at which new applications are being received make it likely that as many as 50 new funds will be licensed in FY 2003. This will ensure the continued flow of critical venture capital to the fast-growing U.S. small businesses that are the foundation of U.S. job creation and economic growth.



8. What will FY 2003 results show? An extrapolation from investment data through January 2003 indicates that dollars invested will remain level or increase slightly, but that there will be a substantial increase in the number of companies receiving financing—perhaps as many as 2,500. All projections at this time are clouded by the uncertainty related to the situation in Iraq. What can be said with certainty is that the program is strong and that there is continued growing interest in the program among experienced venture capital management teams. That is good for the program and U.S. small businesses.

Thank you for your attention and for your consideration of our proposals for the SBIC program. We enjoy a very strong and positive working relationship with SBA and believe the program is on a strong footing. We believe the changes we have suggested will make the program stronger still and even more effective in supporting U.S. small businesses in the future, particularly small U.S. manufacturing businesses. I would be pleased to answer any questions you might have about the program in general or our proposals for the reauthorization bill in particular.

Robert Finkel, President of Prism Capital, has invested in private equity in Chicago for the last 13 years, most recently with the Prism Opportunity Fund, of which he is both founder and Managing Partner. Prism Opportunity Fund is a Small Business Investment Company licensed by the U.S. Small Business Administration (SBA) to invest in U.S. small businesses that meet the size and operational requirements set by SBA. The fund received its lines in 1999. Prism's investment focus is on non-startup information technology companies and manufacturing companies. Prism is headquartered in Chicago, IL, and has additional offices in Englewood, NJ, Milwaukee, WI and Seattle, WA. Prism manages $50 million (including SBA matching funds) from institutional and family investors and is currently one-third invested in seven portfolio companies. In formation is Prism's second fund, Prism Mezzanine Fund, which will focus on manufacturing and distribution companies located in the Midwest.

Mr. Finkel serves on the Boards of Directors of Penn-Wheeling Closure, Fitzroy Dearborn Publishing, The Coleman Center, and Junior Achievement of Chicago, and represents Prism on several other boards as observer. Mr. Finkel is also Vice Chairman of the Illinois Venture Capital Association.