Important Source of Venture Capital Is Frozen
January 24, 2005

By Sree Vidya Bhaktavatsalam
Wall Street Journl

Congress last week voted to freeze all new commitments to venture capital and private equity funds channeled through the Small Business Investment Company program, citing projected losses as high as $2 billion in recent years.

The move, effective through Sept. 30 of next year, promises to leave dozens of emerging venture capital and buyout firms scrambling for alternative sources of money. Over the last five years, the SBA has, on average, licensed 20 to 30 new venture capital and buyout firms - including 29 firms through September 2004. Firms typically can raise $2 from the SBA for every dollar that they raise from private investors. All told, the SBA manages roughly $4 billion in commitments to 207 venture capital and LBO funds under the participating securities program.

The National Association of Small Business Investment Companies or NASBIC, is already working with the Small Business Administration to resurrect the program. In coming months, the NASBIC plans to propose a restructuring of the program, using different fee and profit-sharing structures, so that the SBA doesn't lose money, according to NASBIC President Lee Mercer. One possible way to offset losses from the program would be to increase the government's share of the profits. Previously, the government's maximum share of the profits in venture capital and buyout-focused SBICs was 8%.

The NASBIC plans to present a restructured version of the program to the Congress next year, and is "cautiously optimistic" that the program could be revived the following year, according to Mercer.

The most recent vote was part of an Omnibus Appropriations Bill for the current fiscal year, which ends on Sept. 30, 2005. The freeze on new commitments applies only to SBICs that operate under the "participating securities" program, which include mainly venture capital and buyout firms. The SBA does plan to honor commitments to participating securities SBICs approved before Sept. 30, 2004.

The bill will not affect SBICs that operate as part of the "debentures" program, which provide mezzanine or subordinated debt financing to companies.

The new bill "is unfortunate from a lot of perspectives," says Attorney David M. Broderick, who co-heads the SBIC practice at law firm McCarter & English LLP. "It took a long time to convince VCs to team up with the government, but this unfortunately has reinforced certain stereotypes," Broderick says, about the government being an unreliable business partner.

Broderick also worries that "some good talent will be forced out" of the business.

Many well-known venture capital firms, including the predecessor firm to Austin Ventures, Austin, Texas, have received their start from the SBIC program.

NASBIC's Mercer says that the SBIC program had generated $450 million in profits for the government through the end of 2000 - a time of good returns for the private equity industry. But those profits evaporated over the next few years, mirroring poor returns elsewhere in the business as the technology bubble burst. Through this September, the SBIC program had racked up $1.2 billion in losses, and those losses are estimated to eventually run to $2 billion.

A copy of NASBIC's newsletter obtained by LBO Wire points to a study undertaken by its investment division analyzing returns from participating securities funds licensed between 1994 and 2000. The study found that for those years, SBA received returns almost identical to the returns of the private equity industry's largest limited partner, California Public Employees' Retirement System.

The SBA's goal through the SBIC program is to help in the creation of small businesses. It does not have any returns expectations, although it requires that it break even on its investments in the long run.

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