E171: SBIC Funds: How to Raise $175 Million for Private Equity & Credit Funds

Summary

Podcast Summary: E171 - SBIC Funds: How to Raise $175 Million for Private Equity & Credit Funds

Title: How I Invest with David Weisburd
Episode: E171: SBIC Funds: How to Raise $175 Million for Private Equity & Credit Funds
Release Date: June 6, 2025
Guests:

• Brett Palmer, President of Small Business Investor Alliance
• David Demeter, Managing Director at Davidson College Endowment

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1. Introduction to SBIC Funds

In this episode, host David Weisburd delves into the intricacies of Small Business Investment Company (SBIC) funds, exploring how they raise substantial capital—up to $175 million—for private equity and credit strategies with government support. Brett Palmer and David Demeter join the conversation to shed light on the mechanisms, benefits, and attractiveness of SBICs in the investment landscape.

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2. Performance of SBICs vs. Other Funds

David Demeter highlights a pivotal study by the Institute for Private Capital, a consortium comprising esteemed universities like Duke, UNC, Stanford, and Chicago. The study revealed that SBICs outperform their non-SBIC counterparts significantly.

David Demeter [00:39]: "SBICs outperform non-SBICs by about 4% on a net IRR basis and 0.68x on an MOIC basis, showing meaningful outperformance against the Burgess benchmarks."

This superior performance positions SBICs as attractive options for institutional investors seeking robust returns in the private investment space.

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3. Government Leverage and Its Benefits

A key advantage of SBICs is the leverage provided by the Small Business Administration (SBA), which significantly amplifies returns for both General Partners (GPs) and Limited Partners (LPs).

David Demeter [01:58]: "The government leverage amplifies returns for both GPs and LPs, allowing small funds to scale and providing LPs with leveraged returns on their investments."

SBICs typically operate with a leverage ratio of 2:1, meaning for every dollar of private capital raised, an additional two dollars are borrowed from the government. This structure enables funds to manage portfolios effectively while enhancing potential returns.

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4. Focus on the Lower Middle Market

The lower middle market emerges as a focal point due to its inherent inefficiencies and growth potential. SBICs thrive in this segment by professionalizing small businesses and driving substantial value creation.

David Demeter [11:10]: "In the lower middle market, there's more inefficiency and a lot of the things our GPs do—like building out management teams and establishing KPIs—create significant value."

This market segment offers numerous opportunities for growth, making it an attractive area for investment through SBICs.

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5. Growth and Expansion of SBIC Funds

The SBIC program has seen remarkable growth, expanding from $2 billion in assets in 2008 to over $50 billion today, with projections suggesting an additional $15 to $20 billion influx in the near future.

David Demeter [06:13]: "Since 2008, SBICs have grown from about $2 billion in assets to north of $50 billion, with significant growth expected to continue."

This expansion is fueled by increased private credit market activities, regulatory changes limiting traditional banks, and a growing recognition of the lower middle market's potential.

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6. SBICs in Private Equity and Private Credit

SBICs are versatile, encompassing both private equity and private credit strategies. Fund managers with proven track records can leverage SBIC funds to enhance their investment capacity and returns.

David Demeter [07:54]: "SBICs are used for both private equity and private credit funds, requiring managers to have a successful investment history aligned with their SBIC strategy."

This dual capability allows SBICs to cater to a broad range of investment preferences within the private capital sphere.

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7. Structural Alpha Achieved by Davidson’s Investment

David Demeter explains how Davidson College's endowment leverages SBIC funds to achieve structural alpha, enhancing returns through strategic use of leverage.

David Demeter [08:40]: "SBICs outperformed their Burgess benchmarks by about 4%, and the leverage amplifies these returns, offering LPs net levered returns that surpass gross unlevered returns."

This approach not only boosts returns but also diversifies the investment portfolio, mitigating risks and enhancing overall performance.

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8. Challenges and Licensing Process

Becoming an SBIC-backed manager involves a rigorous licensing process, ensuring that only experienced and reputable fund managers gain access to government leverage.

David Demeter [24:26]: "The licensing process requires experienced fund managers with a proven track record, thorough due diligence, and typically takes about a year, posing a significant barrier to entry."

Additionally, SBICs must adhere to strict investment criteria, such as exclusively investing in U.S.-based small businesses, which can deter some potential fund managers.

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9. Portfolio Construction at Davidson

Davidson's investment strategy employs a barbell approach, heavily allocating to hedge funds (35%) and venture capital (25%), alongside SBIC funds (20%). This diversification aims to balance high-risk, high-reward investments with more stable, leveraged SBIC investments.

David Demeter [28:40]: "Our hedge fund program, comprising about 35% of the endowment, focuses on low beta and low correlation strategies, allowing us to take on more risk while maintaining diversification."

This strategic allocation seeks to maximize returns while managing overall portfolio risk through a mix of asset classes.

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10. Future of SBIC Funds

Despite the growth, SBIC funds face limitations in scaling due to their smaller fund sizes, which can exclude larger institutional LPs. However, ongoing efforts to raise leverage caps and increase awareness among diverse LP bases signal a promising future for SBICs.

David Demeter [21:28]: "We're working with Congress to raise leverage caps, enabling larger investments and attracting a broader range of LPs, which will drive further growth in the SBIC program."

As awareness and regulatory support continue to evolve, SBICs are poised to play an increasingly significant role in the private investment landscape.

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Conclusion

Episode E171 of "How I Invest with David Weisburd" provides an in-depth exploration of SBIC funds, highlighting their superior performance, leveraged return benefits, and strategic focus on the lower middle market. Through insightful discussions with Brett Palmer and David Demeter, listeners gain a comprehensive understanding of the mechanisms that make SBICs a compelling option for institutional investors seeking to optimize their private equity and credit strategies.

For those interested in exploring SBIC funds further, the Small Business Investor Alliance (www.sbia.org) serves as a valuable resource, offering information and matchmaking services for both GPs and LPs.

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Notable Quotes:

• David Demeter [00:39]: "SBICs outperform non-SBICs by about 4% on a net IRR basis and 0.68x on an MOIC basis."
• David Demeter [01:58]: "The government leverage amplifies returns for both GPs and LPs, allowing small funds to scale and providing LPs with leveraged returns on their investments."
• David Demeter [06:13]: "Since 2008, SBICs have grown from about $2 billion in assets to north of $50 billion, with significant growth expected to continue."
• David Demeter [08:40]: "SBICs outperformed their Burgess benchmarks by about 4%, and the leverage amplifies these returns, offering LPs net levered returns that surpass gross unlevered returns."

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Resources:

• Small Business Investor Alliance: www.sbia.org

Transcript

[Host]

Today we're unpacking how SBIC funds work and what it takes to raise 175 million for private equity and private credit strategies from the government. My guests are Brett Palmer, President of Small Business Investor alliance, and David Demeter, Managing Director at Davidson's College Endowment. We'll cover why SBIcs consistently outperform other funds, how government leverages amplifies returns for both GPs and LPs and what makes the lower middle market so attractive. Without further ado, here's my conversation with Brett and David.

[Brett Palmer]

Brett, tell me about the Institute for Private Capital study done by the University of North Carolina.

[David Demeter]

Sure. The Institute for Private Capital is a nonpartisan consortium of universities, Duke University, unc, Stanford Chicago, a whole bunch of them that get together and study finance issues. It's a phenomenal organization. And last year they did a study on small business investment companies and their performance. And their performance that they, they found was, was surprising to them, not to us, but just how much better SBICs perform because it's not very well known. They're relatively small and, but, but they really do perform better than most everything else they see out in the market.

Sbics represent a variety of different investment strategies, but once they were benchmarked against their appropriate strategy, SBIcs outperform non SBIcs by about 4% on a net of IRR basis, net of FIR basis, and.

On an MOIC basis, you know, they outperformed by about 0.68x larger. So it was a meaningful outperformance from the BURGESS benchmarks that they looked at for several hundred funds.

[Brett Palmer]

0.68X is certainly no small number. Talk to me about who's outperforming.

[David Demeter]

Sbics are small business investment companies, so they're private equity and private credit funds. They raise private capital from institutional investors, they go through a licensing process at the government, then they can access leverage from the federal government, from the Small Business Administration at the fund level, not an individual deal level, but at the fund level that's very attractive leverage. As far as the terms go, there's no guarantee on the performance of the sbic. If you invest poorly, you lose money. If you invest wisely, you make money. But leverage is an amplifier. And so the government has this program to, to have small business investors amplify the capital. Where the private capital leads this SBA leverage follows and that is incredibly beneficial to the LPs and to the GPS as well. Let small funds get scale and it lets LPs have leveraged returns on their investments.

[Brett Palmer]

Tell me about the function of leverage in sbic. What kind of quantity of capital are we talking about?

[David Demeter]

These are smaller, tend to be smaller funds, because as funds scale up larger, they have to write bigger checks. And small businesses would love giant checks, but they really can't use them. They need check sizes that really are fitting to their scale. So the total amount of leverage that an individual fund can borrow is $175 million. And it's generally done on a ratio of 2 to 1, $2 of leverage for every dollar of private capital. So the fund sizes are generally below $350 million, but some are significantly larger. But these funds also can have multiple funds in succession. And so you have like all funds, you have an investment period and then you have a harvesting period, and you never want to be out of the market. So when you finish or finishing up your investment period of one fund, you start another one. So the total amount of outstanding leverage that a small business investment company can have outstanding at any given time is $350 million across all of its funds.

I'll just add these strategies. These strategies range across asset classes. So there's a lot of direct lending in sbics. There's senior lending, there's even venture debt. But they also go down into equity buyouts and growth equity. And now with a newer program that's focused on equity strategies, you're seeing even some venture in SBIC.

[Brett Palmer]

So let's talk brass tax. So if you raised 80 million in equity, you can now borrow to X that 160. So you're basically going around with a $240 million fund. Let's say that $240 million fund returns 2x net to investors. Tell me about how the different parties benefit from that structure.

[David Demeter]

The fund managers, general partners benefit from getting scale. They have a larger fund to work with. They get to do more deals, they get to write more checks. And yes, that also means that a bigger fee, because the SBIC's generally, not always, but generally get management fees on the projected leverage as well as the private capital they have. And the LPs get levered returns. And so for say, an SBIC is going to be making a $9 million investment, they'll pull 3 million from their LPs, they'll pull 6 million from this SBA credit facility at a very low cost and very, very attractive terms. And then they make that investment. And so, you know, you really get significantly amplified returns for the LPs. And so in many cases, you get sort of equity like returns for debt, like risk, which is a different model than you can get anywhere else. Because the way this leverage works is it's a fixed rate leverage, you know, you have for 10 year period. It's basically the 10 year treasury plus a, you know, 50 to 80 basis points and there's no prepayment penalty. It's non amortizing. And so it's very attractive leverage that you could never get anywhere else in the market. And so that's really advantageous to the LPs. And that's how, you know, endowments like Davidson Colleges Endowments and others get really attracted to this model because one, it's a very inefficient market in the lower middle market and two, you get this leverage amplification which is really attractive.

[Brett Palmer]

Right before the podcast you mentioned that it had grown from 2 billion to 50 billion. Double click on where that growth has come from.

[David Demeter]

So I've been president of this trade association for about 17 years and in 2008 the SBIC's were about 2 billion in assets and today they're north of 50 billion. And there's probably 15 to 20 billion more coming online in the next 18 months or so I would imagine. You know, you really have a significant growth in the private credit markets during that period, which this dovetails with. You also have significant regulatory changes in the banking world where the banks aren't allowed to do a lot of things they used to be able to do. And so the SBICs are filling some of that gap. I think there's also been a significant discovery of the lower middle market and the opportunities for a relatively inefficient market. Once you get to the upper middle market, it's a very efficient market. Even if it's still a private market. The lower middle market is still very inefficient. There's still lots of value to be created, there's still a lot of growth to be had. And so you've really seen a very significant influx of investors that are performing well and LPs that are getting interested. The biggest challenge to further growth really is just the scale. You know, these are relatively small funds and you know, a lot of the big platforms with who have the huge dollars can't write check sizes that small to a fund. And so for some of them that's limiting. But for smaller platforms it works. Family offices, smaller university endowments, it's really attractive.

[Brett Palmer]

Brett, the SBIC funds are not only for private equity funds, but also for private credit funds. Tell me about that. And how do managers use SBIC funds for private credit?

[David Demeter]

You have to have a track record of investing this way. And you have to propose to the Small Business Administration that, hey, we're going to continue to invest the way we were. You have to have an analogous record and we're going to raise private capital and then we're going to amplify that with your leverage. Now, if you can't raise your private capital, if the market doesn't trust you with your capital, the government's not going to either. And that makes sense. But most of these fund managers have really come in and they've said, hey, look, this private credit opportunity is very significant.

[Brett Palmer]

David, you're at Davidson College, you're an lp, and a lot of these structures. Walk me through the structural alpha that you achieve through investing in an SBIC fund, both on the credit as well as on the equity side.

[David Demeter]

The most quantitative way to answer that is to refer to the IPC paper, which found across all strategies, SBICs outperformed their Burgess benchmarks by about 4%. But it's an amplifier. So, you know, if you have lower gross of fee returns, unlevered gross of fee returns, you're going to have less magnification from the leverage. One anomaly you find with SBIcs that people don't always pick up on is the net of fee levered returns are frequently higher than the gross of fee unlevered returns. Just to say that again, the net of fee returns would be higher than the gross of fee returns because give.

[Brett Palmer]

Me an example of that.

[David Demeter]

I always try to make this argument, you know, to try to hit a 3x net return in a private equity fund is a very difficult thing that a lot of us aim to do. Only about 8% of private equity funds from 2000 to 2020 have done that. And even then, a lot of that was luck. Sometimes you just picked a great vintage year to do that in a traditional fund, you probably have to earn something like a 3 1/2 x gross of fee return, something a bit higher. In an SBIC, you probably have to hit about a 2 1/2x growth gross unlevered return to hit a 3x net levered return on an MOIC basis. When you actually look through it, you know, fund returns are a bell curve, right? You know, and that 3x net return fund is way out on the right tail. If all I have to do is hit a 2 1/2x gross, which would nutritional fund would be like a 2x net. Well, something like 40% of funds. Private equity funds in the lower middle market did that from 2000 to, to 2020. So that increases your odds of picking by like 5x. Now I'm not trying to pick this outlier that's it's way out on the right tail. I actually have a fighting chance inside an SBIC. It hit a 3x net MOIC private equity.

[Brett Palmer]

The returns are much more bandit than maybe a venture capital or a biotech fund. So the difference between a medium median returning fund and a top top 10%, in this case top 8% fund could literally be 1x.

[David Demeter]

And this can really help you get there without taking enormous amounts of risk or trying to grow companies too exuberantly, too aggressively.

[Brett Palmer]

Last time we chatted you said that you had a bias towards lower middle market even without the SBIC structure. Why do you like lower middle market so much?

[David Demeter]

In the lower middle market there's just more inefficiencies and a lot of the things our GPS do. It's not rocket science. It's building out management teams, installing new accounting software, establishing KPIs. They're really most frequently building out these companies that have never had institutional investment before. And it's a great place to do that and sell it on to the next private equity owner.

Being the first institutional capital is a really great place to be one. There's huge amounts of value to be created. You know, simple technologies, simple you know, human resources tools that really amplify it. It also from a lot of the LPs I talk to, it takes away some of the reputational risk. The only way to make money in the lower middle market is to grow the business. You know, you're not talking about hey, we invested in something, they had to slash a bunch of jobs or they ship stuff offshore. The only way to make make money is to grow it. And you can grow it. And there's, it's a proven business model, very, very low strikeout numbers. You know, it's unusual to have a failed investment. Very unusual because these are proven models that just haven't been professionalized in some cases. And so it's a win win reputationally, it's a win win from a financial standpoint. And there's frankly a lot more choice as far as the number of deals. I mean these funds are looking at 4 to 500 opportunities for every one they actually invest in. It's that inefficient of a market.

[Brett Palmer]

Thank you for listening. To join our community and to make sure you do not miss any future episodes, please click the follow button above to subscribe. We like to romanticize small businesses in our culture, but There is a reason small businesses stay small. They may be operating on clipboards. Literally they're not even in Excel, let alone AI not have a CRM. They might just have a file with their customers or just know them by name. So coming in and picking up those low hanging fruit could be a great source of alpha versus the upper middle market. Oftentimes you have to rely on leverage and other kind of more riskier investment strategies than just fixing the business.

[David Demeter]

And you've also squeezed out some of those profits and those efficiencies early and you've sort of what you paid for as you've gone along. As it relates to small businesses. I mean most small businesses in the United States, the vast majority, it's over 90% of small business in the United States have zero employees. And that's not what we're talking about here. We're not talking about, you know, some guy who's alone and just a consultant. These are businesses that are meant to outlast the founder. And so it really is making sure that it maintains itself as an ongoing enterprise. And so it really is taking sort of the cream of the crop and then making sure that it just, you know, they keep ramping up and going. So the bigger platforms that have sort of stretched down to the smaller part of the market are sometimes surprised about the professionalization that's, that's needed. No, your sister can't be your auditor, your girlfriend cannot be your secretary. You know, you know, these small businesses have, you know, real human components to them that need to be professionalized. And that's why I say like HR components are a really big thing with these smaller platforms. These smaller platforms are so busy, you know, operating, they're often growing, but they don't really have time to think strategically or don't have the networks across the industry, across geographies to go from a, you know, small player to a regional player to maybe even a national player. And that's what these fund managers do. Not just with money, but also with expertise and networking.

We have to remember that this program exists for job growth. We romanticize small businesses because that is where a lot of American job growth comes from. These groups need capital and this program provides that without a cost to the U.S. government.

There was a study done by the Library of Congress a couple years ago, a nonpartisan research division, Library of Congress. And for SBIcs, the equity oriented investments added, I think it was number was north of 350 new jobs per organic jobs per investment. And the debt oriented ones were 175 or 180. I think something along those lines per investment. Those are big numbers for small businesses. You know that's not going to be gm. That's not going to become Tesla though. Tesla was an SBIC investment back in the day. That's sort of an outlier. You don't have to go public to make money with these. But know there really are meaningful growth that in both in revenue and earnings and in employment. That really is something that takes away some risk for the LPs from a reputational standpoint.

[Brett Palmer]

You get this money from the government. Where does that money come from and who backs the leverage?

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[David Demeter]

You raise private capital, you go through this licensing process, you get approved by the sba. Then when it's time to make investments, you draw just in time. You don't get all the money at once. So if you have a fund where you're borrowing, you have $150 million of leverage capacity. You don't get that 150 at once. You get it on a deal by deal basis and you pull the leverage from the Federal Home Loan bank of Chicago. At the same time you're pulling leverage from your LPs. And so that money comes from the Federal Home Loan bank of Chicago. And then every six months it gets put into a trust certificate and auctioned off. And when it gets auctioned, the buyers are fixed income funds and insurance companies and hedge funds and all the big financial players. Because these trust certificates have the full Faith and credit of the United States behind them. So they're not guaranteeing any individual performance for the sbic, but they guarantee that that trust certificate will perform. And it's generally the 10 year treasury plus, you know, 45 to 85 basis points. And again, the nature of that leverage is really attractive. No prepayment penalty, you can pay it back whenever you want. You know, it's a fixed rate, it's not going to go up or down. You know, it's non amortizing. So it's, you're just making interest payments for 10 years, then you have a big slug at the end. And that's how it works. And so the pool sizes generally are around $2 billion plus or minus every six months.

I would add the most attractive feature of the leverage is that there's no refinancing risk. It's 10 year leverage. There's a lot of investors that are wary of leverage and rightly so. I always remind people that Warren Buffett, fundamental value investor, rightly argues that margin debt is dangerous because it can be pulled from you at any time. But I also remind people he has an insurance float. It's also very special leverage that is low cost and has no refinancing risk. When you take away the refinancing risk from, from leverage, you take away a huge portion of that risk. And so this, this leverage is very special in that it does not have refinancing risk if you manage it properly.

[Brett Palmer]

And David, you're essentially a buyer of these type of funds at Davidson. Why do you think this hasn't become a bigger program?

[David Demeter]

Well, it has become bigger over time, but these are smaller funds. You know, they typically only raise 50 to 200 million in LP capital. It's usually below the threshold that most placement agents are willing to work. These funds the historically have been the largest LP base is from banks. Banks get special treatment under Dodd Frank and to invest in these and they get Community Reinvestment act credits that they need under regulation. So banks don't talk as LPs don't really exist outside of SBICS. So there isn't a lot of cross communication between that investor base and other investor bases. So there just isn't a lot of people talking about it. I mean that's why we're here today on your podcast, to try to get the word out because this program really is growing and we see a lot more GPS coming into the market.

Yeah, I'd add to that, David, you're not the only one asking that question. We gave A presentation to a group of 75, 85 family offices down in Texas late last year. And that was the first question, like, if this is real, you know, if this isn't just some brand new flash in the pan, why haven't we heard of it before? And this has been around since 1958. This has been around for a long time. It just really has been reinvented and really grown dramatically since the financial crisis. And Dodd Frank alongside the private credit market's growing. And so it's getting the attention of folks is hard when you're smaller platforms, but it's getting a lot more attention from family offices. It is getting more attention from university endowments. But again, there's just that scale issue that David touched on a little bit is just large check sizes. If you don't want to be more than 10% of a fund and you cut a minimum $50 million check or $25 million check, that just excludes a lot of the very large institutional LPs that get a lot of the attention.

That is a big problem. So investment offices that have the sophistic, the staff and sophistication to go do the work on the space generally cut larger checks. And then they don't see it as an opportunity. Smaller groups like myself, we're very time constrained. Trying to get a small investment office to go look at something new is difficult. But we at Davidson find, you know, that's our competitive advantage. You know, we're a smaller group. We're going to use our size to access interesting investments like these.

[Brett Palmer]

Would there be anything that keeps an emerging manager from utilizing this capital for their first couple of funds and then going off this capital as they get bigger?

[David Demeter]

People do that all the time, but a lot of funds, so you know, these are not rookies that are running these funds. And I think that's one of the things in the larger private equity and private credit space. When you look at smaller funds like, oh, you're just emerging, you're just starting out in your career. These are really established people that are professionalized at this level. And some of them have grown and some of them have grown to multi billion dollar platforms. But a lot of them actually just like this part of the market, you know, they really know this part of the market. They like having the choices they have in this part of the market. And so, you know, you can grow up. And there are certainly some funds that have grown so large that it just stops being a meaningful portion of them. And a number of the, for example, a number of the BDCs, the business development companies, started as SBICs like Main Street Capital, I think. I don't know, they're an $8 or $9 billion BDC and they still have a couple SBICs. But they started as, I think, a $50 million SBIC, and they took it and they grew. And there are a number of folks who have done that. Hercules Capital, big venture lender in Silicon Valley, similar, and there are others. But the program has grown both in the amount of institutional investment coming in as well as the leverage caps themselves. Now Congress controls those leverage caps. And one of the things I do that's kind of unusual in finance is I regularly talk to the government, whether it be the Treasury Department, the White House, the sba, the people writing laws in the House and Senate to help them understand private credit and private equity policy. And, you know, we're trying to work with them to raise some of these leverage caps to let the market, you know, really fill, because there's a lot more demand for slightly larger checks. And this program works very well. So I think we're going to be successful in getting that a little bit bigger and making it so that funds don't have to leave the program because it is so attractive to them and to the job creation across the country.

Generally speaking, I think the managers that enter the program send a great signal to LPs because they're willing to do the work to go get one of these licenses, but also that, you know, their fund growth is probably going to be a little bit more moderate than you would see outside of an sbic, because they want to keep that leverage relevant to their fund size.

[Brett Palmer]

There's a licensing process. How difficult is it to become an SBIC backed manager?

[David Demeter]

You have to have real experience and real successful experience investing in the strategy that you're going to pursue with the sba. So if you're going to form an SBIC license and you're going to be doing private credit, you've got to have private credit experience in a similar size. You can't say, hey, I've got private credit experience, I'm not going to go do venture capital. Not going to happen. They're looking at it from both the financial return standpoint to make sure that the taxpayer is protected, that these loans are paid back. But they're also looking at it from the reputational side. You know, if you've made lots of money, but you've left a trail of lawsuits and wreckage and companies going bankrupt behind you, they're not going to license you. It's just not going to happen. It doesn't mean, doesn't mean the companies can't go bankrupt, that you've invested before that happens or there can't be a lawsuit that happens. But if there's a negative pattern, they just don't want to deal with it and they're not going to. And so that is a limiting factor. It also takes some time, it takes the better part of a year for a first time fund to be able to do this. And it costs a lot of legal fees. We're trying to do some things to take those costs down a little bit, but it is a barrier. But that being said, we have currently north of 50 new platforms that are in the advanced stages of getting licensed right now. And at your average fund size of 200 to 300 some odd million, that's a pretty big number as far as what's coming on. And that's just already what's in the process, you know, in gone through the interviews, gone through the FBI background checks because that's the other thing from an LP perspective that's different. Not only have the LPs done the diligence and the fund managers and the government's done the diligence, the managers, they've actually run the applicants through the FBI to make sure, hey, are we good? You know, and if the answer is no, you're not getting a license. And so that gives a number of LPs an added layer of comfort in investing in this space. But it takes the better part of a year to get one of these things. But the return ultimately is very attractive. And once you've had one, the second and third and fourth and fifth and sixth and seventh licenses are moving much faster than they have in the past and now running around three or four months to get your follow on license.

[Brett Palmer]

What's the main reason that an otherwise qualified fund typically does not become eligible for SBIC funding?

[David Demeter]

There are a couple of reasons. One, some people just don't like the idea of working with the government and where the government's going to be a creditor, a lender to you. Two, a number of platforms like to invest internationally and you can't. So the investments you make via the SBIC, 100% of those businesses have to be primarily inside the United States. And so a number of funds will say hey we want to do 20% in Canada. Can't. You can do a parallel fund and do that, but that's just not an option. So when you're investing in these businesses, they have to be small enough to qualify. This isn't going to. If you're focusing on 20 to 25 million dollars EBITDA companies, it's just too big. And this is called the small business investment company program, not the medium or middle market business investment company program. So you have to be really focused on this part of the market. You have to be willing to invest exclusively inside the United States. Again, those businesses might have sales offices other parts of the world, but you have to have at least 50% of the employees inside the United States. And then you have some folks who just frankly have a lot more lawsuits on some ugly stuff that, that can be hindering. And so when they discover that, hey, they can't get, they might not get through because of some previous, you know, unpleasantries, we shall say they just don't go in. But I think the government aspect of it, the international aspect of it, the size aspect of it, and the deeper diligence is one that are things that sometimes steer people away.

[Brett Palmer]

Taking a step back, Davidson has a barbell approach to investing. Talk to me about the Davidson endowment investing strategy.

[David Demeter]

We invest a lot of endowments, but I'd say where we differ is we tend to have a larger hedge fund program Today that's about 35% of the endowment. And within that hedge fund program you tend to have. We tend to have a lot less market risk, a lot less beta, and a lot more, a lot lower cross correlation among funds that allows us to take a lot more risk. On the private side today, about a quarter of the endowment is in venture capital and another 20% is in other private illiquids like SBIC funds. We really want our capital on the private side to deliver, you know, high returns. We want all of those liquid commitments to compete for capital so we shoot so we can get the best returns. And, and like we said earlier, you know, there's a wider standard deviation of returns in the private markets. There's a much greater ability to add value there. And so we want to emphasize that.

[Brett Palmer]

So you also invest 25% into venture capital. Given that you have the SBIC part of your portfolio, why also invest in venture capital?

[David Demeter]

In venture capital, if you can, you know, through luck or skill pick the best funds, you will have the highest returns. It's the highest returning part of the private markets. On average, venture returns have typically equaled private equity returns over a long period of time. But there's a much greater, you know, tail, positive tail in venture capital where if you get in the best ones, it can be truly extraordinary returns.

[Brett Palmer]

And you mentioned 35% of your money is in hedge funds. That's a pretty high number. And hedge funds are these kind of black box instruments, at least to the outside world. Double click on some of the strategies in your hedge fund portfolio.

[David Demeter]

As a smaller investor, we have a little bit of an advantage investing in hedge funds. We can invest in smaller ones where there can typically be more alpha. About half of our capital and half of our relationships in the hedge fund book are with fundamental long short hedge funds. These are typically lower net funds with and higher gross exposure funds. Our goal across all of hedge funds is to hit something like a low double digit net return on a five year plus time horizon. If we can do that, we can keep up with long only public equity markets, I feel and do so with much more diversification, you know, providing liquidity in times of stress of the portfolio.

[Brett Palmer]

And why is there more diversification in these strategies?

[David Demeter]

Just because you emphasize stock picking and you get away from the market risk, you know, just keeping that net exposure low and you know, using your gross exposure to take on more idiosyncratic risk within long short. You're taking on idiosyncratic risks related to the individual companies that you're going long or short.

[Brett Palmer]

So you're, you're long part of the market or short part of the market. So what remains is manager skills.

[David Demeter]

Skill.

Yeah. And hopefully you picked right. We don't always do that, but the goal is to get the whole portfolio in that sort of low double digit net return area so we can, like I said, keep up with public markets in the long run so this diversification doesn't drag perform our long term performance down. And I failed to speak earlier, the other half of our hedge fund book tends to be more quantitative doing similar things, but in a more quantitative manner.

[Brett Palmer]

Talk to me about portfolio construction of quant strategies within your portfolio.

[David Demeter]

We tend to pick managers that are smaller that we can have a trusted relationship with and we do that across all asset classes. And that's a little tougher in the quantitative space. We, we've specifically looked at managers that are typically under 5 billion in a where we can have that better relationship. You know, we're never going to fully understand what all the algorithms are doing. We'll have some sense of it, have some logic behind it, but we're not there looking at the daily numbers or anything. We're trying to find really experienced professionals that we can trust and have open dialogue with where everything isn't just a black box.

[Brett Palmer]

Why do you think a lot of your peers and other endowments have much less allocation to hedge funds.

[David Demeter]

As your asset size increases, the number of different hedge funds you can access decreases and then you start getting into problems over, you know, how much are hedge fund fees capturing the alpha versus how much alpha is coming through in net returns. I think it's very difficult to run a hedge fund that's sort of 50 to 80% net long with a 2 and 20 or just a 20% performance fee and not have a lot of the alpha captured by the manager as opposed to the LPs. So you know, you typically see as AUM increases, hedge funds are also going to be going upper, going upmarket away from small and mid caps and you know, it just becomes a much tougher game.

[Brett Palmer]

Perhaps it's obvious, but why are small hedge funds more likely to outperform larger hedge funds?

[David Demeter]

Just a greater range of investment opportunities in small and mid cap stocks. It just becomes more unwieldy to deal with large amounts of capital in the manner I'm talking about with a high gross exposure. So it's, it's as much tougher game as you go up up market.

[Brett Palmer]

And there's more sophisticated competitors as well.

[David Demeter]

Oh totally. Yeah.

[Brett Palmer]

Brett and David, this has been a masterclass on SBIC funds. If a manager is considering adding SBA funding into their fund, what's the best resource for him or her to go.

[David Demeter]

To to find out more www.sbia.org small businessinvestoralliance.org we're the trade association that started that way. We're both GPs and LPs so if you have LPs that are looking to invest in these, we do a lot of matchmaking and help them find the funds that match their criteria as well as for funds that are thinking about forming an SBIC fund, whether it be a buyout fund, a mez fund, whatever structure they want to be. There's a lot of information on that website and we can also talk to them and help them get them pointed in the right direction.

[Brett Palmer]

David, any parting words?

[David Demeter]

Thanks for having us on. We really appreciate it. It's a topic that might be a little bit dry, but you know we love it and are always happy to talk about it.

[Brett Palmer]

We were joking that it's a special type of person that finds us very exciting and thankfully our audience is that person. So thank you for jumping on and look forward to sitting down in person soon.

[David Demeter]

Thank you David.

[Brett Palmer]

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