A (3:00)

Of EBITDA, it has to have roughly under 15 million in EBITDA, which could put the target companies at somewhere between a 75 to to 150 million kind of max valuation.

B (3:15)

Yeah, I'd say. So that's pretty fair. And you know, there's been a lot of different types of institutional investors over the years. Right. So historically, banks were the biggest supporters. I've had over 300 bank commitments on the SBIC's I've worked on. And that makes sense. Cause it's very clearly defined that SBIcs are, you know, in the banking regulations and regulatory framework. Banks continue to invest still, and many of them have created annual allocations now. So some of the largest banks in the country, like a bmo, Harris Bank, Truist, Wells Fargo, but also this program allows for the community and regional banks to invest on the same terms and conditions and still have the oversight of the sba. Outside of banks, we have insurance companies, of course, foundations. There's a few funded funds that have recently formed. And last but not least, David, I think, you know, a big thing we're starting to see is endowments. So there's a few that are invested and there's a lot that are considering the program, especially over time. And now with the performance data available, University of Michigan is a, is a significant limited partner in many SBIcs, but they have a very narrow lens of, you know, what they're interested in for their mandate. And it's really in the private credit side where they'll come into an SBIC. They're probably the largest LP in those funds, but they're only looking at maybe 10 or 20% of the GPs that are out there. On the other hand, David, you interviewed Dave Demeter of Davidson College, and he's also a big LP in this space. Even though it's a smaller endowment. He's, he's super active and has a different mandate. So I would guess there's probably no crossover between what University of Michigan and Davidson are in, even though they're both looking at this program. The first and most obvious thing is the return returns. And once they've seen that themselves and can and have, you know, had the chance of diligence, not just the space, but the specific gps, I think that's really played out. You look at the Institute of Private Capital's numbers and SBA numbers, and they largely beat private credit and private equity outside of this program. I think the better question is how are they able to do it on a small scale? Because it's not as big as some of these other funds. And, you know, I think that's where the bottleneck is, because you have to have the teams like a Davidson, like a Michigan, that are not necessarily doing everything through consultants.

C (5:40)

Right.

B (5:40)

They're doing it on their own, searching out their own opportunities, and probably have a little bit greater flexibility.

A (5:46)

Tell me if this is too reductionary, but the LPs are able to access these returns typically because there's leverage at a low cost for the underlying funds. So they're able to get maybe similar unlevered returns. But levered against the SBA grants, against the SBA investments, it becomes a better performing asset.

B (6:10)

Yeah, absolutely. I mean, you can look at the underlying, right, and what they're investing in. You know, lower middle market, a lot of opportunities, a lot of work to be done, but they're generating, you know, mid teens or low 20s type IRRs. You effectively use the SBA capital and in most cases the net ends up higher than the gross. You know, people think of leverage, they think about risk, and if it can go this way, it can go the other way. And that's where I come back. I really look at SBA as more of a special limited partner. They're not trying to take over your companies. They're providing capital at the fund level rather than individual portfolio company levels. And that capital allows for a larger team, a larger investment size, you know, larger companies that they can go after instead of doing all sort of startup type things, even though these are small businesses. And I think that the SBA capital not only enhances the return, but does also reduce the risk at the portfolio level.

A (7:09)

SBIC funds as a category has grown massively over the last decade. Why has it grown so much?

B (7:17)

Yeah, that's a great question. It has grown a lot and it's become much more appealing. I think a couple things, some of the restrictions and regulations were amended over the years. A couple I'd point to is raising the family of funds limitation that allowed, you know, what happened was a lot of the better performing SBIC's would then outgrow the program and go raise a traditional institutional fund because they were limited raising fund. The next subsequent fund, many of them are back because that got raised to 350 and there's even talk of it going up again. Similarly, another big change that I think happened was the maximum allowable leverage per fund was increased from 150 million to 175 which allowed for slightly larger funds, allowed you to grow your fund. You know, 10 years ago these SBIC's were like 100 million to 225 of total capital. And now most funds I'm seeing are 150 on the low end to 350 million. You know, maybe a few that are larger. When you have a larger fund it allows for more institutional capital to come in based on their limitations and sort of what they're trying to put to work. And I've really seen it as a big blessing for this SBIC program. I hope that continues.

A (8:32)

One thing that really surprised me when we were last chatting is that you have large platforms setting up SBIC funds as one of their strategies. Tell me about that and what's a good example of that.

B (8:44)

We've seen that a lot and that's really been over the last five or ten years in my opinion. A great example. I raised capital for Oaktree Capital's first SBIC license. I mean incredibly experienced middle market finance team that they wanted to have a vehicle where they could finance these smaller businesses. The deals they saw lots of attractive opportunities lending to companies that would fit within the SPIC program, both size and geography. Right. But really hard to do when you have a multi billion dollar fund that the team manages. But a tremendous opportunity at sub $300 million SBIC. Other large asset management firms too. You've seen like Barings Energy Impact Partners, they've come out and raised SBIC's specifically for their private credit strategies. I think that's going to continue especially as the SBIC program has really, as you mentioned, evolved and grown. And now you're even seeing sort of the entire lifeline of a small business from starting at venture capital type SPIC are now available. Totally different than what we'd seen, you know, the past 15 or so years.

A (9:53)

When we chatted the very first time. What I loved about our conversation is you are plowing your own money into the same asset class that you work in. Tell me about your own personal investments into SBIC funds.

B (10:07)

Absolutely. You know, I know the people who are involved and I've received, I've seen the returns firsthand. You Know, before the performance data and everything came out, I witnessed this and seen it. You know, I see who wins the deals, I know who I want to avoid. You know, those are kind of all the key elements to making investments. And I've been in an LP in 10 funds and I'm looking to add more in the end of this year and into 26.

A (10:32)

Les Baccaran, who runs Alpine, one of the top kind of placement agents in the world. He talks about this unique vantage point where he gets to make a decision on whether to invest after he sees hundreds of different slices and dices of the diligence. It's this really underrated vantage point from which to make investment.

B (10:52)

Of course, of course. And spending time with the managers, you.

A (10:54)

Know, and also seeing how they react to the diligence questions, whether they're thoughtful, whether they're honest people, fundamentally kind of being on their side gives an interesting vantage point.

B (11:05)

For sure, for sure.

A (11:07)

So when you invest your own money, what are you looking for when it comes to SBIC funds?

B (11:15)

That's a good question. And I'll break it down a couple ways because one is when we invest our own money, but then also groups we'd want to work with.

C (11:22)

Right.

B (11:22)

So it's going to vary on that because not all the investors have the same interests and risk perceptions and tolerances. So for example, David, like some funds we've raised are solely marketed to banks because it helps them meet their community Reinvestment act needs in specific markets and is well aligned with that and other funds only had one or two banks as investors.

C (11:43)

Right.

B (11:44)

But in all the cases it always comes back down to who is the team, the GP team that's managing it. As you know, most SBIC's are either smaller firms or smaller teams at a large firm. And then it really comes down to them because they're the ones who are sourcing the investments, the opportunities to invest, they're performing diligence and then most importantly they're helping the companies execute on their game plan.

C (12:07)

Right.

B (12:09)

For me and at amplify what we focus on, we have three kind of core requirements. Number one, alignment, two, integrity and three, wisdom. Fairly straightforward, but it all comes from our experience. You know, you learn from both great and poor experiences. So we've put alignment number one. I think that's critical. Even with the guardrails of the sba, oversight and annual audits etc, really being aligned with the GP is important. Integrity, you know, this is about trust. You're making a long term commitment and you're, you know, Believing in a team that they're going to execute their strategy over a long period of time and obviously work together, stay together. You know, I look at their backgrounds, check the Internet, things like broker, check what is their reputation, you know, do your diligence, right, you're going to be committed for a long time. And then last is wisdom, of course, like what have we learned from our experiences, what is being marketed and told versus what we've personally seen in the last eight, 18 plus years of evaluating SBICs and you know, with the goal of like let's not make the same mistakes again, right. When we drill down further and are going to commit capital, right, for our own account, we're really looking at SBIcs that have a expectation to beat the median returns. You know, I think on your prior podcast it was 16 point, 16.9% net IRR and 2.3 times net multiple of invested capital. To get compensated for that sort of long term commitment with our capital, we want to see a track record that not only beats that, but the expectation that they're going to generate 2 1/2 times net multiple invested capital or greater. And look, I'd be super happy with the median performance, right. Those numbers beat what you'd regular see produced. But we believe in our, in this space we can get access to the top performing managers, so we think we can beat that.

A (14:02)

Said another way, just because it's an SBIC fund, the rules of private equity or private credit do not change. You're looking for the same thing, track record, team references, all the same things. It's just here it's a favorable structure from what you're investing in.

B (14:17)

Absolutely, yeah. And I feel a bit more protected with the SBA involved and maybe that's my proximity to them and having seen it over the years. But their diligence is unmatched and they don't let things slide by and they've done a really, really good job of, you know, I think that's why the programs perform so well.

A (14:36)

Tell me, exactly what is the SBA looking for? Outside of the criteria around the companies, what are they looking for in the team of a potential SBIC fund?

B (14:46)

That's a great question. And I get this one a lot from people, you know, especially as the program is expanded for venture capital, private credit and private equity strategies, it still goes back to the management team qualifications being generally the same. SBA wants to see a relevant and recent track record, you know, investing in the types of businesses you're proposing to do and the structures you're Proposing right. Then not only qualify as SBIC eligible, but fit that strategy basically. You know, I don't know if there's a bright line, but they're going to want to see at least eight investments for the team, probably four or more exits as a minimum, which you probably need anyway to get validation from the private markets. SBA is going to value the team, the structure, the economics. They highly believe in alignment as well. So they're going to want to see, you know, the GP getting the carried interest and being committed for the life of the fund. Their SBA is also going to look at the ability to raise capital, right? They've got to spend their time, they've got to put them through the licensing process. So they're going to want to know how do you raise that initial capital to get license, but then ultimately the entire fundraise, right. How are you going to get to your targets? This isn't one of those programs you're going to sneak in or buy an old license. Like they're incredibly diligent. The level and the rigor of the diligence is like unmatched. You've got FBI background checks, 25 references from each partner that can't overlap. Full disclosure and transparency around like work and legal history. It's really, really extensive. And it takes at least six months, probably a year or more for most GPs. So you've got to be really committed to get through this approval process. And look, that said, SBA only does so much, then it's a public private partnership. So unless you get the private sector to step up and validate by making commitments, you know, the license never happens.

A (16:43)

So how does a venture fund go about accessing SBIC money?

B (16:48)

The Biden administration set up a new license within the SBIC program called the accrual debenture license. This was a direct response for sort of the capital gap in venture capital and also growth equity within the traditional standard debenture. Sbic, you know, as it's now called, very creative and compelling for LPs. And this also allows GPS to scale and provide more inpatient capital, you know, to the small businesses they're investing in. David, I raised capital for the very first one, okay. Is the first accrual licensee is a group called Pelion Ventures out of Salt Lake City, Utah. Team has an amazing record, track record. They've been investing and creating jobs supporting the venture capital ecosystem in Utah and know in other markets as well. But their kind of hook is that they're the largest VC fund in Utah. And this Most recent fund date was 500 million. And you'll find this interesting. So there's a traditional unlevered fund that a lot of institutional investors went in. And then there's the parallel accrual sbic. Right, and the accrual sbic. Of course banks can invest, but so could other investors. They're going into the same companies, same securities. But the accrual SBIC can access up to 175 million from the SBA, discounted to about, let's call it 125 million because that's how the accrual debenture works. And look, I understand why people invest with that firm, but I can understand why you would not do the accrual if you had the opportunity. So I think there's more education that needs to happen there. But you're seeing a lot of these venture firms now sniffing around the program and getting licensed.

A (18:30)

Double click on that. Because I was wondering the same thing, which is you have these parallel funds. Is that just the fund meeting their LPs, where they are from, a kind of how they're thinking about investing in venture? Because it would seem that those institutional investors would also want to be levered if they really understood the leverage.

B (18:47)

I wonder, and I ask a lot of the investors themselves. I think you have a couple of things going on. One, the institutional investment consultant community is not going to look at the SBIC levered vehicle. Hopefully that changes here in the near future, but historically it hasn't. So the folks that are using consultants are generally going in the other fund. And then of course, you know, different investment policies around leverage and SBA being a kind of a different version of leverage. You know, you don't really distinguish between that and their investment policy.

A (19:20)

You mentioned eight investments, four exits AKA four companies, was with some sort of dpi. Could that be done at a previous firm? Does this work for spin outs or this is just kind of a fund to fund three phenomenon?

B (19:34)

No, that's a great question. Yeah, a lot of spin outs actually. In fact, that's where some of the best groups came from initially. And let me maybe take you back through time a little bit, David. So like when I started doing this over 15 years ago, you could get through as a first time fund manager, you know, a small team, maybe two or three partners, very limited track record even as a fundless sponsor. But if you could raise 20 million of private capital commitments and target the right size businesses that are in the US you could probably get approved. Today, I think the bar has risen and you'll rarely, rarely see a GPU with less than three partners, right. Probably more. An extensive track record. Even first time fund managers, right, coming out of their old shop or bank or wherever they worked. And the majority that I've seen now need to close on at least 30 million of private capital to get through that final licensing step.

C (20:31)

Right?

B (20:32)

So that can be really difficult. It used to be 20 million or less. Now you've got like LP considerations where they only want to be so much of a fund as a percentage or they don't want to go into a first close, which creates sort of a chicken and the egg, right? Cause you need the first close to get the license issue. And I'll tell you the reason why all that. I think, I think it's positive, right? This is SBA's sort of reaction. About 10 years ago there was a study done that showed SBIC's that raised less than 25 million of private capital were six times more likely to go into the office of Liquidation. Because which is obviously a bad outcome. Doesn't mean that they didn't get all the money back. It just means now SBA is kind of directing how you're going to operate. And so that's not good. SBA adjusted based on those numbers and now they want to see a higher first close. So you're seeing much larger first closings. And to do that you need the support of either your prior LPs or a really great story or some sort of anchor coming out for fund one.

A (21:33)

So in another way, one thing that GPS might want to consider is adding the ability to take SBIC money into their original LPA so that they have that optionality after the first close.

B (21:46)

Oh yeah, definitely, definitely.

A (21:48)

Are those things that are typically baked into LPAs or is this like some special provisions that people typically have to add?

B (21:55)

Great question. You know, it's funny to me, I see non SBIC funds and the LPAs can kind of be all over the place. Place one of the benefits of this program is it's the SBA's program, so they'll accept changes and modifications and stuff, but they have created a standard LPA that you kind of can navigate away from. But most things are, you know, pretty standard across SBIC. Typically 150 million to 500 million per fund, you know, depending on the team and strategy. I think I mentioned earlier, most SBIcs as we've seen over the recent years, you're going to see kind of 250 to 350 for those top performing GPs who have the Ability to attract institutional capital.

C (22:36)

Right.

B (22:38)

And you know, funds under 500 million. That's really the opportunity set because it's largely been ignored by the institutional investment consultants. And the nice thing is it creates the opportunity, but it's also constrained sort of the acceptance among the broader institutional investor universe. You know, that could change. Recently SBA put out their report that benchmarked against Cambridge data for both private credit and private equity. And of course we mentioned the Institute for Private Capital's study. As that information continues to come out, I think it'll be helpful. But at some point the data is too much to deny and hopefully there will be certain consultants that say, look, we want to find the best risk adjusted returns for our clients. You know, so I think that's, that's one component. The other thing is you're seeing, as you mentioned, larger firms, David, a lot of the firms I've worked with will have a sort of a flagship or larger fund that's a billion dollars plus of committed capital. But they can't do that into SBIC eligible businesses and sort of the relevant time frame. So it creates a nice opportunity. And I like that dynamic because you've got the institutional resources and support and processes of the firm and you can bring that to the lower middle market businesses through this sbic. So not many groups I see these days raise an SBIC and then go away from it. That usually is in addition to their, you know, offerings.

A (24:01)

And I know there's some legislative efforts underway to try to increase the amount that SBIC funds can invest. Tell me about that.

B (24:12)

Yeah, very exciting stuff here. It's been a minute, but you know, there's a number of conversations going in dc. The one I'd focus on the most is Investing in All of America Act. I know there's a number of other conversations, but this seems most relevant to me and for a couple of reasons. One, they have a potential inflation adjustment for the leverage. So for the standard SBIC program that happened over seven years ago for accrual, that's a new program. So not part of the proposal, but the most recent proposal I heard would increase the amount of leverage per SBIC to go from 175 to 250. Okay. And as a family of funds, remember FGI is outstanding across prior funds up to 475. The last time this number these numbers were increased, it helped not only retain but also attract some of what I consider the top gps today. You know, I expect it would have a very similar effect this time around as well. And Then you know, also interesting, but not as you know, I think that could be one of the biggest changes ever to the program. Another interesting thing, there's a proposal for bonus leverage. If an SBIC can invest in rural and low income areas or manufacturing companies or national security related sectors, you know, that's the one thing where you'll see the federal government trying to help direct where capital can go. But they're doing it through bonus, not through requirements of the initial mandate.

A (25:36)

I totally buy the thesis that the increase in amount of the funds will not only increase the amount that current GPs are raising, it'll also just completely change the dynamics of who's looking at this program. The bigger the number. It's kind of has this like exponential effect versus a linear effect. We saw similar effect in the early stages in crowdfunding when it went from 1 to 5 million it didn't just go up by 5 times. But now companies that would never had, you know, that would never have dealt with the regulatory pains of raising a million dollars. Suddenly at 5 million it became more worthwhile. So I think we would see the steps improvement.

B (26:15)

And as long as you're still targeting the small businesses and it fits, I mean it makes a lot of sense. You know, many of these groups utilize a lot of co investment so you've got to have partners that are willing to do the co investment or you put the opportunity at risk. You know, still staying below 500 million of a fund size, you can do really well in this lower middle market and have the room for growth if that's what your strategy is.

A (26:39)

What are some investing mistakes that you made as an LP in these funds early on that you've since corrected.

B (26:46)

The first thing is, you know, I backed the wrong manager through their first fund when they realized their goal is really how do we get to fund two that's going to be larger and have more management fees, etc. You know, as a result we'd still consider first time SBIC. Fund managers understand the dynamic but, but our strong preferences for Fund 2 or later and some of the things they can learn about the nuances of the program. I took on a few groups that were coming together for like the first time that now I wouldn't do again or for their next fund even if the returns were decent. But it worked out right. I think the other big thing, and this is probably most important, is the licensing process and understanding the timeline to get approved by the SBA. There were two SBIC's I was working with that had a plan in Place thought they were going to raise the money, they were getting leverage. By the time they got through the SBA process, they were getting significantly less leverage than the plan was initially. And you know, that changes the deal not just overall, but two LPs, right. So had to kind of relook at that look that seems to be more in the past. SBA last year put in a new process that speeds things up and they are hitting all time record high numbers when you include the venture funds. So it's really hard to argue is massive success of the program. And I think there's a lot of room, you know, to grow and achieve outstanding returns through investing in, you know, American small businesses.

A (28:14)

Where do GPs that raise capital from SBIC go wrong? Are there certain strategies that should not be borrowing this type of money and getting this interest rate capital?

B (28:26)

Where do they go wrong? Well, one, you've got to get through the SBA's process. So the strategy and all that's going to be thoroughly assessed.

C (28:35)

Right.

B (28:35)

So by the time you get there, you're probably a fit. I think the issue, I would say where they go wrong is trying to fit something into the program that's not so. Now that there's a venture program, growth equity program, you're going to see those in the accrual debenture rather than a standard debenture where it doesn't match up the cash flow timing of things.

A (28:55)

So you've been in the space for 18 years, which is significant amount of time, especially versus the average person. You've seen this industry really grow. What one piece of advice would you have given Eric 18 years ago, right before you started in the SBA, in the SBIC.

B (29:14)

Wow, great question. Definitely the leadership in the team, definitely at the top. Their ability to create, to produce those returns again that were in the track record and really understand the dynamic. Who's sourcing the opportunities, how do they work together? That's helped me find the best, the best performers.

C (29:36)

Right.

B (29:36)

And then also think about who I might avoid. The other thing I would say is people that are willing to take the win and move on.

C (29:46)

Right.

B (29:47)

Some of these funds you see hanging out way too long. And I feel that the people that have more of a process and kind of get through it faster in a more reasonable timeframe on the portfolio, companies have grown much more and done a lot better.

A (30:02)

It's interesting because there's this positive correlation and how long somebody has been in the industry and how successful and how far up they've climbed to the probability of them seeing team and culture. It scales very well. If you ask like a CEO of a 10 billion dollar asset manager, the odds of them saying something around people versus about trades or even process is highly likely. So it's something that it's almost like this consensus view that people come to over many decades.

B (30:33)

Well, especially over time. And you see and you what stands out in your mind is the example of what didn't work and what really worked well, right?

A (30:42)

Yeah, absolutely. Well, Eric, this has been the masterclass on SBIC Funds. Appreciate you jumping on the podcast. Look forward to continuing this conversation live.

B (30:50)

Likewise. Thanks a lot David. Appreciate it.

A (30:52)

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