The question over who should pay for the SBA is something of a proxy for a long-standing debate over whether it should exist at all. Free-market conservatives make no secret of their disdain for the agency; in the 1980s, the Reagan administration tried to kill it outright. The argument goes like this: The notion that small businesses lack access to capital is largely a myth. While it may be true that "minority firm owners are less likely to have bank loans of any kind, they have easy access to transaction loans from nonbanks," Veronique de Rugy of the American Enterprise Institute wrote in a paper last year. "Bank loans represent only one of many ways to acquire credit." At most, she suggests, citing research from 1988, perhaps 2 percent of businesses have been unfairly denied credit, and another 4 percent have been discouraged altogether. In any case, she suggests, the SBA's role in the American economy is statistically insignificant--less than 1 percent of all businesses receive SBA loans each year--yet constitutes unfair competition to businesses that don't need such help and a potentially huge liability to taxpayers should the economy tank. (Because losses in guaranteed lending are relatively low--just 6 percent over 50 years--it's tough to call it a huge liability at the moment.)
The problem with this proposition, from a political standpoint anyway, is that despite the SBA's past failings, and the evident hypocrisy in Washington, the ribbon cuttings the agency delivers to congressional districts around the country make it enormously popular on Capitol Hill. However sympathetic Bush officials may be in private to De Rugy's thinking, they've had the sense not to publicly propose eliminating the SBA. In this light, the zero-subsidy faction appears to tread a fine line between conservative principles and a popular program. What is striking is the willingness in Congress, even among some Democrats, to go along.
One consequence has been the curtailment of a particularly influential program, one that targets early-stage companies. In 2004 the SBA stopped licensing so-called "participating security" Small Business Investment Companies, venture funds that use SBA-backed leverage to make equity investments typically up to $5 million each. SBICs have been around since the Small Business Investment Act became law nearly 50 years ago--in fact, they're the forerunners of modern venture capital. Participating security SBICs, created by Congress in the early 1990s, defer interest payments until their investments mature, correcting a flaw in the program that forced successful funds to limit their investments to businesses generating cash flow. They also distribute 10 percent of their profits to the government. Through last year, these SBICs had borrowed $8.4 billion in government-backed leverage to invest $11.6 billion in young growth companies.
Through 2000, according to the SBA, SBICs had performed competitively when compared with conventional venture funds. But the whole venture industry suffered with the dot-com crash. It also became apparent that profitsharing didn't compensate for a deal structure that benefited the private investors at the government's expense--a lot of SBICs made big profits even as the SBA lost money on its investment. The SBA projects the program will ultimately cost the Treasury $2.4 billion. Of course, venture investment is cyclical, and as the market has rebounded, so have the SBICs. As of last June, less than 2 percent of active participating security SBICs had losses high enough to be considered "impaired," compared with 20 percent a few years ago. Indeed, since 2005 the subsidy forecast has actually improved by $300 million. Yet by shuttering the program as the market hit bottom and forgoing the possibility of future profits, the government, as Lee Mercer, president of the National Association of Small Business Investment Companies, puts it, "has decided to lock in its losses."
VCs, too, have lately retreated from early-stage financing. Of the roughly $25 billion in venture capital raised in 2006, only about $5 billion went to businesses under development or just beginning operation, according to separate surveys by Dow Jones (NYSE:DJ) and PricewaterhouseCoopers. Nearly a third of that, $1.5 billion, came from participating security SBICs. These SBICs tend to invest in sectors that VCs often ignore (like manufacturing), and they spread the wealth to the far corners of the U.S. The $21 million in participating security funds invested in Virginia businesses constitutes nearly 6 percent of all seed and early-stage funding in the state last year. "There are very few early-stage funds active in Virginia now," says Thomas Dann, managing director of ECentury Capital Partners, an SBIC in McLean. The program's demise, he adds, "is going to impact deal flow for later-stage funds."
The traditional SBIC program limps on, and existing participating security funds will continue to make investments for another couple of years. Still, by closing the program to new funds, the SBA, by its own admission, has "removed the primary method by which [it] can provide access for small businesses to equity capital." Legislators from both parties have proposed reforming the program to make it more palatable to a risk-averse executive branch, including a more generous profit-sharing arrangement. Under this plan, says Mercer, "the only way the government could lose money is if it invested only in the worst performing funds." The SBA, however, disagrees. "We looked very hard at different structures for a new participating securities program, but it would have been prohibitively expensive for us to put that capital out there," says SBA administrator Steven Preston. "And models that would've enabled us to meet this zero-subsidy standard weren't models that were attractive to the industry."
It remains to be seen whether the zero-subsidy dynamic will remain in place with the Democrats in charge on Capitol Hill. For its part, the SBA, under Preston, has adjusted its priorities. Rather than eliminating the microloan program, for instance, Preston's 2008 budget request proposes raising interest rates to the intermediaries and offloading the technical assistance to partners that already provide training. It would not provide them with any additional money, however, and most have been flat-funded for years.
