The Sunshine Report

In my post­ing last Fri­day with Mark Sun­shine, TARP Isn’t Work­ing For Small Busi­nesses; Two Sim­ple Solu­tions For Small Busi­ness Lend­ing, we dis­cussed the severe fund­ing stresses being faced by small and medium sized busi­ness enter­prises (“SMEs”). Unfor­tu­nately, most of the gov­ern­ment aid announced to date does not help in deploy­ing cap­i­tal to SMEs any faster. In par­tic­u­lar, the non-bank lend­ing sec­tor is shrink­ing dra­mat­i­cally as their lever­age lines get pulled and other cap­i­tal dries up, which is bad because these pri­vate finance com­pa­nies and other lend­ing sources have tra­di­tion­ally been the source of a sig­nif­i­cant por­tion of SME fund­ing. SME’s, of course, are the well­spring for north­ward of 75% of the jobs that are cre­ated in this coun­try, so help­ing SMEs is crit­i­cal to national recov­ery.

In our post­ing last week, we sug­gested mod­i­fy­ing tax rules and amend­ing the mutual fund rules to attract and free up cap­i­tal for senior secured SME loans. A third idea, dis­cussed below, involves the government’s mak­ing direct equity or pre­ferred equity invest­ments in pri­vately man­aged loan funds, which would use this money to make new senior, junior and mez­za­nine loans to SMEs. This would not be gov­ern­ment aid, down the sink­hole, but gov­ern­ment invest­ment, achiev­ing mar­ket returns on cap­i­tal to the ben­e­fit of all Amer­i­cans, while also cre­at­ing long term jobs, help­ing sta­bi­lize the econ­omy and encour­ag­ing more pri­vate invest­ment. Addi­tion­ally, the invest­ment of Fed­eral monies as equity in smaller, SME-oriented loan funds would bet­ter enable those funds to attract cur­rently frozen pri­vate cap­i­tal, through the reas­sur­ance of gov­ern­ment reg­u­la­tion, decreased risk of fraud and com­mu­nity of inter­ests due to the invest­ment of Fed­eral funds along­side pri­vate cap­i­tal, not above it.

Mod­els for this type of pro­gram have existed in gov­ern­ment for decades, at the SBA, OPIC and a host of com­mu­nity rede­vel­op­ment invest­ment pro­grams. The prob­lem has been that they take years to obtain approval – time that we do not have – and these pro­grams typ­i­cally involve the gov­ern­ment inject­ing debt or debt guar­an­tees rather than equity into these invest­ment funds (e.g., SBICs). Market-appropriate struc­tur­ing of the government’s equity par­tic­i­pa­tion would enable stream­lined approval processes for Fed­eral invest­ment. Cus­tom­ary fund struc­tural fea­tures, that have worked for decades at pro­tect­ing pri­vate investor cap­i­tal, would do the same for the government’s money, and incen­tivize a prof­itable out­come (some­thing we prob­a­bly will not see from most of the TARP invest­ments).

Fund man­agers, who would be required to have some of their own cap­i­tal at risk (as is almost uni­ver­sal with pri­vate funds of this sort), would charge a man­age­ment fee, but most of their expected com­pen­sa­tion would be based on the suc­cess of their invest­ments, i.e., for every dol­lar of real­ized profit on the government’s equity invest­ment (and of other pri­vate investors par­tic­i­pat­ing in the vehi­cle), the man­ager would earn a twenty per­cent per­for­mance fee, per­haps above a pre­ferred return hur­dle rate. In order to min­i­mize expo­sure to inex­pe­ri­enced man­agers, this pro­gram would only be open to man­agers for their sec­ond (or later) fund­ing pool, with at least three years’ expe­ri­ence run­ning invest­ment vehi­cles of sim­i­lar invest­ment objec­tives, and their prior fund(s) would have to have been audited by a major audit­ing firm and received clean opin­ions. The government’s equity con­tri­bu­tion, together with privately-sourced equity con­tributed to that fund, would be capped at an amount equal to twice the equity level of the largest of their pre­vi­ous funds, capped at $200 Mil­lion per fund man­ager, to ensure that they can effi­ciently and quickly deploy the cap­i­tal to SMEs for growth (after all, the whole pur­pose of this pro­gram is to effi­ciently deploy cap­i­tal as quickly as pos­si­ble, to obtain fis­cal stim­u­lus NOW, within the next 6–12 months). Fur­ther to that point, the government’s equity would only be draw­able for twelve months from com­mit­ment, renew­able at the government’s option (pri­vate funds typ­i­cally allow an invest­ment period that is any­where from two to three years – the point here is that, within rea­son, we need the cap­i­tal deployed quickly).

This pro­gram could either be admin­is­tered out of the SBA, which has rel­e­vant expe­ri­ence in these mat­ters but is hope­lessly under­manned to move quickly, or by the Trea­sury Depart­ment, in either case employ­ing third party invest­ment con­sult­ing firms with rel­e­vant domain exper­tise,
work­ing off an expe­dited set of approval cri­te­ria. With this pro­gram, applied with urgency and using pri­vate indus­try deci­sion processes, money could be flow­ing to SMEs within three months of final­iza­tion of the plan.

No sin­gle magic bul­let will solve our finan­cial cri­sis. This SME pro­posal, though, would more than carry its weight in cre­at­ing long term jobs quickly.

Click here for Rob Blum’s bio.