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.
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