Small Business Investment Companies Research Articles

When Do Firms Risk Shift? Evidence from Venture Capital

This paper studies the agency costs of debt and the role of risk shifting as firms face financial distress. The Small Business Investment Company (SBIC) program is a novel setting to evaluate the importance of these costs. It provides participating venture capital funds with debt financing from the U.S. government at a negligible premium to the 10-year Treasury Note. Economic mechanisms that might prevent risk shifting, such as covenants and reputation concerns, are primarily not present in this program. Using a difference-in-differences setting, I find that managers of distressed funds invest in firms with lower sales, employment and patenting activity, and are more likely to use equity investments. Distressed funds reallocate capital to riskier firms in their portfolio, rather than searching for new investments. Equityholders respond positively to riskier investments for distressed funds and debtholder losses increase, consistent with the prediction that risk shifting transfers wealth from bondholders to equityholders.

Hibernia Corp.

AbstractCommercial Banking (MIC: 8.1 SIC: 6021 NAIC:522110)Hibernia is a bank holding company headquartered in Louisiana. As of June 30 2003, Co. had assets of $17.92 billion and 263 locations in 34 Louisiana parishes, 17 Texas counties and two Mississippi counties. Co. conducts its business through its sole depository institution subsidiary, Hibernia National Bank. In addition, Co. also owns Hibernia Capital, which is licensed as a small business investment company and provides private equity investments to small businesses. Co. offers financial products and services, including retail, small business, commercial, international, mortgage and private banking; leasing; investment banking; corporate finance; treasury management; and insurance.

Response to August 2000 Forum Article by Timothy Bates on Financing for the Development of Urban Minority Communities

Tim Bates focuses on the poor performance of Minority Enterprise Small Business Investment Companies (MESBICS) in the 1987-to-1994 period as a basis for criticizing the U.S. Small Business Administration (SBA), the Community Development Financial Institutions Fund, New Market Venture Capital, and other federal efforts at promoting capital formation in the inner city. MESBICS did indeed fail during that period, but so did a number of conventional Small Business Investment Companies (SBICs)—and mostly for the same reasons. The SBA made sweeping program changes in 1994 and 1995 that significantly improved the SBIC industry performance and dramatically increased participation of inner-city entrepreneurs. The SBA’s job is not to mitigate risk by avoiding financing gaps, but to take the risk that the private sector cannot or will not take—and develop effective ways to manage it. The process is necessarily iterative, and the key questions are as follows: What are the impediments we face now, and how do we overcome them?

FORUM: Introduction

Government intervention in financial markets seeks to alter capital availability patterns that disadvantage minorities and low-income people. The desire to increase access to credit for these underserved groups motivated President Clinton to launch the Community Development Financial Institution (CDFI) program. In fact, CDFI-like institutions proliferated in the late 1960s, and many of them still exist. The Minority Enterprise Small Business Investment Company (MESBIC) program, started in 1969, created several hundred privately owned firms that finance inner city-situated and/or minority-owned small businesses. This study uses U.S. Small Business Administration records to analyze the impacts of actual MESBIC investments in small businesses. Strategies used by MESBICs that actively financed minority business enterprises are identified, and the traits of effective MESBICs are contrasted to traits of those that have shut down. Nearly 100 MESBICs remain active today, and the track record of the program over the past 30 years offers a wealth of insights to present-day proponents of CDFIs.

Rejoinder to Charles D. Tansey: Moving Toward a More Effective Small Business Administration

Former Small Business Administration (SBA) Deputy Administrator Charles Tansey defends the SBA’s record, countering criticisms appearing in the author’s August 2000 Economic Development Quarterly article. He defends the venture capital incentives contained in the SBA’s New Market Venture Capital program. Yet these incentives are based on a debenture financing scheme that failed when used previously to support venture capital investing in the SBA’s Small Business Investment Company program. Tansey defends the SBA’s record of expanding loan guarantees to minority business borrowers in the 1990s. These guarantees, however, have increasingly flowed to high-net-worth Asian immigrant borrowers rather than the minority groups most prone to have limited access to financing. The SBA is wedded to outdated strategies and concepts that have lost their applicability to 21st-century problems. A pragmatic rethinking of the agency’s financing mission is overdue.

Public Subsidies and the Role of Suburbanization in Urban Economic Development: A Reply to Timothy Bates

This article commends Professor Bates’s analysis of the Minority Enterprise Small Business Investment Company (MESBIC) program, acknowledging its important object lessons: that size, excellent management talent, and effective cost and risk containment are critical to MESBIC success. I challenge, however, Professor Bates’s implicit indictment of the Clinton administration’s signature community development initiatives. The article argues that such community development investments are justified and should be understood as a small but important component of an overall strategy to connect economically marginal communities and the citizens who live there to the regional economy. More important, this article argues that the next wave of community development strategies sponsored by federal and state government ought to squarely address issues of regional inequity, avoiding subsidization of rapid suburbanization in a manner that exacerbates interjurisdictional disparities of tax-base wealth and of citizen opportunity.

Financing the Development of Urban Minority Communities: Lessons of History

Government intervention in financial markets seeks to alter capital availability patterns that disadvantage minorities and low-income people. The desire to increase access to credit for these underserved groups motivated President Clinton to launch the Community Development Financial Institution (CDFI) program. In fact, CDFI-like institutions proliferated in the late 1960s, and many of them still exist. The Minority Enterprise Small Business Investment Company (MESBIC) program, started in 1969, created several hundred privately owned firms that finance inner city-situated and/or minority-owned small businesses. This study uses U.S. Small Business Administration records to analyze the impacts of actual MESBIC investments in small businesses. Strategies used by MESBICs that actively financed minority business enterprises are identified, and the traits of effective MESBICs are contrasted to traits of those that have shut down. Nearly 100 MESBICs remain active today, and the track record of the program over the past 30 years offers a wealth of insights to present-day proponents of CDFIs.

Hidden Treasure

A veil of mystery still often surrounds private equity as an asset class. After having defined what constitutes a private equity investment, the authors trace the origins of the asset class - venture capital, as it is known today, how it got its start with the authorization of small business investment companies in 1958 - and its evolution through several cycles and significant market events. They discuss the mechanics of private equity partnerships and the performance record of the asset class as a whole. An important element of private equity investment is also identified: their relative tax-efficiency, as returns tend to be predominantly long-term in nature and thus exposed to lower rates of taxation. The authors conclude with the suggestion that individual investors should find private equity investments attractive, if they can deal with their relative illiquidity.

Small Business Investment Companies

Small Business Investment Companies

Venture Funders — Are They the Solution?

The author briefly describes what venture funders do and how they do it to illuminate the process of high-tech business formation and development. By way of illumination, he gives two short histories of successful university spin-outs that his company, Zero Stage Capital, has helped launch. He then examines how this firm's knowledge and experience may apply in the context of the Scottish university and financial climate, and bearing in mind the goals of Scotland's Technology Ventures strategy. Finally, he discusses the US government support initiatives for small business, the Small Business Investment Company (SBIC) Program. He suggests an approach for its application in increasing the birth-rate of fast-track technology-based ventures in Scotland or in other countries that have the infrastructure to support and enhance the process.

The Minority Enterprise Small Business Investment Company Program

Specialized small business investment companies (SSBICs) are privately owned companies that are funded by the U.S. Small Business Administration to finance minority-owned businesses. Most SSBICs began operations as nonviable companies, inherently limited in their ability to serve the range of capital needs of small firms in their targeted markets. Most of the SSBICs chartered over the last 26 years are out of business today. In the midst of this generally dismal industry, some SSBICs are growing substantially and operating profitably from their returns on minority business investments. This article differentiates the successful SSBICs from the failures.

Determinants of venture capital firms' preferences regarding the industry diversity and geographic scope of their investments

Competition is intensifying in the venture capital industry in the U.S. The number of venture capital firms (VCFs) tripled from 1980 to 1989. Supplier power (in the form of institutional investors such as pension funds) continues to grow. Foreign venture capital has grown to the extent that commitments to foreign VCFs exceeded domestic commitments in both 1988 and 1989. Further, alternative sources of financing for entrepreneurs such as individual investors (“angels”), corporations, and strategic alliances are increasingly viable options. VCFs face pressure to seek lower risk investments, improve rates of return, and provide value to new venture development. Surprisingly, few scholarly studies have begun to investigate the strategies VCFs are aiming to implement in order to deal with this increasing pressure. Building on the premise that decisions regarding product-market scope are a key component of firm strategy (Hofer and Schendel 1978), this study examined 169 domestic VCFs in order to identify factors that might explain variations in preferences regarding the industry diversity and geographic scope of their investments. The sample, drawn from California, Massachusetts, and Texas, represented about 27% of all U.S.-based VCFs in 1987, the year in which the data were gathered. In terms of the total size of investment portfolio, the average for these 169 VCFs was $69.8 million, which is statistically indistinguishable from the U.S. average of $65 million. Results indicate that (1) VCFs specializing in early stage ventures prefer less industry diversity and narrower geographic scope relative to other VCFs; (2) corporate VCFs (i.e., those owned by non-financial corporations), prefer less industry diversity but broader geographic scope relative to non-corporate VCFs; (3) larger VCFs prefer greater industry diversity and broader geographic scope than do smaller VCFs; and (4) provision of small business investment companies (SBIC) financing by the VCF has no impact on preferences regarding industry diversity but is associated with a preference for narrower geographic scope. One implication of these results is that VCFs in the U.S. are not homogeneous as regards the intended product-market scope of their portfolios. This, in turn, holds implications, not only for VCFs, but also for their suppliers (limited partners), buyers (entrepreneurs), and policy-makers. VCFs can no longer rely on haphazard investment schemes; they need to attract investors by virtue of the benefits offered by their portfolio strategy, and they need to attract superior investments via offering valueadded services and know-how. Potential investors in venture capital will want to examine, for example, the impact on risk and return of investing smaller amounts in several VCFs at one extreme versus making one large investment in a very diversified VCF at the other extreme. The results of this and other studies suggest that outcomes (timing, magnitude, and riskiness of returns) of choosing such alternatives will vary widely and will depend in great part on the strategies of the VCFs involved. It will not be possible for investors to make wise choices without a full examination of their own objectives and of the profiles of VCFs. Entrepreneurs with the most attractive ventures have alternative sources of financing to consider and should weigh the benefits of being financed and supported by various VCFs as part of the VCFs' portfolios. Knowing a VCF's preferences regarding product-market scope improves their chances of approaching and selecting the right fit and, for those entrepreneurs with a narrower set of options, such knowledge may make the difference between receiving and not receiving financing in a timely manner. Finally, policy-makers may be able to make use of knowledge of the forces that influence the investment strategies of VCFs. Presently, concerns for policy-makers may include the gap in seed capital, increased foreign presence in the U.S. market, and the export of promising innovative technology via alliances with foreign firms. All of these factors are influenced by the strategies pursued by VCFs as they jockey for position in the increasingly competitive venture capital market.

The risk-return attributes of publicly traded venture capital: Implications for investors and public policy

Despite having provided original seed money to extremely successful start-ups such as Federal Express, Cray Research, and Apple Computer, the Small Business Administration (SBA) with encouragement from the U.S. Senate, has recently placed a moratorium on granting new small business investment company (SBIC) licenses. And, due to perceived fund mismanagement, at least some senators have suggested that the misguided SBIs could lead to “a mini S&L bailout.” Consequently, the SBA has threatened the existence of the SBIC government-assisted program. Two public policy issues arise. First, should the government sponsor SBICs given their past risk-return characteristics? Second, if SBA support does re-emerge, should changes be made to the organizational structure of SBICs? With respect to the first issue, our study examines the risk/return attributes of two categories of venture capital funds: publicly traded business development corporations (BDCs) and SBICs. Popular folklore, as well as a recent study in this journal, suggest that a well-diversified fund of venture capital containing both SBICs and BDCs outperforms the general market. While previous research assumes that SBICs are similar to BDCs, we find striking dissimilarities between these groups. During 1980–1986, SBICs demonstrate significantly greater total and unsystematic risk, but significantly less systematic risk than BDCs. In addition, SBICs experience much higher returns, on a risk adjusted basis, than either the market proxy or BDCs. Financial theory suggests a number of reasons for the differential performance among the two groups. Moreover, given the strong investment successes of publicly traded SBICs during the early to middle 1980s, and the ability of the public to monitor SBIC investment in lieu of the SBA, we conclude that continued SBA financing of SBICs benefits the investment community. However, the investment performance of SBICs in the late 1980s contrasts with the successes achieved earlier in the decade. Since 1986 many publicly traded SBICs have performed poorly, liquidated, or changed their organizational status. We conclude that many of these problems originate with the Investment Company Act of 1940. This Act limits operating flexibility of SBICs, discourages public trading and related monitoring by public investors, and reduces the equity capital cushion. Accordingly, we propose guidelines, including audit and equity capital considerations, that may mitigate difficulties stemming from the organizational structure of SBICs. Public policy issues related to SBA sponsorship of SBICs are relevant to individual and institutional investors—particularly as they relate to dividends, liquidity, investment allocation, and portfolio risk of venture capital related funds. For example, our study indicates that publicly traded SBICs, on average, appear to have greater corporate financial leverage and a large percentage of their portfolio invested in fixed income securities, compared with private SBICs (which invest more heavily in equity funds). To the extent that the SBA relaxes dividend payout restrictions on SBIC operating income, we might expect lower financial leverage and a greater portfolio allocation to equity instruments. This change would tend to reduce the financial risk related to SBIC ownership and encourage the provision of equity capital to emerging enterprises.

Venture Capital Investment in Minority Business Enterprise: An Evaluation of MESBIC Investment Preferences

The encouragement of minority entrepreneurship is frequently advocated as a means of promoting social and economic development. The Minority Enterprise Small Business Investment Company (MESBIC) program pursues this goal by increasing the access of minority business enterprise (MBE) to both human and financial capital. This research provides an exploratory empirical description of the regional, industrial sector, and funding-stage preferences of MESBICs. It is concluded that these preferences are largely antithetical to the formation and expansion of MBEs in growth sectors that offer the market potential for entrepreneurial takeoff. The primary problem seems to be the small size of the majority of MESBICs. Policies governing licensing requirements and administration should therefore be reconsidered.

Publicly traded venture capital funds: implications for institutional “fund of funds” investors

Institutional investors supply the bulk of the funds which are used by venture capital investment firms in financing emerging growth companies. These investors typically place their funds in a number of venture capital firms, thus achieving diversification across a range of investment philosophy, geography, management, industry, investment life cycle stage and type of security. Essentially, each institutional investor manages a “fund of funds,” attempting through the principles of portfolio theory to reduce the risk of participating in the venture capital business while retaining the up-side potential which was the original source of attraction to the business. Because most venture capital investment firms are privately held limited partnerships, it is very difficult to measure risk adjusted rates of return on these funds on a continuous basis. In this paper, we use the set of twelve publicly traded venture capital firms as a proxy to develop insight regarding the risk reduction effect of investment in a portfolio of venture capital funds, i.e., a fund of funds. Measurements of weekly total returns for the shares of these funds are compared with similar returns on a set of comparably sized “maximum capital gain” mutual funds and the daily return of the S&P 500 Index. A comparison of returns on an individual fund basis, as well as a correlation of daily returns of these individual funds, were made. In order to adjust for any systematic bias resulting from the “thin market” characteristic of the securities of the firms being observed, the Scholes-Williams beta estimation technique was used to reduce the effects of nonsynchronous trading. The results indicate that superior returns are realized on such portfolios when compared with portfolios of growth-oriented mutual funds and with the S&P 500 Index. This is the case whether the portfolios are equally weighted (i.e., “naive”) or constructed to be mean-variant efficient, ex ante, according to the capital asset pricing model. When compared individually, more of the venture funds dominated the S&P Market Index than did the mutual funds and by much larger margins. When combined in portfolios, the venture capital funds demonstrated very low beta coefficients and very low covariance of returns among portfolio components when compared with portfolios of mutual funds. To aid in interpreting these results, we analyzed the discounts and premia from net asset value on the funds involved and compared them to Thompson's findings regarding the contribution of such differences to abnormal returns. We found that observed excess returns greatly exceed the level which would be explained by these differences. The implications of these results for the practitioner are significant. They essentially tell us that, while investment in individual venture capital deals is considered to have high risk relative to potential return, combinations of deals (i.e., venture capital portfolios) were shown to produce superior risk adjusted returns in the market place. Further, these results show that further combining these portfolios into larger portfolios (i.e., “funds of funds”) provides even greater excess returns over the market index, thus plausibly explaining the “fund of funds” approach to venture capital investment taken by many institutional investors. While the funds studied are relatively small and are either small business investment companies or business development companies, they serve as a useful proxy for the organized venture capital industry, despite the fact that the bulk of the funds in the industry are institutionally funded, private, closely held limited partnerships which do not trade continuously in an open market. These results demonstrate to investors the magnitude of the differences in risk adjusted total return between publicly traded venture capital funds and growth oriented mutual funds on an individual fund basis. They also demonstrate to investors the power of the “fund of funds” approach to institutional involvement in the venture capital business. Because such an approach produces better risk adjusted investment results for the institutional investor, it seems to justify a greater flow of capital into the business from more risk averse institutional investment sources. This may mean greater access to institutional funds for those seeking to form new venture capital funds. For entrepreneurs seeking venture capital funds for their young companies, it may also mean a lower potential cost of capital for the financing of business venturing. From the viewpoint of public policy makers interested in facilitating the funding of business venturing, it may provide insight regarding regulatory issues surrounding taxation and the barriers and incentives which affect venture capital investment.

Venture capital, technology and taxes

Throughout history men and women with adventurous spirits have been willing to accept the exposure to inordinate risks in return for the promise of extraordinary rewards. The discovery of America in 1492 was essentially “a venture capital” project, although Christopher Columbus may have lacked some of the attributes of today’s skilled professional managers and Queen Isabella of Spain probably did not consider herself a venture capitalist when she used the royal jewels to finance the voyage. In the United States, the venture capital “industry” began to emerge during World War II and its development accelerated in the immediate postwar period as the electronic age burst forth upon the nation. The earliest participants in venture capital investments were primarily wealthy individuals who operated either individually or through pooled family funds, with the Rockefeller, Phipps and Whitney families setting the example. The institutionalization of the industry began in 1946 with the organization of the American Research and Development Corporation of Boston, financed in part by the John Hancock Mutual Life Insurance Company and the Rosenwald family. However, it was not until 12 years later with the passage of the Small Business Investment Act of 1958 that the banks and insurance companies began to participate in the industry in a meaningful way. From 1960 through 1962 approximately 585 Small Business Investment Company (SBIC) licenses were approved and more than $200 million in private capital was raised to finance their operation . The SBICs were off to a fast start, but disappointment set in almost immediately. Investor expectations were unreasonable, and managements lacked experience as well as an appreciation of the discipline required in the venture investment process. There was too much emphasis on short-term results, particularly by the publicly held SBICs, and the industry was burdened by cumbersome and excessive government regulation. Unfavorable economic conditions and a weak stock

Venture capital at the corporate planning desk

Rumors to the effect that venture capital died in the early 1970s are untrue. It is true, however, that the decline of stock market values has accelerated the flight of risk dollars to other arenas, such as options and commodities. It is similarly true that the number of Small Business Investment Companies (SBICs) and venture capital firms has shrunk from over 800 in 1972 to less than 400 in 1978.

A Constructive Look at Mesbics

The Federal Government9s major thrust in promoting black capitalism is the MESBIC (Minority Enterprise Small Business Investment Company), begun in 1969. The MESBICs9 problems are many and are often similar to those of Small Business Investment Companies (1958). This article examines MESBICs and SBICs, MESBIC operations, MESBIC problems and solutions to those problems.

A Quantitative Analysis of the Small Business Investment Company Program

This paper examines the quantitative aspects of the small business investment company program. The total amount of investments made by SBICs is compared with the amounts of capital and loan funds which have been put into the SBIC program. Next, an attempt is made to determine the total direct dollar costs of administrating the program and the indirect costs associated with making SBIC investments. While the paper does not examine in detail all the qualitative aspects of SBIC investments, it does examine those qualitative features which affect the quantity of “legitimate” SBIC investments.

A Quantitative Analysis of the Small Business Investment Company Program: Discussion

A Quantitative Analysis of the Small Business Investment Company Program: Discussion