[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
PRIVATE EQUITY FOR SMALL FIRMS: THE IMPORTANCE OF THE PARTICIPATING
SECURITIES PROGRAM
=======================================================================
HEARING
before the
COMMITTEE ON SMALL BUSINESS
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
__________
WASHINGTON, DC, APRIL 13, 2005
__________
Serial No. 109-10
__________
Printed for the use of the Committee on Small Business
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
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COMMITTEE ON SMALL BUSINESS
DONALD A. MANZULLO, Illinois, Chairman
ROSCOE BARTLETT, Maryland, Vice NYDIA VELAZQUEZ, New York
Chairman JUANITA MILLENDER-McDONALD,
SUE KELLY, New York California
STEVE CHABOT, Ohio TOM UDALL, New Mexico
SAM GRAVES, Missouri DANIEL LIPINSKI, Illinois
TODD AKIN, Missouri ENI FALEOMAVAEGA, American Samoa
BILL SHUSTER, Pennsylvania DONNA CHRISTENSEN, Virgin Islands
MARILYN MUSGRAVE, Colorado DANNY DAVIS, Illinois
JEB BRADLEY, New Hampshire ED CASE, Hawaii
STEVE KING, Iowa MADELEINE BORDALLO, Guam
THADDEUS McCOTTER, Michigan RAUL GRIJALVA, Arizona
RIC KELLER, Florida MICHAEL MICHAUD, Maine
TED POE, Texas LINDA SANCHEZ, California
MICHAEL SODREL, Indiana JOHN BARROW, Georgia
JEFF FORTENBERRY, Nebraska MELISSA BEAN, Illinois
MICHAEL FITZPATRICK, Pennsylvania GWEN MOORE, Wisconsin
LYNN WESTMORELAND, Georgia
LOUIE GOHMERT, Texas
J. Matthew Szymanski, Chief of Staff
Phil Eskeland, Deputy Chief of Staff/Policy Director
Michael Day, Minority Staff Director
(ii)
C O N T E N T S
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Witnesses
Page
Guzman-Fournier, Mr. Jaime, Associate Administrator for
Investment, U.S. Small Business Administration (SBA) Speaking
on Behalf of SBA Administrator Hector Barreto.................. 5
Blaydon, Mr. Colin, Ph.D., Director, Center for Private Equity
and Entrepreneurship, Tuck School of Business, Dartmouth
University..................................................... 7
Preston, Ms. Susan, Director of Attorney Training and
Professional Development, Davis Wright Tremaine................ 8
Redding, Mr. Mark, President & CEO, Banner Service Corporation... 10
Clark, Mr. Redmond, Ph.D., President, Metalforming Control
Corporation.................................................... 11
O'Connell, Mr. Daniel, Director, The Golder Center, University of
Illinois at Champaign Urbana................................... 13
Appendix
Opening statements:
Manzullo, Hon. Donald A...................................... 27
Prepared statements:
Talent, Senator James (R-MO)................................. 30
Guzman-Fournier, Mr. Jaime, Associate Administrator for
Investment, U.S. Small Business Administration (SBA)
Speaking on Behalf of SBA Administrator Hector Barreto..... 33
Blaydon, Mr. Colin, Ph.D., Director, Center for Private
Equity and Entrepreneurship, Tuck School of Business,
Dartmouth University....................................... 37
Preston, Ms. Susan, Director of Attorney Training and
Professional Development, Davis Wright Tremaine............ 52
Clark, Mr. Redmond, Ph.D., President, Metalforming Control
Corporation................................................ 68
O'Connell, Mr. Daniel, Director, The Golder Center,
University of Illinois at Champaign Urbana................. 72
Attachments:
Heesen, Mr. Mark, President, National Venture Capital
Association................................................ 76
(iii)
PRIVATE EQUITY FOR SMALL FIRMS: THE IMPORTANCE OF THE PARTICIPATING
SECURITIES PROGRAM
----------
WEDNESDAY, APRIL 13, 2005
House of Representatives,
Committee on Small Business,
Washington, D.C.
The Committee met, pursuant to call, at 2:15 p.m., in Room
311, Cannon House Office Building, Hon. Donald A. Manzullo
[Chair of the Committee] Presiding.
Present: Representatives Manzullo, Akin, Velazquez,
Bordallo, and Moore.
Chairman Manzullo. Good, afternoon, and welcome to this
hearing on the very important topic for small businesses around
the country--access to capital.
A key part of economic security is creating the environment
for entrepreneurs to take risks in starting or growing
businesses, thereby creating jobs. The question becomes, what
should the Federal Government do to foster a better economic
climate for small businesses to grow?
This Committee can play a key role in achieving economic
security by ensuring that the Federal Government and America's
small businesses work together in a sound partnership to spur
growth in the economy.
In February, this Committee held its first hearing of the
109th Congress to go over SBA's budget and key programs within
that budget. One of the topics dealt with small business
investment companies, SBIC; specifically the Participating
Securities program.
In the hearing it was noted by SBA's own analysis that
participating securities funds licensed between the years of
1994 through 2000 have performed as well as non-SBIC venture
funds of the same vintage years in which CalPERS, the
California Public Employees Retirement System was invested.
Over $2.5 billion in leverage was invested in 3 years, 1998 to
2000, immediately before the collapse of the economy.
I asked Administrator Barreto how much of the losses in the
program can be attributed to the recession. He said, "I would
be happy to go back and research this for you." I expect the
SBA to answer that question today.
I also asked him if he would be willing to commit to
working towards a solution of this problem, to which he
replied, "Absolutely."
I want to congratulate the Administrator and his team for
following through on a commitment to find a solution to this
thorny problem in the Participating Securities program. I will
let our witnesses get into the details of how significant the
program is for start-up and early stage funding.
The SBA Inspector General's report for May of 2004 states,
"Over the last 10 to 15 years the General Accounting Office and
the Office of Inspector General have found that SBA's policy of
allowing extensive time for financially troubled SBICs to
attempt rehabilitation has allowed SBIC assets to decrease and
reduced SBA's potential for recovery. SBA's policies of
allowing capitally impaired SBICs to charge significant
management fees, and the way SBA applies distributable gains
from SBICs also contribute to program losses.
"The standard operating procedure for the SBIC program has
not been revised since March of 1989, and existing guidance
does not provide a systematic approach for estimating the level
of financial risk, ensuring the implementation of restrictive
operations, transferring capitally impaired SBICs to
liquidation status, or liquidating SBICs receiving
participating securities."
The report goes on to state that, "The structure of the
SBIC funding process for participating securities and the
quality of SBA oversight have contributed significantly to the
losses in the SBIC program in recent years."
Some believe the notion that if it is a good business plan,
then someone will fund it. As our witnesses will attest, this
simply is not true. According to the Council on Competitiveness
National Innovation Initiative Report, dated December of 2004,
"For those ideas that are pursued commercially, only 7 out of
every 1,000 business plans receive funding."
Mr. Steve Vivian, board member of the National Association
of Small Business Investment Companies, testified at our
hearing on the budget back in February that the Participating
Securities program accounts for roughly half of all SBIC
investment dollars and, since inception in 1994, has infused
nearly $9 billion into U.S. small businesses. In fact, he goes
on to note that 35 percent of that $9 billion went into small
and growing U.S. manufacturing companies.
[Chairman Manzullo's statement may be found in the
appendix.]
Chairman Manzullo. According to Mr. Vivian, these are
investments that would not have been made by traditional
venture capitalists or banks. But for the equity participation
of the SBA, these jobs, products, revenues, and taxes would
likely not exist.
Listen to these quotes:
``SBIC financings work to fill the gap in private equity
markets, especially at the earliest stage of a company's
growth.''
``By encouraging private risk taking, the program is capable
of supporting thousands of entrepreneurs through the slow
economic period with the prospect of growing leading-edge
businesses out of the down cycle.''
These comments did not come from a trade association or an
industry guru, but from the SBA's special report on the SBIC
program, dated June of 2002. SBA's report goes on to highlight
that:
``SBIC's financings represented 64 percent of seed
financings during fiscal year 1994 to 2002.''
``The SBIC portfolio companies in the year 2002 created
73,000 jobs, sustained 176,309 jobs, and supported over 1
million jobs.''
``Revenues in the SBIC portfolio companies in fiscal year
2002 were 14.8 billion.''
``SBICs generated $6 billion in taxes in fiscal year
2002.''
``Between fiscal year 1994 and 2002, SBICs provided 65
percent of financing to nontechnology and life sciences as
compared to the overall venture industry with only 9 percent of
venture financing dollars in that category.''
The SBA feels pressure to say the program doesn't work as
evidenced by the losses sustained. SBA must take some
responsibility for how the program currently works. Again, from
the IG report, and I quote, "Capitally impaired participating
securities, securities SBICs that have been transferred to
liquidation, are not being liquidated by the SBA. To improve
the program's ability to limit risk and prevent major avoidable
program losses, officials should pursue legislative reforms and
act in a timely manner in dealing with and liquidating
capitally impaired SBICs."
We are not going to solve all the problems today.
Nevertheless, my hope is that the SBA would take an open and
honest look at the program and recognize its necessity. It is
an accepted fact that there are structural problems in the
program, but I believe it can be fixed between willing
participants. I am willing; industry is willing. According to
Mr. Barreto's previous testimony, the administration is
willing.
One final quote from the SBA report: "Our mission is to
improve and stimulate the national economy in general and the
small business segment thereof, in particular, by establishing
a program to stimulate and supplement the flow of private
equity capital which small businesses need for the sound
financing of their business operation and for their growth,
expansion, modernization, and which are not available in
adequate supply."
In light of the SBA's own words as to the positive aspects
of the Participating Securities program, they have an
obligation to work with industry to resolve this problem, and I
trust that will take place.
Senator Talent advised me they may not be able to make it,
but if he does make it, I promised him that we would stop
whatever testimony is going on, immediately take his testimony,
and then resume other testimony. His statement will be made
part of the record without objection.
[Senator Talent's statement may be found in the appendix.]
Chairman Manzullo. I now turn to the ranking member for her
comments, Mrs. Velazquez.
Ms. Velazquez. Thank you, Mr. Chairman.
There is no doubt that our Nation's small businesses need
all the help they can get when it comes to accessing affordable
capital. Being able to successfully secure capital is what
allows our nation's entrepreneurs to reach their goals,
stimulate economic growth, and create jobs.
The challenges in accessing capital are not easier with
venture capital; it is extremely difficult for start-ups to get
capital, and this is a key area where demand is greatest. This
is of particular concern in minority equity investment.
Minority-owned businesses have traditionally had a more
difficult time accessing venture capital. Currently, minorities
only get 3 percent of venture capital investment. Clearly,
there is a need for getting seed venture capital in the hands
of start-ups.
We are here today to look at the SBIC Participating
Securities program, which is the program that has filled this
gap in the past and has been internationally proclaimed as
innovative. The SBIC Participating Securities program has also
been credited as being the most reliable source of equity
capital during times of recession.
Despite the obvious need for start-ups to access venture
capital, the administration wants to take away the only program
that makes that possible. We are hearing today from the
administration that there is no longer a demand for the SBIC
Participating Securities program; it is showing huge losses and
is costing the American taxpayer too much money. The
administration blames the industry and the program, but in the
midst of these excuses, it fails to accept any of the blame
themselves. The administration has yet to step up and take
responsibility for the poor management and lack of leadership
in this program.
It is evident that this program has deteriorated over the
past 4 years. From 1994 through 2000, the SBIC Participating
Securities program received $225 million in profits and no
defaults occurred. But 4 years later, under the Bush
administration, it was taken to a zero subsidy rate and placed
costs on the small businesses and lenders; and there has been
$1.1 billion in losses since then. Clearly, this program has
been mismanaged to the point where it is functioning far below
its capacity.
The fact is that the administration has been negligent in
intervening with the SBIC Participating Securities program. The
Agency should have stepped in, liquidated investment--and
liquidated investments in the program. Instead, they choose to
take no action when companies were struggling, which only
caused the program to decline further.
What this Committee needs to know is that if the SBIC
Participating Securities program is not the right way to get
seed venture capital to start-ups, then what is? In the past,
it seems as if the answer from the administration was to simply
do nothing.
Well, let me tell you, that is not an option. The bottom
line is that our Nation's small businesses are not getting the
venture capital they need. We clearly cannot expect the capital
market to be relied upon solely to fill this gap on its own.
Given the tacit support that has been shown for the New Markets
Venture Capital program in the past, I want to know what the
options are. If it isn't the New Markets Venture Capital
program that can serve this vital program and it isn't the SBIC
Participating Securities program that can provide seed capital
to start-ups, then tell me what can.
We cannot afford to not take action right now. There is a
need from start-up firms across the country to tap into the
venture capital market, and these needs deserve to be met. As
the main job creators, our Nation's small businesses require
that venture seed capital be available to them. This Nation's
entrepreneurs already face enough challenges accessing capital.
By working to repeal this program and explore our options, we
are broadening the availability of venture capital to small
businesses across the country.
Thank you, Mr. Chairman.
Chairman Manzullo. Thank you.
Chairman Manzullo. Our first witness is Jaime A. Guzman-
Fournier, who is speaking on behalf of Administrator Hector
Barreto. He is the Associate Administrator For Investment at
the U.S. Small Business Administration.
We have a 5-minute clock, and if you could follow that, it
would be okay. But because you have got a load here, I am going
to set your clock at 7 minutes and the rest would be at 5. But
you can end any time before 7 if you want, okay?
Thank you.
STATEMENT OF JAIME GUZMAN-FOURNIER, ON BEHALF OF U.S. SMALL
BUSINESS ADMINISTRATION ADMINISTRATOR HECTOR BARRETO
Mr. Guzman-Fournier. Mr. Chairman, Ranking Member
Velazquez, members of the Committee, my name is Jaime Guzman-
Fournier, Associate Administrator for Investment in the Office
of Capital Access at SBA. Administrator Barreto asked me to
testify on his behalf, and I appreciate the opportunity to
discuss with you today the Small Business Investment Company
Participating Securities program.
I know the Committee shares the President's goal of a
fiscally responsible government, and understands why we cannot
continue operating a structurally flawed program that loses
taxpayers' money. At the end of fiscal year 2004, 2.7 billion
of losses were projected on the more than 6 billion disbursed.
As shown in chart number 1, you can see it to the right here,
the cash flow minus appropriations was a negative 1.3 billion;
29 percent of participating securities SBICs licensed prior to
fiscal year 2001 have failed to repay their obligation to the
Federal Government. In contrast, only 5 percent have fully
repaid their leverage.
While fund performance is part of the problem, the fact
that several failed SBICs were able to pay back their private
investors, but not the taxpayers, demonstrates the flawed
structure of the program. In fact, of the SBIC funds that fully
repaid their private investors, over 75 percent had not fully
repaid SBA as of the end of fiscal year 2004.
Let us look at the Participating Securities instrument. In
essence, the Federal Government borrows money by guaranteeing
SBICs on the securities they issue to the public. Then SBA pays
the associated interest on behalf of the SBICs and is paid back
only if and when they become profitable. The SBICs invest that
money in long-term equity investments such as patient capital
for seed and early-stage companies. The SBA is supposed to be
paid back out of the returns of these investments.
We have identified several problems with the structure I
have just described. One problem is that SBA defers interest on
the money SBA borrows. This accumulated interest can often
exceed the original investment and is often never repaid. In
fact, we have one fund that owes the SBA approximately 25
million in interest payments, but owes less than 20 million in
principal.
Another flaw in the program is the profit distribution
formula. SBA typically contributes two-thirds of the capital of
an SBIC, but receives less than 10 percent of the profits, if
any, of the fund. Moreover, Participating Securities SBICs
distribute capital based on a formula that allows SBICs to
minimize distributions to the SBA and maximize profit to
private investors.
The key problems with this formula are, number one, profits
to all investors are paid before SBA leverage; number two,
SBICs can make optional tax distributions providing even more
of the profits to the private investor at the expense of the
taxpayer; and number three, when SBA is less than 50 percent of
the capital in the fund, it gets only its profit participation,
typically less than 10 percent.
For example, as shown on chart number 2 here to the right,
one SBIC made a single distribution of $207 million. Because
the SBA percentage of outstanding leverage to total capital was
only 49.5, the SBA received less than $18 million, while 189
million went to the private investors and general partners of
the fund. This was a 650 percent return on their initial
investment.
While this distribution, by itself, is disconcerting, the
SBA's percentage of outstanding capital was under 50 percent
only because 2 weeks prior the SBIC had made a distribution of
less than 37 million which dropped the SBA's percentage. Had
the SBIC made a single distribution, SBA would have been paid
back all leverage plus a profit distribution, and the private
investors would still have had a 400 to 500 percent return.
As shown in chart number 3 to the left, on a community
basis this structure has allowed private investors to receive
1.9 times their paid investment, where the taxpayers have lost
50 percent of their investment. As of the end of fiscal year
2004, Participating Securities SBICs had 4.9 billion in
outstanding leverage and 5.7 billion in unfunded commitments.
The important issue that the administration must continue
to address is: How do we manage this program in order to
minimize losses? SBA, in consultation with outside experts, is
implementing clearer policies to ensure all necessary steps
will be taken to protect the taxpayers' money.
Finally, I want to say that SBA's role in venture capital
is not ended. We continue to support and encourage the SBIC
debenture program. While it focuses on later-stage financing,
it produces results without the fiscal difficulties inherent in
the Participating Securities program.
I thank you again for the opportunity, and I look forward
to your questions.
Chairman Manzullo. Thank you.
[The Honorable Barreto's statement may be found in the
appendix.]
Chairman Manzullo. Our next witness is Professor Colin
Blaydon. He is the Buchanan Professor of Management and
Founding Director of the Center for Private Equity and
Entrepreneurship at the Tuck School of Business at Dartmouth.
We look forward to your testimony.
STATEMENT OF COLIN BLAYDON, TUCK SCHOOL OF BUSINESS, DARTMOUTH
UNIVERSITY
Mr. Blaydon. Thank you, Mr. Chairman, Ranking Member
Velazquez, and members of the Committee. My center--and I am
accompanied today by our Executive Director, Fred Wainwright,
who is here with me--was asked by the National Association of
SBICs to examine the data from the SBA and data available about
private investment and venture capital, and to compare the
patterns to see what gaps might be present.
One thing I would say at the outset is that it is well
known in academic research that the private equity markets for
venture capital are inefficient. Those inefficiencies are one
of the contributors to the very high returns that people expect
from these high-risk investments. But inefficiencies, while
also indicating the presence of high possible returns, also,
almost by definition, assure that there will be gaps. The
question is, where do those gaps exist?
The preliminary data that we have been able to look at so
far would say that there are gaps in three areas, and I think
you will hear some of my fellow panel members discuss them in
more detail in their testimony. The three areas are in
financing, in geography, and in industry sectors.
The financing comes about really in both the size of the
investments that are made in companies and the stage at which
investments are made. The private venture capital funds have
raised enormous money in recent years. They have also become
newly cautious after the bursting of the tech bubble. As a
result, they are trying to put to work very large amounts of
money, and they are trying to put them to work much more
safely. As a result, their investment in seed and early-stage
investments has fallen to about 2 percent of the total amount
of investing capital that they are making today, down from 16
to 20 percent in the mid-1990s.
In addition, the idea that this will be made up by angel
investors or by a large overhang of capital that these venture
funds still have to invest, I think you will hear other panel
members talk about. I won't say anything about the angel
investors here because I know my colleagues will say something
more about it. But I would like to say something about the
venture capital overhang.
It is pointed to a great deal in the press, but our
research indicates that much of this overhang is, in fact,
money that these funds have reserved for follow-on investments
in their portfolios. So while it is not yet spent, it certainly
is not available and certainly is not available for the kinds
of businesses that we are talking about and are concerned with
here today.
The second area in which there is a gap is geography. The
venture capital industry, the private venture capital industry,
is bicoastal, with a few other centers that are much smaller
around the country, but basically Silicon Valley and Route 128,
the Boston/New England area. By contrast, the criteria that
have been used for funding SBICs have permitted SBICs over the
last 20 years to grow from being in about 25 States to being in
45 of the 50 States today. So the geographic coverage and
availability of this type of private capital goes places where
the private venture capital industry simply does not operate.
The third area is by sector. The private venture capital
arena invests heavily in high tech, in life sciences, in
software, biotech, medical devices. The SBICs, by contrast, are
much more broad in their investment. They are investing heavily
in manufacturing; 28 percent of SBIC's investment post-bubble
has been in the manufacturing sector, one that is almost
totally ignored by the private venture capital funds.
Lastly, I would want to say something about what the bubble
did. The bubble did the same thing for SBICs that they did for
private funds.
Chairman Manzullo. How are you doing? Your bubble is about
ready to burst.
Mr. Blaydon. My bubble is about to burst. I will reserve
the rest of my comments, Mr. Chairman, for questions that you
may have for me.
Chairman Manzullo. Thank you very much. I appreciate it.
[Dr. Blaydon's statement may be found in the appendix.]
Chairman Manzullo. Our next witness is Susan Preston who,
like my wife, is a microbiologist. She also has her J.D. She is
currently an Entrepreneur-in-Residence at the Kauffman
Foundation.
Ms. Preston, we look forward to your testimony.
STATEMENT OF SUSAN PRESTON, DAVIS WRIGHT TREMAINE
Ms. Preston. Thank you very much.
Chairman Manzullo, Ranking Member Velazquez, and members of
the Committee, thank you very much for inviting me here to
testify today before the Committee on this important issue of
the continuance of the SBIC Participating Securities program. I
am going to speak to you specifically regarding angel investing
and the funding gap.
To define the funding gap for you, historically we have
looked at in the early 1990s a funding gap that was between a
half million and 2 million. That funding gap has extended to
between $2 million and $5 million, and that number of the
funding gap is supported when you look at some of the
statistics that have already been noted of the move of the
venture capitalists out of funding anything in the seed and
start-up stage. In fact, in 2004, only 1.7 percent of the
dollars invested by venture capitalists went into seed and
start-up stage, in only 171 deals. That is a 90 percent
decrease in the last 6 years in seed and start-up stage.
In addition to that, if you look at the average investment
amount that venture capitalists make, it is around 7 million--
$6 million to $7 million per deal--clearly, again, above the
funding gap that we are looking at of 2 to 5 million or half a
million to $5 million.
Now, let us look at the angel investors. Angel investors
have become very active in recent--and I will talk in a moment
about the Angel Capital Association. But if we just look at the
specific numbers, it is estimated last year, in 2004, that
angels invested around $22.5 billion.
To put that into context, that was into 48,000 deals. We
are early stage investors, clearly, but if you do your simple
mathematics, 48,000 deals into $22.5 billion comes up with an
average investment of just under half a million dollars,
clearly under the range of the funding gap that we are talking
about.
What is important to understand about angel investors--and
is important to understand also for the SBIC program--is it is
patient money. These are very early-stage investors. We
understand the need to wait up to 10 years to see return on our
investments and understand that in the earlier stages of
possibly a 5-to-7-year time frame the return is still going to
be negative. And we need to understand that we need to allow
the companies to grow, but we also need to understand that we
need the follow-on funding.
One of the biggest issues for angel investors right now is
we look at this as the best of times and the worst of times.
Valuations are very low, but we fear that there is no follow-on
funding, because our average investment, again, is between 25-
and 250,000 for individual angels, and then through angel
groups it is up to half a million, but still clearly outside
the funding gap.
Through Kauffman Foundation we have started an organization
called the Angel Capital Association, which is a professional
alliance of angel organizations. We have only been in existence
for about 1 year, but we already have 85 groups as members. It
is a phenomenal success for us and a recognition by the
Kauffman Foundation of the need to finance entrepreneurs in
this early stage.
It also recognizes that angels are not necessarily
investing up into the funding gap, but that angels understand
the potential for the lucrative return on early-stage
investing. And so we are not leaving this funding area, but in
fact returning to it and understanding the need to fund into
the early-stage companies.
We are just starting, as angel groups, to talk about
syndication, which may give the opportunity to build those
numbers of investment dollars, but it is clearly not there yet.
Most angel groups and individual angels are very geocentric in
their investing, and only invest locally both because of their
interest of staying connected with the companies they invest in
but also because they want to give back to their community. So
to look to the angel industry to fill the gap is unrealistic at
this time or anywhere in the near future.
The other thing that I would like to point out as far as
angels are concerned is that when we invest, we are much more
sophisticated about our investment now. And when we look at a
company that is carrying debentures or debt on their balance
sheet, it makes for an unattractive company, particularly when
money is being paid to interest on those debentures. Any money
that we put into companies or any other early stage, we want
that money to work to build the company rather than to repay on
notes. And so having a Participating Securities program is
extremely important to do that.
The last point that I want to make is that in order to have
the ability for the lower and middle class to fund companies
rather than only the upper class that can self-fund their
companies, we do need something that fills the funding gap; and
the SBIC Participating Securities program does that,
particularly for women and minorities.
Thank you.
Chairman Manzullo. Thank you.
[Ms. Preston's statement may be found in the appendix.]
Chairman Manzullo. Our next witness is Mark Redding. He is
the CEO of Banner Service Corporation.
And, Mr. Redding, we look forward to your testimony.
STATEMENT OF MARK REDDING, BANNER SERVICE CORPORATION
Mr. Redding. Thank you, Chairman Manzullo, Ranking Member
Velazquez, and members of the Committee. I appreciate the
invitation to testify at this hearing.
The Participating Securities program has been of great
importance to me. My name is Mark A. Redding; I am the Chairman
and Chief Executive Officer of Banner Service Corporation in
Carol Stream, Illinois. Banner is a manufacturing company with
about 60 employees engaged in the precision steel bar industry.
For the past 30 years, I have worked in the metal products
industries, from an early position as a production control
analyst to now, twice, being a Chief Executive Officer. I have
worked in both large and small firms. In 2003, I led the effort
to purchase Banner from its founding family. Two licensed SBIC
private equity firms, Prism Capital and Alpha Capital Partners
joined with me to make that purchase and revitalization of
Banner possible.
For one to understand the importance of these issues to us,
I would like to briefly describe our business. Originally,
Banner was a small metal distributor. During the course of its
history, it expanded many times, added additional equipment,
and created new jobs. Eventually, it outgrew its facility and
began to look for a new home.
In 1997, as the U.S. economy blossomed, Banner relocated to
a new facility, but at significantly higher cost. As a result
of this, Banner's business grew in sales revenue to over $25
million. However, there was trouble ahead for Banner at its new
scale. Much of that growth was based upon making bars for the
office products industry, such as computer printers. Much of
the demand for these bars evaporated as the office product
sector moved offshore. Later, the recession impacted many other
clients, and the result was a serious decline in Banner's
revenues to less than $17 million. Liquidation studies were
conducted with the possible result of simply ceasing to operate
the business.
Our transaction to buy Banner occurred over a time frame
from May to September of 2003. During that period, I was
working on dual fronts to negotiate the terms of the purchase
while also attempting to raise equity capital.
Armed with a letter of intent signed by the seller, I
searched the financial community to attract investors to
combine with capital of my own. I contacted more than 8 firms
in the greater venture capital market. I committed not only to
invest my own personal capital in the venture but also my full-
time leadership. There was little interest. The investor market
for deals of this nature and size was very limited.
I was able to meet Steve Vivian of Prism Capital, who
showed interest in this opportunity, and he visited the company
with me. We met with Andrew Kalnow of Alpha Capital and
enlisted his support to join us, which he did. The transaction
closed on September 3, 2003.
What has happened thereafter is quite a success story.
During what remained of that year, Banner was able to make a
profit and have a positive cash flow. With a firm financial
structure anchored by SBIC-backed equity, we had the time to
reposition the business. By the end of 2004, Banner was able to
regrow its revenue back to $24 million and more than double its
free cash flow. It met every one of its debt payments,
increased its employment, added new products, and invested
$600,000 in additional production line. It provided work for
machine installers, electricians, plumbers, truck drivers, and
others. New, permanent jobs have been created.
Also, this transaction supported by the SBIC and Prism
created a new class of ownership at Banner. Four long-term
employees became eligible to participate in the common unit
plan. This included one gentleman over 60 years of age and one
woman over 55. The plan also provides for future key members of
Banner's management team to qualify for ownership.
In summary, new life has been given to Banner Service
Corporation. It is my opinion much of the success was due to
the Participating Securities program and its cooperation with
small business--the small business community through SBIC
licensees like Prism and Alpha.
With help from the SBIC Participating Securities program
there could be many more stories like Banner. Please consider
us and those other small businesses when you consider the
future of the Participating Securities program.
Thank you. It has been a privilege to participate in this
process.
Chairman Manzullo. Thank you very much.
Chairman Manzullo. Our next witness is a constituent, Red
Clark, who has a dual role as a manufacturer and somebody who
also has had to raise a tremendous amount of money for venture
capitalist purposes.
And I have got to get over there and take a look at both of
your factories. Any time anybody has got a new process--and I
want to check out this Ford modulator system. I drove General
Kinematics nuts because I wanted to know how they make objects
move uphill on a conveyor. They finally gave me a little bit of
knowledge as to what it was, and I want to see what that system
does.
Red, we look forward to your testimony.
STATEMENT OF REDMOND CLARK, METALFORMING CONTROL CORPORATION
Mr. Clark. Thank you.
Thank you, Chairman Manzullo, Ms. Velazquez, and members of
the Committee. I appreciate the opportunity to be here.
I am the guy you are spending money on. I am the guy that
receives the money and puts it to use in the field in
companies. I am a serial entrepreneur. I have been operating
and turning around venture-backed companies for the last 20
years. The fact that I am a serial entrepreneur also means that
I am a slow learner.
I have raised approximately $50 million for the companies
that I have managed over the years, and a significant fraction
of that money in two of the most recent deals that I have
operated have come from the SBIC.
My colleagues have already mentioned some of the trends
that I have seen in venture capital. I will just touch on them
again for emphasis.
Venture capital investment in the private sector is
growing. It is up 250 percent over the last 10 years. At the
same time, seed investment has dropped by 75 percent in the
same period. There is more money going into venture capital in
the private sector, more money coming into the public sector,
and less money going to seed.
In addition, you have already heard that it is a bicoastal
market. Most of the venture capital is available on the East
Coast and on the West Coast, and there is a very limited amount
available in the Midwest and in the center of the U.S. as a
whole. And I can give you some experiential information on what
it is like to raise money in that marketplace.
In the last two start-ups that I have run, we were backed
by the SBIC. We raised $1 million to $3 million for each of the
companies. They are both headquartered in the Chicago area, and
we had to go 800 miles from Chicago in order to find capital or
investors that were willing to place their capital into our
organization, into the sector that we are working in and into
the geography that we are working in. The funds that we found
which were distant from the Chicago area were SBIC funds that
were investing in our sector.
It was very, very difficult to find money in the 1990s; it
is very difficult to find money in the 2000s, no matter where
you are, if you are a sector or a geography that is not in
favor. The SBIC is one of the programs that literally applies
capital with a degree of quality throughout the U.S. and makes
it available and gives us a chance to operate.
Very simply, my experience is a guide, I think, for all of
us; and that is, if there is no money, there will be no
companies. The private sector may supply some of the money, the
public sector may supply some of the money, but if there is not
a sufficient amount of money, the companies will not exist.
What did the SBIC money get in our companies? I will give
you a brief list here: to date, in excess of $50 million in
sales.
We are actively reducing the weight of vehicles in the
United States with one of our technologies. And, according to
the DOE, if we continue to commercialize successfully, we will
cut oil imports by approximately 1 billion gallons per year.
We have reduced, eliminated, or recycled somewhere in the
area of 1 million tons of industrial toxic waste.
We have removed lead paint from more than 100 million
square feet of metal surfaces throughout the United States.
All of these things that have happened over the last decade
happened with SBIC money as the lead investor and the lead
player. Without SBIC, we are not in business.
Just a few concluding thoughts: As I mentioned a moment
ago, as I mentioned several times, the SBIC is one of the few
programs that supplies capital throughout the U.S. It is very
important.
The second comment I would make is that what the SBIC does
today is not going to bear fruit in our business world for
another 6 to 10 years. That means money that was invested 6, 7,
8 years ago is only now beginning to bear fruit. This is a
long-term investment. It is unusual that governments get
involved at this level at this length of time, but it is very
important for us.
The SBIC funds are biased towards seed. The gap is real. We
need to continue to address that gap wherever possible. If you
look at the total amounts of dollars that the SBIC has invested
in what we would call "seed areas" over the past 7, 8, 9 years,
you find that they are a major, major player in this sector of
investment.
Lastly, the venture capital community passes through cycles
of good and bad times. Companies pass through cycles of good
and bad times. The SBIC program, from where I am sitting, is no
different. There have been wonderful times to invest, there are
poor times to invest, and there will be in the future. But the
continuity of the program I think gives you a greater
opportunity to get an acceptable rate of return as long as you,
in fact, do structure the programs so that you share in the
successes just as you share in the losses.
Just one last concluding remark, and that is, we all
understand how important small businesses are to our economy.
We are a job creation engine. We make things happen. We make
things change. We keep our economy competitive. We need
whatever support the government can offer in this area.
Thank you very much.
Chairman Manzullo. Thank you.
[Mr. Clark's statement may be found in the appendix.]
Chairman Manzullo. Our next witness is Daniel O'Connell,
who joined the College of Business at the University of
Illinois at Urbana-Champaign with nearly 30 years of venture
capital and small business investing experience.
We look forward to your testimony.
STATEMENT OF DANIEL O'CONNELL, UNIVERSITY OF ILLINOIS AT
CHAMPAIGN URBANA
Mr. O'Connell. Thank you, Mr. Chairman, Ms. Velazquez, and
members of the Committee. I am the guy who has written checks
to the people such as the two people next to us over all the
years. And I can tell you that it is people like this that make
our job both infuriating, but so satisfying when you pick the
right team, and you are able to support them.
More than 30 years ago I was introduced to the venture
capital industry when, as a summer intern, I was at the then-
First National Bank of Chicago. Over the ensuing years I have
been all around the venture table, acting at various times as a
general partner, a limited partner, or an investor in a wide
range of private equity situations.
In the early 1990s, I was a NASBIC governor, and I had the
honor to serve on a Committee whose work ultimately led to the
creation of the Participating Securities program. So I was kind
of here before this got started.
By any measure, these past 30 years have been a time of
incredible expansion for our industry. During this period,
there has also been a huge broadening of possible investment
vehicles that get defined as private equity.
Today, broadly defined private equity includes a wide
spectrum of possible investments ranging from angel and
earliest-stage start-ups through and including international
multibillion dollar buyouts. Yet while the industry has
expanded dramatically, it remains fundamentally granular. And
what I mean by that is that there exists an immense matrix of
possible investment strategies that a private equity group
might choose to execute, and these strategies are described
across multiple dimensions--size of the company, stage of the
company, the industry, the geography, to name just a few.
Competition for the available limited partner dollars, the
private equity part of the SBIC program, encouraged general
partners to identify niches in which they feel they can compete
most successfully. I can only see this trend towards
specialization continuing. And it has always been true that
successful execution of a private equity group's business
strategy requires an underlying match of its human and
financial capital to the needs of its chosen niche.
So what do these things have to do with the Participating
Securities program? In my experience, it was conspicuous to
those of us using SBA debentures that there was a problem when
we wanted to invest in situations characterized by high risk,
high growth, and potentially high returns, i.e., venture or
growth companies.
There was a fundamental mismatch between our sources of
funds and our uses of those funds. At one level it made little
sense for us to borrow money to make an equity investment in a
company. But did we make those investments anyway? Yes, we did,
but in less than optimal ways.
In my opinion, a Participating Securities program was
intended to provide a better match between the nature of the
funds provided to the SBIC and the realistic demand of the
businesses into which the SBIC would invest.
So is there still a need today for this kind of program?
Absolutely. If anything, the increasing specialization of our
business suggests an even greater need.
From my experience, SBICs fill important pieces of the
private equity matrix. They tend to be more geographically
focused in regions underserved by other sources. Because we
have learned how to prosper from other than the public markets,
we are more comfortable with smaller businesses and with
businesses and industries, or niches, of a size that typically
does not represent IPO potential. And, once in an investment,
SBIC principals often add value in somewhat different ways than
traditional VCs.
Could traditional venture funds and larger buyout groups
make these kinds of investments? Yes. And from time to time
they do, but only when it is easy for them to do so. It is just
not time- or dollar-efficient for them to aggressively make the
kinds of investments that an SBIC is formed to make.
Regarding how the program might be more effective going
forward, I would like to make a couple of observations. First,
I believe it is absolutely critical that there be a match
between private equity fund sources of capital and its uses as
seen in the investments it intends to make. If you expect the
SBIC managers to make relatively high-risk, low-liquidity,
long-term but potentially high-return, i.e., equity type
investments, then the SBA dollars that might be used should be
patient, long-term, and risk-tolerant.
In any company situation seeking funds from a diverse set
of players--and when you have the SBA limited partners and
general partners, that is a pretty diverse group--there are
pricing and term issues. To be successful, all parties to a
transaction must feel there is a fair and reasonable sharing of
risks and rewards, and that there are reasonable oversight and
controls consistent with the players' position in the
transaction.
Chairman Manzullo. You have got a red light there. How are
you doing?
Mr. O'Connell. All right. I will just finish. Let me talk
to two things.
I think it is important that a pool of private equity
investments at the SBA be properly diversified across both
character and time, and I think that the money must be patient.
And in order to be patient, that requires those with largely
portfolio management issues, and those are best met by having a
staff of professionals that I think requires a commitment to
the SBA itself.
Chairman Manzullo. Thank you very much.
[Mr. O'Connell's statement may be found in the appendix.]
Chairman Manzullo. I have the first question here to ask of
our Deputy Administrator. From the documents I have seen
generated by the SBA, it appears the SBA was aware of problems
with the Participating Securities program as far back as the
summer of 2003, but it submitted a proposal to modify the
program to the House and Senate Small Business Committees.
Furthermore, the SBA was aware that the Inspector General
had issued a report in May of 2004 concerning problems with the
Participating Securities program. Nevertheless, the SBA
licensed more than 30 new Participating Securities SBICs in
September of 2004.
My question is if the program was such a problem, why did
the SBA license and, in fact, work overtime to do so many new
Participating Securities SBICs?
Mr. Guzman-Fournier. I appreciate the question.
The Agency basically made a determination to continue to
operate the program through the period of the authorization.
There was a decision made that we had a statutory obligation to
carry out the program. We intend to fulfill our obligations
with the outstanding commitments, but we need to continue to
monitor the risks with this money that we have already
committed.
Chairman Manzullo. The problem is that your J-curve, or
your turnaround, is 5 years, and you had come to the conclusion
an entire year before this thing was a black hole, and yet--I
mean, it is not cheap to set up a participating securities
SBIC. It is a tremendous amount of money in attorneys' fees and
accounting fees, et cetera. It seems inconsistent.
You have a statutory obligation to continue the program
now, but you have decided that you do not want to. It just does
not make sense that in September of last year, what, 6 months
ago, you gave the nod to 30 new companies, SBICs, to go ahead
and start new programs.
Mr. Guzman-Fournier. Part of the problem was that we also
had--the industry noticed that the program was going to be
terminated, and we had a lot of private investors' capital
interest, as this chart shows. If you are making 1.9 times your
money in profits, you would really be interested in
participating in such a program.
Chairman Manzullo. But you fueled that. You could have
said, ``Look, it is going to be our intent to zero this thing
out.''
Mr. Guzman-Fournier. We had a lot of debate about that
internally in the Agency, and the decision was made we had to
fulfill our obligation.
Chairman Manzullo. But at that time you knew you wanted to
terminate the program; isn't that correct.
Mr. Guzman-Fournier. As I said, we had a lot of private
interest in the program.
Chairman Manzullo. That does not answer the question. The
question is, at the time that you authorized and licensed 30
new participating security SBICs, you knew at that time that
you wanted to eliminate the program.
Mr. Guzman-Fournier. Actually, we knew at the time that the
program was not going to continue, and we knew that that was
the main reason we were going to be getting a lot of demand for
our leverage. Again, this was an Agency decision.
Chairman Manzullo. I do not care if it was an Agency
decision or not. You still have not given me the reason why at
a time when you knew that you--when a decision had been made to
end the program, nevertheless you told 30 new SBICs to go ahead
and start new programs.
Mr. Guzman-Fournier. And we have commitments until fiscal
year 2008 for those. They will have money for the next 5 years,
and we intend to fulfill our obligation to them. But they are
going to have their 5-year cycle, so we are not shutting them
down. When we made the decision that we were going to fund
them, we said we are funding you with alongside commitments,
and those are 5-year commitments.
Chairman Manzullo. Were they aware of the fact they were
going to have one shot at it and that was it.
Mr. Guzman-Fournier. I believe they did, because if the
program was going to be--pretty much everybody at that time
within licensing was, and we were, internally letting funds
know that this was pretty much termination of a program. So I
think so.
I think people knew. Most of the funds applying knew.
Chairman Manzullo. Were you at the SBA at the time in
September of 2004?
Mr. Guzman-Fournier. I was.
Chairman Manzullo. Okay. Thank you.
Ms. Velazquez.
Ms. Velazquez. Thank you.
Mr. Guzman, the lack of availability of venture capital for
minority women and veteran entrepreneurs is near crisis level.
Overall it is estimated that minority entrepreneurs receive 3
percent of all venture capital investment and women get only 2
percent.
What is the SBA going to do to increase veterans',
minorities', and women's access to this form of capital?
Mr. Guzman-Fournier. We have a debenture program, and we
also have something called the LMI debenture, which is part of
the debenture program, and that is focusing more on the lower-
and middle-income areas of the United States. The key
difference with that debenture is that whereas with the normal
debenture, you have to repay interest back to us semiannually,
on the LMI debenture, you get a 5-year period. It is a zero
coupon bond.
Ms. Velazquez. But, sir, answering my question, I am
telling you that only 3 percent of all venture capital is going
to minorities. Apparently, what you are doing is not working.
So what is it that you are going to do to make it work?
Mr. Guzman-Fournier. We have been trying. Within the past 2
years, we have had an initiative within the SBIC to try to
reach out to more minorities and women fund managers, which I
think is the critical thing you are mentioning here. You want
to have fund managers that know their communities so that this
money can spread to different areas that are not being served,
as you said.
But I think--and let me just speak based on fact here.
Unfortunately, the LMI debenture, we have not had a lot of
interest in that debenture from the current funds.
Ms. Velazquez. Does that mean that you are going to support
the new market venture capital program?
Mr. Guzman-Fournier. That program, it still has--we did not
see a lot of interest in that program when it was created. In
fact, we had fewer applicants than--
Ms. Velazquez. So what you are trying to tell me is that
the SBA is not going to support the new market venture capital
and that you are going to try to get rid of that program, too?
Mr. Guzman-Fournier. No, I am not saying that.
That program has commitments from us, as well as the
regular SBIC; and we are going to commit to fulfilling that
obligation as well. Up until the time those commitments expire,
we will be funding those companies.
Ms. Velazquez. How long did it take for the administration,
SBA in this case, to issue the regulations on the new market
venture capital?
Mr. Guzman-Fournier. I would need to get back to you on
that.
Ms. Velazquez. Two years? So it showed a lack of interest
and leadership coming from the administration to support the
program.
Sir, the SBA is responsible for managing the SBIC program
so that it is implemented in a prudent manner. However, SBA
took back and let many SBICs flounder, losing much of their
leverage extended. Why did SBA not intervene sooner in so many
of the cases where it was evident that the SBA was highly
likely to take a major loss?
Mr. Guzman-Fournier. That is a good question. We have
venture capital, as was said in this panel, has a long-term
view of things. So we have what is called a forbearance in our
program. And what that means is for a fund that is a vintage
year 1994 fund that started operating in that year, you give
them between 4 and 5 years of operations without us
intervening. Even if they are capital impaired, we give them a
forbearance time because there might be a possibility, as was
said here, that some companies are going to exit or come to
fruition with the funds.
So the way we look at it--and I am going to be up front
about this--we do not disagree that we could have done somewhat
more at some periods, but if you think about who are the funds
in liquidation that we have currently, they are mostly 1994
through 1998 funds. We were not here at that time. Those funds,
75 percent of the funds in liquidation currently are from those
years.
When you get to your job and you see that you have some
failed funds from those years, there is not much you can do
about it.
Ms. Velazquez. I do not have much time, but you clearly
admit the poor mismanagement of the program on the part of the
administration.
Thank you, Mr. Chairman.
Chairman Manzullo. Mrs. Moore, do you have any questions.
Ms. Moore. Well, thank you, Mr. Chairman, and thank you
ranking member. I feel very privileged to be here this
afternoon, and I have enjoyed both panels.
I guess the question that I have is for Mr. Guzman-
Fournier, because the rest of the second panel seems to believe
that you have indeed succeeded.
You say that the program is structurally flawed. Is it
possibly structurally flawed because you are not patient? You
talked about a 5-year window, and we know that that is not a
big enough window for venture capital.
You also complained about the distribution of profits to
investors. Well, according to the testimony we have had here
today, we have had millions, billions of dollars of angel
investors come to the table because of this program. And if in
fact our goal--and of course, 75, 80 percent of the businesses
in our country are small businesses so that if we want to
continue to be globally competitive, if we want to continue to
encourage investors here on our shores to invest, how can we do
it without this instrument?
All of the structural flaws that you have talked about tend
to reflect on a lack of patience, which all of our other
witnesses have talked about as being absolutely necessary.
Also, the investment in seed capital in early ventures will
be severely hampered if, in fact, we close down the SBIC
program. And, of course, we have heard from our other witnesses
that there would be a geographic mismatch if you were to pull
out. In other words, only those businesses that were willing to
locate on the coasts would be able to attract private venture.
So I am wondering about that old saying that you should not
throw the baby out with the bathwater. Is it not possible to
structure our investments for longer terms and really see the
benefit of investing in our economy, so that we do not continue
to be the highest debtor Nation in the world?
And please excuse my voice. I am just kind of sick today,
but this was so important that I thought I should come.
Mr. Guzman-Fournier. Thank you. Thank you for the question.
Let me talk a little on the not being patient enough. In
fact, as I mentioned to Ranking Member Velazquez, we have
probably erred more on the side of being too patient in this
program. When the program started, the deal was made that we
were not going to receive up-front profits in the same way as
private investors, but that on the back end, which is when a
fund failed, we could take action and get some of those
creditor rights to move on funds.
Part of the reason why we have the $1.3 billion in the cash
flow right now is because we had a lot of failures in the
program of funds, that we had to repurchase their securities.
And as I mentioned, 75 percent of those come from 1994 through
1998, their beginning years. And we are already into 2005, so
it has been a while; and we have given funds time to prove if
exits are going to come. But we have also some regulatory ways
that we need to comply with the regulation.
We have a forbearance period. And once a forbearance period
ends is when we need to move and take some action. We do it--I
mean, we have discussions with management. We bring people for
portfolio management meetings, and we have discussions to find
out if this portfolio is going anywhere, if their companies
have any chance of succeeding. And if not, then we move.
I agree with you that--I did not come here to say that
there is not a need for equity investing. What we are saying is
that the structure of this program is flawed, and it is so
flawed that we are experiencing huge amounts of losses because
of the way it is structured; and that is our main point today.
Chairman Manzullo. We will have time for another round. Did
you have a short follow-up? Go ahead.
Ms. Moore. Thank you, Mr. Chairman.
I guess if we are experiencing losses on paper through
SBIC, are we not recouping those investments by the economic
impact of creating all the jobs and creating the businesses
that are reflected here? Is that not part of the balance
sheet--I mean, a governmental program should not operate like a
private firm--that what you are calling losses are actually
investments?
I mean, all these companies, obviously, do not succeed, but
are you not experiencing losses because you have in fact
generated thousands of jobs and created businesses, and you
basically have subsidized the growth of our economy?
Mr. Guzman-Fournier. I wish I could come here today and
tell you that this program has been a success, but from a
financial standpoint it has not been a success, and the
taxpayer has got the burden of $1.3 billion now in liquidation
and potentially more. We have projections of $2.7 million in
losses right now.
Ms. Moore. Can I direct the question to someone else on the
panel?
Chairman Manzullo. You are over time. Let me go to Ms.
Bordallo, and then we will have time to come back. Thank you.
Ms. Bordallo. Thank you very much, Mr. Chairman. I will
make mine very quick.
I want to thank you and Ranking Member Velazquez for
holding this hearing. I also thank the witnesses.
In reading some of the testimonies, it seems we are all in
a consensus that the SBIC program is important to small
businesses and the economic growth, but because of the erosion
of small businesses across the Nation and because of foreign
competition, it seems to me that this is a program that should
be maintained. If it is flawed, we should fix it. And I would
like to continue working with the committee to see that we fix
this program.
Certainly, we cannot allow our small businesses just to go
out there and try to work their way up. This is a tough
business right now. And all we hear at this Committee on Small
Business with our hearings is one small entrepreneur after
another saying how they have gone broke, they have had to close
family businesses. So we need to give them programs that will
assist them and help them get on their feet and continue to
grow.
So, Mr. Chairman, I support the program, and if it is
broken, let us fix it.
Chairman Manzullo. Thank you.
Congressman Akin.
Mr. Akin. I do not really have any questions at this time,
Mr. Chairman.
Chairman Manzullo. I want to get back to Dr. Blaydon.
Just as you got to the bubble, the time bubble burst. Do
you want to pick up at that point?
And anybody else who wants to add about the bubble just
feel free to jump in.
Mr. Blaydon. Thank you, Mr. Chairman.
What I was going to say is that the bubble hit everybody;
it hit SBICs; it hit private venture capital firms. And the
private venture capital firms of vintage year 1999, if one of
those funds breaks even, returns its capital, it is going to be
in the top tenth percentile of all funds.
Most of those funds from 1999 vintage year are going to
lose money. The same is true of the 1999 vintage year of the
SBICs. However, the difference is that the funds that have
resources that are able to go in and try to work out their
portfolios are, in fact, going to be the ones that are at least
going to get back to break-even, and a lot of those funds are
doing that. Those are funds that typically have been around for
several years before, have reasonably large pools of capital to
invest in restructuring and working out in restructuring their
portfolios.
The people who are going to lose are the people who had
funds that were out of money and cannot invest in restructuring
those portfolios that suffered in the down economy. There are
going to be those who are not willing to go forward. Those are
largely the corporate venturers who, when they saw the
downturn, also, you might say, panicked and pulled out. People
are going to make money off of their portfolios because others
are going to come in and take over those companies. They are
going to restructure them; they are going to put more capital
into it.
What it appears is going on with the SBIC is that the
SBIC--apropos of the question of patience, the SBIC sees 5
years in a program, a vintage year, late 1990s, that is not
doing well, and if they do not permit them to continue to
invest, to restructure them, they are almost assuring that
these companies may well fail, cannot be restructured; and the
government, as well as the companies and the private investors,
are going to lose money.
Chairman Manzullo. Anybody else want to comment.
Red? Go ahead.
Mr. Clark. The Federal Government is using the SBIC program
not only to encourage innovation and encourage small business
development; they are discussing--we are discussing the program
today as a failed investment vehicle. If you are going to
invest money in the venture capital industry, I think it is
fair to ask the question, Why are you doing so with a different
set of rules?
If you take a look at the rates of investment from the
private sector in the institutional venture capital industry
over the last 10 years, remove the bubble and what you see is a
steady, increasing trend of investment. It has gone from $8
billion to $22 billion, $23 billion over the last 10 years. If
you track the performance of those funds, when you cut the
bubble out, what you find is that there are--the industry as a
whole is making an acceptable rate of return.
And what you also find is that the way the returns come in
varies a great deal from firm to firm, but more often than not
you get very large returns on a very small number of
investments; you get average returns on a modest number of
investments; and you break even or lose money on a handful of
investments. Your existing program cuts off the upside.
You cannot participate in the upside the way that it is
structured right now. You have changed the rules. If you change
the rules, it does not matter how much money you pour in. If
you cannot win, you cannot win. You have rigged the game in the
way the program has been put together right now.
So if there is an awareness that you can take away from
this hearing, it is not that you cannot invest money and show
an acceptable rate of return, it is not that you cannot invest
money and encourage innovation and encourage new business
development; it is that if you change the rules and you make it
a loser, you are going to lose.
Chairman Manzullo. One rule is that I am out of time.
Ms. Velazquez.
Ms. Velazquez. Mr. O'Connell, we have clearly indicated
today that the greatest shortage for capital is for early-
stage companies, correct?
Mr. O'Connell. Yes, ma'am.
Ms. Velazquez. The participating securities programs
investment in start-ups has declined from 50 percent in the
1990s to 30 percent today. Do you think the SBIC will continue
to shy away from start-ups, just as traditional venture capital
has done?
Mr. O'Connell. I have always looked at the venture business
as a business, and our goal is to take capital from whatever
source, and to effectively deploy it and generate capital
gains, and to do that by creating companies or expanding
companies that are worthy of investment.
Those dollars ebb and flow. And, at times, earliest-stage
companies are always the hardest thing to fund, and they are
sometimes less attractive than later-stage things.
We react to the sources of capital that are available to
us. And if the limited partners, who are a primary source,
whether they are pension funds or institutional investors, or
whoever they might be, if they are risk averse, then we tend to
do investments that reflect their risk aversion as well. I
think those things ebb and flow.
So what you have seen is, the bubble spooked everybody.
Looking at my industry, I felt at one point that I had become a
dinosaur, because the way that investments were made reflected
an aggressiveness that was inconsistent with the due diligence
and the patience we needed during the bubble. And I think we
paid for that exuberance that we had.
Ms. Velazquez. But given the fact that there is an
abundance of late-stage funding, but a lack of early-stage
funding for start-up, do you think it would be appropriate to
tailor the SBIC program so that it really serves more start-
ups?
Mr. O'Connell. I think that what I was trying to say is
that we, as the marketplace, will flow to the opportunity. And
if, in fact, we have capital available--and I think that is
what the SBIC program has done historically, the participating
preferred program has done historically is, it has encouraged
general partners, who have a specialty, and who want to invest
in a region or a stage of company, as you are suggesting, that
is out of favor, it does that.
I think if you encourage that kind of investment, you will
get that result.
Ms. Velazquez. Okay.
I would like to ask this question of every witness, with
the exception of the administration, because I know the answer.
Do you believe there is a need for the government to
continue to play a role in making venture capital available?
Yes or no?
Mr. O'Connell. Yes.
Mr. Clark. Yes.
Mr. Redding. Yes, I do.
Ms. Preston. Absolutely.
Mr. Blaydon. Definitely.
Ms. Velazquez. Thank you.
Ms. Preston, do you believe the Federal Government,
specifically SBA, should help in strengthening the angel
investment community, such as by providing leverage to angel
networks?
Ms. Preston. Absolutely, there is no question about it.
There are a number of different ways to provide advantages to
angel investing, and to support the entire process of angel
investing. Whether or not they ever walk up into and fill that
funding gap is a complete unknown, and nothing that we should
have as an assurance of a bet on that. Because I think that is
a long shot of looking at angel investors filling up to $5
million.
Ms. Velazquez. And I know some States are experimenting
with angel investment tax credits.
Ms. Preston. We have 18 States that currently have tax
credits for angel investors.
Ms. Velazquez. And do you think that has been helpful in
stimulating investment?
Ms. Preston. It has been helpful. But still when we look at
the statistics, and even when we have done it through the Angel
Capital Associations, surveyed our own members, the average
investment by the groups themselves, not just individuals, has
been between $100,000 and $500,000. So I think we do have a
definitive issue still that the SBIC needs to address.
Ms. Velazquez. Thank you.
Mr. Blaydon, do you believe the participating securities
program would be better implemented as a grant program; that
is, if the funds were invested with no intention of repayment
to the Federal Government?
Mr. Blaydon. That certainly would remove many of the
conflicts that are going on here, Ms. Velazquez. But I think,
as some of my other colleagues mentioned here too, there is the
possibility of designing the program also so that when the
risks are shared appropriately with the rewards, that the
program can succeed and be a self-funding program going forward
into the future.
A grant program would absolutely assure that it would not
be a question of how the risk is going to play out in the
future, but I do think the program can be restructured in a
way, with appropriate risk sharing and profit sharing, it could
be self-funding over the long term.
Ms. Velazquez. Thank you, Mr. Chairman.
Chairman Manzullo. Thank you.
I have an idea. We have a lot of brainpower here with all
six of you. Would you all be willing to stick around after the
hearing to sort of jam and put out some ideas on how to fix the
program? Would that be okay with you?
Mr. Guzman-Fournier. For how long would that be?
Chairman Manzullo. As long as you can stay. If it is a
half-hour, that would be sufficient. Or have somebody here in
your stead.
Mr. Guzman-Fournier. We have always said that we are
willing to listen and to work with the committee. The question
is the timing here.
Chairman Manzullo. Well, if you cannot stay, Tee can stay.
We will commit him. Is that okay with you, Tee?
Mr. Rowe. Anything you say, sir.
Chairman Manzullo. Okay, thank you, appreciate that. And we
can work with your plane schedules. But I just thought that
since we want to get this thing fixed, why not take advantage
of a very informal situation afterwards.
I have noticed, coming from a background of somebody who
spends most of his time in Congress working on manufacturing
issues, you are partners with Andrew Kalnow, are you not, at
Alpha? You helped them start?
Or you did, Mark?
Mr. Redding. Alpha Capital is a member of the investor
group in Banner Service Corporation.
Chairman Manzullo. Okay. Andrew Kalnow has a very
interesting background. I met him when his family stepped in
the breach when National Machinery from Tiffin, Ohio, went into
Chapter 11. And National Machinery was the last, or is the
last, coal-forming machine tool company in the United States.
It is important because that machine tool makes bullets, and it
went under. The Pentagon did not know about it.
I find it very interesting that Mr. Redding and Dr. Clark,
both of you have this manufacturing background. I know the
answer to it. But could you lay out before us the extra
difficult time that manufacturers have in getting venture
capital? What is it about the nature of manufacturing that
makes it extra difficult?
Mr. Redding. I think in my case, Congressman, when we did
this transaction, the Banner business was in decline, like
many, and the debt financing that was available was very
restrictive and nervous. Equity investment continues to be an
important part of any of these transactions; and the suggestion
that the debenture program is a substitute, I think, is
incorrect.
Manufacturing is a difficult business, thought to be going
overseas, and not particularly attractive to many people who
make these decisions. Those of us who have been in it all our
lives see it differently.
Mr. Clark. In addition to having a bad public profile as an
investment opportunity, just as an industry, the U.S.
manufacturing industry is generally very capital intensive,
very mature, and it tends towards being resistant to change.
The people that are driven into the industry by available
venture capital are agents of change. They are the antithesis
of the way the industry works.
So while the investment community tends to resist the
manufacturing community as an investment opportunity because of
those issues, in fact, it is a necessary marriage. And what we
are beginning to see is that there are a limited number of
firms that are looking at specific dealings inside the
manufacturing community. They see a tremendous opportunity for
change and profitability, and they are beginning to back those.
But they have to really be exceptional opportunities right now
because of the negative profile the industry has.
Chairman Manzullo. We had a situation in Rockford, when
Ingersoll Milling Machine burst into--I guess that is the
word--into several different areas. The cutting tool division
was sold to an Israeli company. The milling machine company,
the one that makes the seven-axis machines that wrap stealth
material on aircraft, ended up in Chapter 11. And the stalking
horse was a Canadian company, but the successful bidder was an
Italian company, Camozzi Brothers.
Phil James came out of retirement, lives in Rhode Island,
and tried to save the company, that division. He went to 10
banks and joint venture capital companies--I do not think he
went to an SBIC--but he could not find anybody interested.
So he went to the Chinese to a company called Dalian, which
is a wholly state-owned Chinese company, who bought the
Ingersoll production line in Rockford where they manufacture
machine tools and export them back to China. Now, you figure
that one out. But what it showed is the fact that it was just
desperation looking for that type of capital.
Now, when we reauthorized the SBA, we made it so that the
504 program could go up to $4 million for the purpose of
infusing more money into the manufacturing sector. And I just
bring that out because it is so difficult, if not impossible,
to get that money into the hands of the manufacturing sector.
Mrs. Moore, did you have any further questions over there?
Ms. Moore. Thank you, Mr. Chairman. I was particularly
interested in a couple of people's testimony, and I just want
to thank Mark Redding for all the work he did in Wisconsin.
Franklin, Wisconsin, literally is across the street from my
district.
And I also wanted to revisit some statements that were made
by Ms. Preston regarding angel investors. I tried to look
through your testimony here to see if I could glean the answer,
and of course, I cannot.
And I also wanted to ask Dr. Clark about the economies that
we have realized. You talked about the fuel efficiency and a
number of others--increases in sales, and reducing our reliance
on fossil fuels, and lead paint, and other things. I was very
interested in that.
But first, Ms. Preston, I wanted you to explain the $22
million of new angel investors that have come in. It is not
clear to me whether in 2004 that was because of SBIC's
involvement.
Ms. Preston. Their estimation is being made by the Center
for Venture Research at the University of New Hampshire, which
has been doing research on angel investors for a number of
years. And for 2004, the estimation was that angel investors
invested $22.5 billion into entrepreneurial ventures, primarily
at the early stage in the United States. And that was into an
approximate 48,000 different ventures. So that is where the
number comes from.
We estimate there are approximately 225,000 active angel
investors in the United States at this time. That is a very
small number compared to who has the ability to be angel
investors. But, again, they are primarily at the very early
seed-stage investing and understand the need, as you pointed
out, of the patience of dollars.
And an expectation, as an angel investor myself, and others
who are angel investors, is that we do not expect to see
necessarily a return on our investment for 7 to 10 years
because we understand that we are investing at that earliest
stage, but at an incredibly vital stage of a company's
development because there is no other source of financing if we
lose the SBICs.
Ms. Moore. So you were really just comparing the patience
and the productivity of those investments in contrast with the
impatience of the SBIC program?
Ms. Preston. That is exactly right.
Ms. Moore. I also am very excited about the economies, and
I believe it was Dr. Clark. Could you please share a little bit
more about that, how we have reduced our reliance on a billion
dollars in gasoline? I want to hear more about that.
Mr. Clark. The technology that we have developed allows the
companies that stamp metal to use thinner, stronger, lighter
metals in order to manufacture anything that is made out of
stamped steel, stamped aluminum, stamped titanium.
In the U.S. auto and truck market, we are currently
deploying technologies. We have not fully penetrated the
market, but we are deploying technologies that allow the auto
industry to essentially reduce the weight of its parts, frame
and body parts, by somewhere in the area of 10 to 20 Percent.
What that means is that for the weight of a car, if you
have a 2,000- or 3,000-pound car, body and frame, you can cut,
let us say, 300 to 400 to 500 pounds of weight out of that
frame by using these new, advanced steels. Industry does not
know how to form them. We have given them a technology that
allows them to form them with fewer defects and make the parts
faster.
When you calculate the impact of the reduced weight on the
vehicles, that is where the fuel savings come from. The numbers
I gave you were numbers that were calculated by DOE, based on
full deployment of the technology.
We are just beginning to write up what we call the "hockey
stick" right now in deployment of the technology within
Chrysler, to a lesser extent within Ford; and we are just
beginning to work on GM, and then we are working in the supply
chain.
So as we continue to deploy, and if other technologies come
along and do the job better than we do in specific
circumstances, we will see reduced fuel demand and improved
vehicle mileage per vehicle because the cars are lighter. We
can push them with less energy. So that is where that figure
came from.
Ms. Moore. And that would be impossible without venture
capital?
Mr. Clark. I guarantee you this technology never would have
hit the street if we did not have the backing of the venture
capital, first, angels and then the institutional venture funds
backed by SBIC. We would not be here.
Ms. Moore. Thank you very much. I think that is the wave of
the future.
Thank you, Mr. Chairman, for your indulgence.
Chairman Manzullo. Well, thank you for those excellent
questions. I want to thank all of you; and we will come down
there in a minute and sit down and chat with you informally.
Again, thank you for coming here, especially those of you
who have come in from long distances. This hearing is
adjourned.
[Whereupon, at 3:55 p.m., the committee was adjourned.]
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