[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


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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

                              ----------                              

                               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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