[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



 
 PROPOSED LEGISLATIVE REMEDY FOR THE PARTICIPATING SECURITIES PROGRAM

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON SMALL BUSINESS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                     WASHINGTON, DC, JULY 27, 2005

                               __________

                           Serial No. 109-27

                               __________

         Printed for the use of the Committee on Small Business


 Available via the World Wide Web: http://www.access.gpo.gov/congress/
                                 house




                 U.S. GOVERNMENT PRINTING OFFICE

23-182                 WASHINGTON : 2005
_________________________________________________________________
For sale by the Superintendent of Documents, U.S. Government 
Printing  Office Internet: bookstore.gpo.gov  Phone: toll free 
(866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2250 Mail:
Stop SSOP, Washington, DC 20402-0001




                      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 A., Associate Administrator for 
  Investment, US Small Business Administration...................     3
Lerner, Mr. Josh, Jacob H. Schiff Professor of Investment 
  Banking, Harvard Business School...............................     5
Mercer, Mr. Lee, President, National Association of Small 
  Business Investment Companies..................................     8

                                Appendix

Opening statements:
    Manzullo, Hon. Donald A......................................    26
    Velazquez, Hon. Nydia........................................    28
Prepared statements:
    Guzman-Fournier, Mr. Jaime A., Associate Administrator for 
      Investment, US Small Business Administration...............    30
    Lerner, Mr. Josh, Jacob H. Schiff Professor of Investment 
      Banking, Harvard Business School...........................    34
    Mercer, Mr. Lee, President, National Association of Small 
      Business Investment Companies..............................    41
Additional material:
    Letter to US Small Business Administration Administrator 
      Hector Barreto from Chairman Donald Manzullo and Ranking 
      Member Nydia Velazquez.....................................    64

                                 (iii)


  PROPOSED LEGISLATIVE REMEDY FOR THE PARTICIPATING SECURITIES PROGRAM

                              ----------                              


                        WEDNESDAY, JULY 27, 2005

                   House of Representatives
                                Committee on Small Business
                                                     Washington, DC
    The Committee met, pursuant to call, at 10:12 a.m. in Room 
2360, Rayburn House Office Building, Hon. Donald Manzullo 
[Chairman of the Committee] presiding.
    Present: Representatives Manzullo and Velazquez 
    Chairman Manzullo. Good morning, and welcome to this 
hearing on a very important topic for small businesses around 
the country: access to capital.
    I am sorry I was late, but it is impolite to walk out when 
the President is speaking. And so I followed the protocol and 
waited until an opportunity arose for me to leave there and 
come here.
    In April of this year, this Committee held a hearing on the 
importance of the participating securities program with small 
businesses needing equity investment. We also learned about the 
equity gap that exists between angel investors and venture 
capitalists.
    The Administrator, on more than one occasion, has given his 
word to help us work toward a solution. Yesterday, I, along 
with Mr. Ramstad of Minnesota, introduced legislation HR 3429 
that would fix the problems caused by the participating 
securities program.
    Both the SBA and industry have had ample time to consider 
the merits of the draft bill.
    I look forward to the testimony of both witnesses regarding 
key aspects of the bill, such as conformity with the Credit 
Reform Act, and repayment of principle and interest back to the 
government.
    I now turn to the Ranking Member for her comments. Mrs. 
Velazquez?
    Ms. Velazquez. Thank you, Mr. Chairman.
    In today's economy, access to capital is clearly the key to 
a successful small business. In particular, venture capital has 
become the lifeblood for entrepreneurs.
    If you look back through our nation's history, when venture 
capital is available to small business owners, the effects are 
amazing. One of the main contributing factors to the economic 
boom of the 1990s was increased flow of venture capital.
    Unfortunately, venture capital is simply not accessible to 
many entrepreneurs just starting out today, particularly 
minority business owners. That is why programs, such as the 
Small Business Investment Company, are so important. This 
program has been internationally recognized, and has a proven 
record.
    Since 1994, it has made $8.5 billion in participating 
securities investment, which led to the creation of over 
228,000 new jobs and $39 billion in revenue.
    As this Committee is well aware, the SBIC program has now 
been shut down for nearly nine months. Since that time, the 
Bush Administration has failed to provide any solution to 
ensure venture capital is going to small businesses. And as a 
result, they have been getting less and less.
    Today's hearing will begin to look for a solution, with a 
review of a proposal that I am sure is just one of many to 
come. It is my hope that this hearing will steer the 
Administration forward into finally taking some action.
    It is important today, as we look into reopening the 
program, we address some of the longstanding issues that have 
plagued the SBIC program in the past. This program has proven 
its effectiveness, but it has the potential to provide even 
more venture capital to those who need it most.
    Clearly, early-stage companies and minority-owned companies 
who rely heavily on this program as a source of seed capital 
need it the most.
    In the 1990s, SBIC made nearly 50 percent of their 
investments in start-ups. However, this dropped to 30 percent 
over the past two years. We must ensure there is no further 
decline, and that the SBICs are not limited by any burdensome 
barriers, so they can continue to make these investments.
    Minority-owned businesses need this investment, as well. 
Right now they receive only 2 percent of all venture capital 
investment. And in 2004, only 11 percent of the total SBIC 
Program financing went to minority-owned firms.
    For a program that was supposed to help close this gap, 
this is unacceptable, and something needs to change. In 
addition, it is important for Congress to recognize that the 
SBIC Program may have to operate with an appropriation.
    With the volatile nature of equity capital, if we have 
learned anything from past failures, it is that the government 
cannot always get something for nothing.
    First and foremost, I want to make one thing clear. 
Operating the program at no cost to the government is not the 
priority here. The goal is to have an affordable equity program 
for small businesses. If that means having the government match 
lenders and small businesses' commitments, then so be it.
    We should also use this opportunity to broaden the scope of 
the program and the participants it attracts. An important step 
in doing this is ensuring that the application process is easy 
to navigate and inviting to users.
    Historically, the licensing approval process has been a 
mystery to those who have to use it. In order to create more 
diversity among the industry and create new appeal, we must 
make these processes more transparent. This will guarantee that 
no applicants are turned away due to a difficult approval 
process.
    The other important component is making sure this proposal 
is attractive to the investment community. Congress can think a 
proposal is wonderful, but if those that us it and invest in it 
do not think so, all of this work will amount to nothing more 
than wasted time.
    These investors are the foundation of the program, and are 
vital in ensuring capital is available to all small businesses.
    In addressing these longstanding issues as we look to 
reopen the program, we will not just have a program for the 
sake of the program, but we will have one that is open, 
accessible, affordable, and focuses on the sectors that need it 
the most: minorities and start-ups.
    If this country continues to rely on this nation's 
entrepreneurs to spur economic development and create jobs, the 
need for venture capital only continues to grow. That is why 
the need for the SBIC Participating Security Program is 
crucial. Small businesses need a true equity program, and most 
importantly, this nation relies on this source of venture 
capital to help small firms advance our nation's economy 
forward.
    And that is the end of my statement, Mr. Chairman. Thank 
you.
    Chairman Manzullo. Thank you very much for that very 
thorough statement and insight into the program we all share, 
and that is lack of capital.
    We only have one panel and three witnesses. I want to set a 
10-minute clock, and not really worry about that.
    Our first witness from the Administration is a statement 
that I know will run more than that.
    [Laughter.]
    Chairman Manzullo. Well, if not--
    Mr. Guzman-Fournier. Probably five minutes.
    Chairman Manzullo. Well, whatever you like. You do not have 
to go 10 minutes. So we look forward to the testimony of Jaime 
Guzman-Fournier, Associate Administrator for Investment, US 
Small Business Administration. I just did not want to cut you 
off on time.
    Mr. Guzman-Fournier. All right.
    Chairman Manzullo. We look forward to testimony, and the 
complete statement of the witnesses and all the Members will be 
made part of the record.
    Thank you.

 STATEMENT OF MR. JAIME A. GUZMAN-FOURNIER, US SMALL BUSINESS 
                         ADMINISTRATION



    Mr. Guzman-Fournier. Mr. Chairman, Ranking Member 
Velazquez, Members of the Committee, I appreciate the 
opportunity to offer testimony on the Small Business Investment 
Company program, and the legislative proposal that attempts to 
correct the serious flaws in the Participating Securities 
program.
    In considering this proposal, we need to ensure that the 
failures and losses of the Participating Security program are 
not repeated.
    We are all familiar with the current estimates that project 
losses of over $2.7 billion on the more than $6 billion of 
participating securities disbursed through Fiscal Year 2004. In 
reviewing the Participating Debentures proposal, the 
Administration needs to ensure that these losses would not 
occur again.
    The Administration has studied the draft proposal to create 
a new form of SBIC security, called Participating Debenture. As 
we understand this proposal, the most basic features of this 
debenture are: a deferred-interest debenture with accrued 
interest unconditionally payable by the SBIC five years after 
issuance, and semi-annually thereafter. Additional payments are 
required if the SBIC has gross receipts, as defined by statute.
    The participating debenture principal would be due and 
payable at the end of year 10, although it could be paid 
earlier.
    However, the proposed legislation is unclear as to whether 
the trust certificate holders are entitled to regularly-
scheduled interest payments during the first five-year deferral 
period, or whether interest on the trust certificate is also 
deferred.
    SBA is further concerned that, although the SBICs are 
liable for interest payments, that their ability to make these 
payments is still largely dependent on the success of the fund. 
Five years of deferred interest on millions of dollars is a 
large sum of money. If SBICs are unable to make their 
significant interest payments at year five, the SBA will be 
required to make the payments on their behalf, as well as 
liquidation procedures to purchase the trust certificate. 
Unfortunately, SBA may ultimately be the party making the 
interest payments for the first five years.
    While this proposal appears to address some of the 
significant issues identified in our written testimony, such as 
ensuring that interest is unconditionally owed by the SBICs, 
many other important issues are still unclear.
    Last week, SBA provided the Committee with a number of 
questions regarding the structure, funding mechanism, 
distribution framework, and other features of the proposed 
participating debentures. We also requested information 
explaining the priority, amount, and timing of all of the 
payments associated with the participating debentures, which 
will help us in evaluating whether it is a debt or equity 
security, and its potential budgetary cost.
    Some examples of questions submitted include:
    Requesting a comparison of Participating Securities program 
cash flows to the Participating Debentures program.
    Requesting information as to who would issue the trust 
certificates--the SBA, the SBICs, or another entity--and 
whether SBA would advance interest payments to the trust 
certificate holders on behalf of the SBICs.
    Clarification, by way of specific examples, on how the 
distribution formula would work, identifying what payments the 
various parties would receive from the SBICs.
    Clarification as to whether SBA leverage is fixed at two 
tiers lifetime, or is refinanceable.
    These are a few examples of some of the critical questions 
raised during our initial review of the draft Participating 
Debenture proposal. We have received a preliminary response on 
some of these issues from the National Association of Small 
Business Investment Companies, to which the Committee had 
forwarded our questions and we look forward to receiving a 
complete response, and discussing these issues with you and 
your staff.
    As we have suggested above, experience with the 
Participating Securities program can provide valuable insight 
into the present proposal. A thorough examination of all 
potential effects of the proposed Participating Debentures 
program is warranted, so that all costs can be properly 
identified and assessed.
    Understanding the structure of the financial terms is 
important to ensure that the benefits to investors and small 
businesses are weighted against the cost to taxpayers.
    I applaud the Committee for taking the time to address this 
complex proposal. I and my staff at SBA look forward to working 
with the Committee to consider all aspects of this legislation. 
Such work is necessary to ensure a full examination of the 
feasibility of the Participating Debentures proposal.
    Thank you again for the opportunity to testify, and I look 
forward to your questions.
    [Mr. Guzman-Fournier's statement may be found in the 
appendix.]
    Chairman Manzullo. Thank you so much. Our next witness has 
just been elevated to the faculty of Harvard Business School. 
Josh Lerner is a Professor of Investment Banking at Harvard 
Business School, Director of the Entrepreneurship Working 
Group, and comes with a very distinguished background. He has 
written several books on venture capital.
    Unfortunately, he could not make it, so Mike Arlinsky, 
Chief Clerk of the Committee, will be reading the testimony of 
Professor Lerner. And Mike, that is probably about the easiest 
degree you picked up. Is that correct? We look forward to your 
testimony.

        STATEMENT OF MR. JOSH LERNER, HARVARD UNIVERSITY



    Mr. Arlinsky. The statement of Josh Lerner, read into the 
Record.
    My name is Josh Lerner. I am the Jacob H. Schiff Professor 
of Investment Banking at Harvard Business School, and the 
director of the Entrepreneurship Working Group and the 
Innovation Policy and the Economy Group at the National Bureau 
of Economic Research. I appreciate the opportunity to submit 
this statement to the Committee.
    The Committee is to be commended for taking a careful look 
at the Small Business Investment Company program. The program 
has a storied history, and played an important role in jump-
starting the venture capital industry.
    At the same time, given the tremendous growth in private 
sector venture capital activity, it is natural to A, if the 
program is still needed, and B, if the reforms proposed in the 
proposed legislation help the program better address these 
challenges.
    In this testimony I outline my concerns with two aspects of 
the proposed legislation.
    First, it is important to note that the SBIC program's 
history provides a great example of how public venture programs 
can help a nation build venture-investing infrastructure for 
the first time.
    To be sure, after the launch of the program in 1958, SBICs 
drew criticism for the low financial returns generated, and the 
fraud and waste associated with some funds. Viewed with 
hindsight, however, the program takes on a different 
appearance.
    Though few of today's significant funds began as a part of 
the SBIC program, the program did stipulate the proliferation 
of may venture-minded institutions in Silicon Valley and 
Massachusetts' Route 128, the nation's two major hotbeds of 
venture capital. These institutions included law firms and 
accounting groups geared specifically to the needs of 
entrepreneurial firms.
    For example, venture economics, which originated as the 
SBIC Reporting Service in 1961, gradually expanded its scope to 
become the major source of returns data on the entire venture 
industry. Moreover, some of the United States' most dynamic 
technology companies received support from the SBIC programs in 
the 1960s, 1970s, and 1980s, before they went public.
    But it is also important to note that the venture capital 
market has changed dramatically since the establishment of the 
SBIC program in 1958. The pool of venture capital under 
management today is, in inflation-adjusted terms, more than 
eight times the size of that of a decade ago, and many hundred 
times of that three decades ago.
    The pace of venture capital investment, while down from the 
overwrought levels of the bubble years, is still 10 times 
greater in real terms than the rate even a dozen years ago. In 
the eyes of many observers, as a review of recent issues of 
publications from Business Week to The Private Equity Analyst 
will reveal, we today have too many venture funds with too much 
capital chasing a limited number of attractive investments.
    These general observations about the market are underscored 
by my experience with the SBIC program participants. To be 
sure, many SBIC-backed funds are run by great individuals who 
are targeting underserved markets.
    But far too many of the SBIC participants in recent years 
have been marginal venture funds whose investments and 
approaches are not really different from their peers, with one 
important difference: the experience of the teams and 
investment theses of the funds are sufficiently tenuous that 
they cannot raise funds from the traditional pension funds, 
endowments, and other limited partners, without the program's 
assistance. It is very hard to see how many of these groups 
have addressed a market failure of any type.
    The emergence of a successful private venture capital 
industry is, thus, in many senses a tribute to the SBIC 
program. But at the same time, this growth raises important 
questions about the program. Is the SBIC program still needed 
today? If so, how should it be structured?
    Turning now to the specifics of the legislation, I have two 
major concerns. The first relates to its reliance on debt 
instruments; the second is the lack of any mandated assessments 
of the program's contribution.
    First, this legislation calls for the government 
contribution to SBICs to be in the form of debt securities. In 
my eyes, this seems troublesome, since it introduces 
inappropriate incentives and ignores global best practice.
    The problem with financing venture funds with debt is that 
organizations that have to make debt repayments will tend to 
make low-risk investments in relatively mature firms, in order 
to ensure that they are able to repay their obligations.
    Moreover, the ownership claims issued by the government are 
quite different from those provided to private investors, 
introducing additional potential conflicts.
    These incentive problems are particularly worrisome since 
they will push SBICs to make investments where they do not 
appear to be most needed. An extensive literature on capital 
constraints and entrepreneurship suggests that if there is a 
market failure in the US for funding growth companies, it is 
among the very small, high-risk firms.
    Firms with a real business plan and revenues today are 
likely to be able to attract plenty of equity or debt 
investors. Yet the proposed design of the SBIC program is 
pushing funds to make investments in precisely these lower-risk 
categories.
    The Committee should thus consider alternative program 
designs that address these incentive problems. One model that 
is being emulated around the globe today is the Israeli Yozma 
program.
    In June, 1992, the government established Yozma Venture 
Capital, Ltd.--Yozma means initiative in Hebrew--a $100 million 
fund wholly owned by the Israeli government.
    Yozma had three goals. To promote the growth of promising 
high-tech firms in Israel; to encourage the involvement of 
major international corporations in the Israeli technology 
sector; and to stimulate the development of a professionally-
managed, private-sector venture capital industry in Israel.
    Yozma, like the SBIC program, also shared the risks 
associated with venture capital investments. Yet it did so 
using a structure that was much more similar to equity, and 
thus avoided many of the problems delineated above.
    More specifically, the legislation that created Yozma 
allowed the government to contribute up to $8 million to a 
particular venture capital fund. These laws also required the 
venture capitalist to match the $8 million by raising at least 
an equal amount of money from limited partners. Therefore, the 
limited fund size was $16 million.
    Thus, if one of these funds tripled in value over seven 
years, net of fees and incentive compensation, both the limited 
partners' and Yozma's investment would also triple, from $8 
million to $24 million.
    The limited partners could then contribute additional funds 
to buy out Yozma's $24 million stake for about $10 million. 
These partners would therefore collect $38 million on the 
fund's $18 million overall investment, turning an annual return 
of 17 percent into one of 25 percent.
    This enhancement to returns was accomplished without 
exposure to the risks and the potential distortion of behavior 
that would have occurred if the Israeli government made loans 
to the venture fund.
    My second major concern with the legislation is a lack of a 
mandate to carefully evaluate how the SBIC program is working, 
and whether it is still needed. As noted above, the venture 
capital has changed dramatically in recent decades, raising 
questions as to the role that the SBIC program plays today.
    There is a real need to evaluate the SBIC program on a 
periodic basis. This should be a rigorous and dispassionate 
analysis of the program's success to date. The evaluation 
should also consider the overall venture capital climate, and 
whether the economic rationales that originally justified the 
program's creation still apply.
    It is interesting to note that in recognition of the 
success of the Yozma program, the Israeli government privatized 
its stake in the fund in 1998, declaring the goals of the 
program met.
    In short, the SBIC program has historically played a 
critical role in encouraging the development of the American 
venture capital industry. Given the changes in the private 
venture capital industry, it is reasonable to ask whether the 
program is still needed; and if so, what structure would be 
optimal.
    I believe that the reliance on debt securities and the lack 
of a mandate for formal evaluations of the program in the 
proposed legislation both raise serious issues.
    [Mr. Lerner's testimony may be found in the appendix.]
    Chairman Manzullo. Thank you, Professor. We look forward to 
grilling you with very difficult questions.
    I was just kidding, Mike. The next witness is Lee W. 
Mercer, who is with the National Association of Small Business 
Investment Companies.
    Mr. Mercer, we look forward to your testimony. You can take 
the liberty, if you want, to incorporate your testimony into 
the two questions or two concerns that were raised in the 
written statement of Mr. Lerner.
    We look forward to your testimony.

 STATEMENT OF MR. LEE W. MERCER, NATIONAL ASSOCIATION OF SMALL 
                 BUSINESS INVESTMENT COMPANIES



    Mr. Mercer. Thank you, Mr. Chairman, Ms. Velazquez, and 
Members of the Committee. And I will probably address some of 
Professor Lerner's statements later on. I will go through a 
little bit of my testimony first.
    And I will start by saying that in April, expert witnesses, 
perhaps not Professor Lerner, but other expert witnesses, and 
company CEOs confirmed the failure to agree on a new structure 
to replace the Participating Security program will have a 
significant negative impact on equity capital available to US 
small businesses. They confirmed the gap that is filled by the 
program.
    It will continue the break in the pipeline of new funds 
that we are experiencing this year. If new funds are not being 
formed every year, the capital available to small businesses 
will dry up quickly.
    H.R. 3429 provides a structure that can solve at least a 
large part of the problem. Perhaps, as Professor Lerner has 
said, not all of the problem, but a large part of the problem. 
And we urge the Committee to work for its enactment in a final 
form later this year.
    H.R. 3429 meets the qualification requirements of the 
Credit Reform Act. We are here because the Credit Reform Act 
does not allow for an equity security, as Professor Lerner 
suggests.
    It would substantially accelerate and increase the percent 
of returns to SBA in all funds, and make interest and principle 
chargeable against private capital, whether or not a fund is 
profitable.
    In addition, SBA's share of the profits and funds that 
produce greater returns would be approximately 260 percent 
greater than SBA's share of profits in participating security 
funds drawing leverage at current interest rates. This would 
assure that SBA would enjoy substantially larger returns in 
those funds that can most afford to pay it.
    We are confident that the proposed legislation would carry 
a zero subsidy rate for appropriations purposes if scored 
reasonably.
    Now let me address some of the specifics of the 
legislation. As far as Federal Credit Reform Act qualification 
is concerned, I believe that there can be no doubt that the 
security created by the proposed legislation is a debt 
security, for the purposes of the Act.
    Attached to my testimony is an opinion of counsel from the 
law firm of Kirkland and Ellis to that effect. We believe that 
that issue is behind us, one that has kept us essentially from 
the negotiating table, we believe, with the Administration for 
about a year now.
    H.R. 3429 has a dramatically improved financial structure. 
It will dramatically improve SBA's financial position in 
Participating Debenture SBICs, compared to SBA's position in 
Participating Security SBICs. It will do that in the following 
ways.
    First, interest on participating debentures would be 
payable, irrespective of the SBIC's profitability, and would be 
chargeable against the SBIC's private capital. That is not true 
in the Participating Security program, in which interest is 
called ``prioritized payment,'' and is payable only to the 
extent of a Participating Security SBIC's earnings. It is not 
chargeable in any degree against the private capital of a 
Participating Security SBIC.
    And while interest would be deferable under certain 
circumstances during the first five years, SBA would not have 
to advance that interest to the holders of securities used to 
finance leverage. Again, that is substantially different from 
the current program. And the proposed legislation makes that 
clear in paragraph K2B, concerning the timing of payments.
    Second, in HR 3429, distribution of any gross receipts, as 
defined in the legislation, would be mandatory, whether or not 
there were realized earnings for accounting or tax purposes. 
This is not true in the Participating Security program, where 
distributions are made only from realized earnings available 
for distribution.
    The change would result in substantially earlier 
distributions to SBA that would pay down interest and leverage 
faster than is the case in the Participating Security program. 
That alone is a substantial reduction in risk for the 
government.
    Third, HR 3429 provides that accrued interest would be paid 
first from any distribution, as is the case in the 
Participating Security program. However, after payment of 
interest, remaining amounts to be distributed would be 
distributed pro rata to SBA or to the, actually to the pools 
issuing the leverage, and private investors, according to their 
interests in the SBIC, until all outstanding SBA guaranteed 
leverage is paid in full.
    That is not true in the Participating Security program, in 
which SBA's share of such distributions over and above interest 
payments is only about 7-1/2 percent in funds for which SBA has 
provided up to 50 percent of the capital.
    In HR 3429, SBA's share would be 50 percent in that 
example, an approximately 565-percent increase in the 
acceleration of funds flowing to pay back leverage. At a 
maximum permissible leverage ration of two thirds of the fund's 
capital, HR 3429 would provide that SBA's share is increased by 
33-1/3 percent.
    Fourth, HR 3429 provides that all sums distributed to SBA 
over and above that required to repay accrued interest would be 
used to repay leverage, until leverage is paid in full. That is 
not the case in the Participating Security program, in which 
SBA books profits before reducing leverage.
    The result of this anomaly is that the Participating 
Security program, in that program SBA has been called upon to 
honor its guarantee of some leveraged principle and related 
interest payments in funds where there were early gains, but 
later losses, unnecessarily increasing interest expense, and 
potential loss for the government.
    Finally, SBA's share of the profits in the Participating 
Debenture SBICs would be greatly increased compared to SBA's 
share in typical Participating Security SBICs. This would be 
accomplished by a two-tier profit-sharing program.
    After all interest in SBA-guaranteed leverage has been 
repaid, SBA would receive a base profit share of approximately 
10 percent in a participating debenture fund leveraged at a 
two-to-one ratio. And that would continue until a fund's 
private investors received distributions equal to their 
original investment. That is about a median performance in the 
venture capital industry.
    Thereafter, SBA would receive about 27 percent of all 
remaining funds of the applicable distribution.
    In marked contrast, at the current 10-year Treasury Bill 
rate, SBA's share of all profits in a participating security 
fund is only about 7-1/2 percent, not the 27 percent.
    The result of this increase in SBA's share would be 
approximately 260 percent. Maximizing SBA returns from the most 
profitable funds will greatly reduce risk of loss to the 
government.
    Finally, I am heartened by the Administration's testimony, 
in that, as Mr. Guzman has suggested, it is an offer to sit 
down together with the Committee's staff to probe the intricate 
particulars of the structure in HR 3429. We welcome that 
dialogue, and look forward to moving forward to what we hope 
will be a successful passage of legislation this year.
    As far as Professor Lerner is concerned, part of his 
testimony should be more applied to the April hearing about the 
need for the program. And he raises some questions about 
whether there is a need for the program.
    His position does not necessarily say no. There were 
experts at the April hearing who took the opposing view, among 
them the Tuck School at Dartmouth College, in a very detailed 
report that the Committee has received. So I guess we are at 
the point where we know that experts can differ.
    As to his suggestion that using debt securities to fund an 
equity program causes some difficulties, there is no question 
but that he is correct. However, the government is constrained 
by the Credit Reform Act if it wants to adopt a program that 
can operate as a subsidy program costing the government less 
than 100 cents on the dollar for every program dollar to be 
invested.
    So I think he raises questions that need to be addressed. 
Some of them I think have been addressed in the April hearing; 
others are more properly a consideration of the role of the 
Credit Reform Act.
    Thank you very much, Mr. Chairman, Ms. Velazquez, for your 
attention.
    [Mr. Mercer's testimony may be found in the appendix.]
    Chairman Manzullo. I think I just have a couple of 
questions.
    Mr. Guzman, would you agree that the proposed bill conforms 
with the Credit Reform Act?
    Mr. Guzman-Fournier. Mr. Chairman, we are still reviewing 
the proposal, and have not yet made a determination on that.
    Chairman Manzullo. The questions that I was going to ask 
really came up in the testimony of the Professor. And I have no 
more questions. I would then defer to Mrs. Velazquez.
    Ms. Velazquez. Thank you, Mr. Chairman. I do have a lot of 
questions. And I would like to go first to Mr. Guzman. And then 
if you have any other questions--thank you.
    Mr. Guzman, looking at your testimony, you criticized the 
Participating Securities program for its losses. In doing so, 
you suggest that these losses justified the elimination of the 
government's role in the sector of the capital market.
    There is a need for the program, particularly one that 
provides equity investment to start-up companies. I say we need 
to make a distinction here. Just because a program costs money 
does not mean that it should be done away with. And there are a 
lot of programs that have costs associated with them, that I 
don't hear the Administration calling for their elimination.
    So setting the current Participating Securities program 
aside, given that so little venture capital is going to small 
businesses, why, then, your testimony seemed to indicate that 
there is no need for an equity program?
    Mr. Guzman-Fournier. I think more than the question of a 
need at this point, what we are talking about, what we are 
analyzing back at the SBA is the cost of the program. And 
making an assessment as to whether the cost of this program on 
balance merits having it at all.
    Ms. Velazquez. Mr. Guzman, cost aside, do we need this type 
of program?
    Mr. Guzman-Fournier. I guess that is the question that even 
experts right now are disagreeing. I mean, I do not--
    Ms. Velazquez. The expert is not saying that we do not need 
the program. He is talking about the start-ups and minority 
businesses.
    Mr. Guzman-Fournier. Right. Well, I think we do not, to be 
quite honest about it, I do not think we have enough data--
    Ms. Velazquez. I think you are not going to answer my 
question. Maybe you will answer my next question.
    What is the Administration's position on this proposal?
    Mr. Guzman-Fournier. Right now our position is that we are 
reviewing it, because it is a complex proposal, as I am sure 
you know.
    Ms. Velazquez. Okay. So--
    Mr. Guzman-Fournier. And we have not made a determination, 
as I mentioned to the Chairman, about whether it meets or not 
credit reform.
    Ms. Velazquez. Okay. Can we get a commitment that you will 
provide the Administration's position, whether or not you 
support or oppose this proposal, within the next two weeks, in 
writing?
    Mr. Guzman-Fournier. The first question we need to resolve 
here is, do we have a program that meets credit reform? I think 
that is critical. And that determination has not been made yet.
    But that determination will be made at some point. Once 
that determination is made, then we are offering here to 
continue working with the Trade Association and the Committee 
to see if we can come up with a proposal that, again, makes 
sense from a cost standpoint.
    Ms. Velazquez. Mr. Guzman--
    Mr. Guzman-Fournier. We are really focusing on the cost. I 
want to add this. Because mainly what we are seeing here, and 
as I look at what I am currently overseeing in this division, 
is we have a program that, in its cash position right now, is 
at negative-$1.7 billion.
    And this program, it is supposed to mirror in a way what 
that program was intended to do. So we want to make sure that 
whatever we do here, we do it with caution, and with enough 
carefulness so that we do not run into that type of situation 
again.
    Ms. Velazquez. But the program has been shut down now for 
nine months. We held a hearing here, where you participated in, 
two years ago. And we had experts on the industry, and we 
discussed the problem of the program. And yet, the 
Administration has not come up with any solutions, either, or 
any proposal.
    So do we, I guess that once you decide and make an 
assessment, you will be submitting to us, or at least to me, 
your position, the Administration's position.
    Mr. Guzman-Fournier. We can at some point, once we resolve 
the issue of the credit reform, at some point we are going to 
have to go into the details of the proposal.
    And yes, the Administration at some point is going to have 
to have the position.
    Chairman Manzullo. Would the gentlelady yield?
    Ms. Velazquez. Yes.
    Chairman Manzullo. You know, I am the Chairman of this 
Committee, and we are the Committee of jurisdiction. You were 
given this three weeks ago. At what point are you going to take 
a detailed look at this thing?
    Mr. Guzman-Fournier. Well, we submitted 35 questions. That 
is detailed. And it took us about two weeks to develop those 35 
questions. And the National Association of Small Business 
Investment Companies has kindly responded to some of those 
questions. But, as Lee and I spoke earlier, not all of them 
have been answered.
    And particularly the most important one--
    Ms. Velazquez. Reclaiming my time, Mr. Chairman, well, it 
does not surprise me that it is going to take forever. We 
passed a Women Procurement program for four years now, and you 
are still studying it.
    Mr. Guzman-Fournier. When we have a program that is at a 
negative-$1.7 billion, you have--
    Ms. Velazquez. Let us go to my next question.
    Mr. Guzman-Fournier. --to take prudence here.
    Ms. Velazquez. Each year, the issue of the low level of 
minority investment in the SBIC program is brought up. And each 
year, nothing changes.
    Last year minority businesses received below 6 percent of 
SBIC financing. Clearly, you are doing nothing, or either what 
you are doing is not working.
    So what do you intend to do? What is it that the 
Administration, what is it that the Administrator intends to do 
to change?
    Mr. Guzman-Fournier. We have had a program for the last two 
and a half years of reaching out and trying to--the critical 
question here is, and I said it on my previous hearing here in 
April, is we need to look at who is out there targeting this 
segment of the population, this business segment. And there are 
people qualified to do this type of investing.
    We have had a program of reaching out and trying to find 
who they are, and inviting them to apply. They have to go 
through a rigorous process, as any other individual would go. 
And at the end of the day, our intent is to--
    Ms. Velazquez. But in the year 2000--
    Mr. Guzman-Fournier. What?
    Ms. Velazquez. In the year 2000, 11 percent of venture 
capital went to minorities. Now it is down to 6 percent. So 
what kind of outreach are you doing?
    Mr. Guzman-Fournier. Well, here is the thing. We do not 
invest in, this program does not invest directly in businesses. 
We do it through venture capitalists that we kind of, in a 
sense, ``hire'' to do it. And we need to target that area of 
the hiring, and who are we licensing here, so that we have some 
areas that might not be covered as well these days, to be--
    Ms. Velazquez. For a long time now.
    Mr. Guzman-Fournier. --covered more.
    Ms. Velazquez. The proposed legislation, while designed to 
comply under credit reform as a debt program, seeks to 
encourage SBICs to make equity investments. What sort of 
complications can arise when a debt structure is used to 
facilitate equity investment?
    Mr. Guzman-Fournier. Well, we have two main concerns here. 
The proposal creates a security that is repaid on the same 
basis as the private equity capital. In other words, the 
participating debenture gets repaid at the same time as the 
limited partner's equity investments in an SBIC.
    So we are analyzing all the features to determine whether, 
even though it gets repaid on a par with the equity, the 
participating debenture might still be a debt security. That is 
an important question.
    Ms. Velazquez. And do you believe that the proposal will 
provide SBICs with the same incentive to invest in early-stage 
companies as the Participating Securities program did?
    Mr. Guzman-Fournier. That is another good question. And 
because of the deferral of interest that is part of this 
proposal, we also need to sit down and discuss that. Because 
that means that by year five, if it is a five-year deferred 
interest, this money is going to come due. And that is going to 
affect, in my view, the business plans of these funds. Because 
they are going to have some pressure to come up with that money 
at that time, and the type of investing that they would do 
would be affected, in my view.
    Ms. Velazquez. So under this structure, do you think it 
will increase investment for small companies, start-ups? Or it 
will decrease it?
    Mr. Guzman-Fournier. We are not sure about that. We are not 
sure about that.
    Ms. Velazquez. Do you believe that SBA's proposed profit 
participation is structured in a manner consistent with the 
amount of SBA investment in the program?
    Mr. Guzman-Fournier. The profit participation is almost 
kept at the same levels as they were in the participating 
program, where we put two thirds of the capital on the first 
tier--and I think Lee alluded to the tiers.
    The first tier of the profit participation will be 10 
percent coming back to the government. That is the same percent 
we are pretty much getting in the participating program.
    Then after the private limited partners get fully repaid, 
we would then get an additional second tier of capital. Which 
again, we have brought up in the questions we sent to the 
Committee as another issue we have.
    Ms. Velazquez. Okay. Do you believe that the proposed tax 
distribution for private investors could limit SBA return; and 
thus, make a zero-subsidy rate difficult to achieve?
    Mr. Guzman-Fournier. We think that the tax distributions 
would most likely have a negative impact on the--negative 
meaning not good, or a good impact, because it gets confusing 
when you talk about subsidy rates. But it is not going to have 
a good impact on the subsidy rate.
    Ms. Velazquez. So are you confident that the proposal will 
operate at a zero-subsidy rate over the long term?
    Mr. Guzman-Fournier. We are not.
    Ms. Velazquez. In your opinion, do you believe that an 
equity investment program designed for higher-risk start-ups 
require an appropriation to function over the long term?
    Mr. Guzman-Fournier. This is the question about whether 
this should be a grant program? Is that a better rephrasing of 
it?
    Ms. Velazquez. No. If there should be an appropriation, a 
fund, an allocation.
    Mr. Guzman-Fournier. It would have to be analyzed, in the 
sense that in a grant program--here we are paying--
    Ms. Velazquez. It is not a grant program.
    Mr. Guzman-Fournier. Well, I am sorry. Here the venture 
capitalist would receive salaries out of this money. And that 
is a question we have.
    I mean, managers here, with an appropriation in this type 
of environment, managers tend to get highly paid. And that is 
something we would need to look at.
    Ms. Velazquez. This is about--
    Mr. Guzman-Fournier. I do not think the government is right 
now involved in any way in this type of, at this level--
    Ms. Velazquez. Keeping the program and the costs of the 
program low for the investors and the borrowers for the start-
ups, so that the fees are not high.
    Mr. Guzman-Fournier. Yes.
    Ms. Velazquez. And we keep the fees and the fee structure 
low. So then we will need an appropriation coming from the 
government.
    Mr. Guzman-Fournier. Yes. If the program does not score at 
zero subsidy, it would need, it would require an appropriation. 
The question is whether, at the end of the day, when we see the 
cash flows and the distributions, and all the things that are 
going to be coming back to repay this leverage, whether they 
are going to meet the zero- subsidy criteria.
    Ms. Velazquez. Thank you. Mr. Mercer, just yesterday an 
Ernst and Young Venture One report showed that venture capital 
is being directed to our later-stage companies, at the highest 
rate in nearly four years. This confirms what our Committee's 
record shows; that the greatest shortage of capital is for 
early-stage companies.
    Do you agree with that assessment?
    Mr. Mercer. I think that is probably true, yes.
    Ms. Velazquez. The Participating Security program's 
investment in start-ups has declined from 50 percent in the 
nineties to 30 percent today. How will the proposed legislation 
reverse this trend?
    Mr. Mercer. I cannot truthfully say that it would reverse 
that trend. I don't know whether it would go any lower. But 
clearly, those who have said that requiring SBICs to pay 
interest in the fifth year would require that at least a large 
portion of their investments be in small companies that were 
later stage than start-ups is true.
    I think that there would still be room for balanced funds 
that would do some early-stage investing, along with later-
stage investing, in order to--
    Ms. Velazquez. Thank you, Mr. Chairman. And I will 
appreciate this later on, I will come back.
    Chairman Manzullo. Absolutely. I want to turn to Mrs. Moore 
from the great city of Milwaukee, where I went to Marquette Law 
School. And then when we are completed with your questions, we 
will go back to Mrs. Velazquez to finish the rest of her 
questions.
    Go ahead.
    Ms. Moore. Well, thank you, Mr. Chairman. And indeed, you 
had a fine education at Marquette University, where I received 
my undergraduate degree. You didn't know that, huh?
    Chairman Manzullo. No, I did not know that.
    Ms. Moore. Well, I have been waiting to tell you that.
    [Laughter.]
    Ms. Moore. And I want to thank our Ranking Member--
    Chairman Manzullo. At least the SBIC program can take 
credit for bringing people together here.
    Ms. Moore. I want to thank you all for just your diligence 
in this area.
    I guess my question is something that I want to address to 
both of our witnesses. And I am very pleased that you have come 
today.
    I have heard, I guess I want to start with Mr. Guzman. I 
think that you have spent a lot of focus of your testimony on 
the costs, the initial outlays of the federal government. And 
you know, if there is this great reduction in risk, there is 
also a reduction in the productivity.
    And I was reminded of a sort of statement that I had 
learned early on in life, that the absence of stress is death.
    And what I am concerned with is that literally, some 
astronomical figure, like 90 percent of all of our businesses 
are small businesses. And if we are destroying the SBIC 
program, there has been absolutely no support from the 
President on the new markets venture capital program, which 
seeded these early-generation businesses.
    And all of the private venture capitalists that we see 
outside of the SBIC have really, really do not contribute to a 
diversified economic landscape in the United States. Literally, 
over half of the venture capital funds are focused on like 
California and Massachusetts. They focus on high-tech programs, 
and a few little niche areas, as opposed to manufacturing.
    I live in a state and in a city, in Milwaukee, in 
Wisconsin. We are like 48th out of 49 in the nation for being 
able to attract venture capital. And it would just kill us to 
have this debenture program, which favors, as our Ranking 
Member pointed out, favors businesses that are already 
launched.
    And so I guess ultimately my question is, are we headed for 
an economic, are we being penny-wise and pound-foolish? We save 
a couple of dollars, we do not make the appropriations. We call 
for a zero risk to the federal government. We divest totally in 
equity investments. I mean, you know, no support for the new 
venture capital program, which functions in these low-income 
geographic areas. This debenture program that does not help 
newly-generated businesses. And then the private capital that 
we have concentrated in two states, in a very small field.
    Where are we going globally?
    Mr. Guzman-Fournier. On the question of new markets, I want 
to make sure that you know that we are keeping track of that 
program internally. We have it as part of our measures that we 
have in the Investment Division to make sure that we know, at 
the end of the day--I think it has probably another year or so 
until we see how those companies have really done.
    Their investment cycle right now is at year three or four. 
So by year five, we are expecting to see whether those six new 
market SBICs, where they stand generally. So I wanted to 
clarify that. We are keeping track--
    Ms. Moore. I just want to stop you for a second, because 
that five-year benchmark, it has the same flaws and foibles I 
think that Mr. Mercer and our Ranking Member were trying to 
point out.
    I mean, the whole point in venture capital is that you are 
supposed to be patient.
    Mr. Guzman-Fournier. Right.
    Ms. Moore. You are not supposed to eat up your success by 
having to repay. So if five years is your benchmark, I am 
getting scared already. But go on.
    Mr. Guzman-Fournier. Yes. I mean, it is early enough for us 
to start looking at results. I am not saying that at the fifth 
year we are going to make a final determination here, but we 
are going to start looking at actual results.
    On your other question, I can tell you that we have a 
debentures program, and that program is running. We are 
licensing funds in that area. That program is currently meeting 
the needs of small businesses, and it is running at a zero cost 
to the government, as we speak.
    And what happened with the participating program was that 
we saw the cash position deteriorating in the billions, which 
really causes concern to anybody. And you have to really look 
at why what the structure of that program was that caused this 
to happen.
    And this proposal relooks at that program, and sees how can 
we make this structure work. But it is a complex proposal. And 
that is why I have come here to say that we are looking at it, 
and we have submitted questions, and we are communicating with 
the committee in terms of questions and answers right now to 
figure out how to move forward.
    Ms. Moore. Well, Mr. Guzman, you know, I am a person who 
just does not buy lottery tickets. And so I am never going to 
win the lottery.
    And I guess, Mr. Mercer, I would ask you to pick up from, 
you know, on my questions. I mean, what is the break-even point 
for the United States' economy? If we run scared with some 
losses, and a billion dollars is a lot of money. If we run 
scared and we don't start making investments in those dynamic 
companies--and I am thinking of Staples, I am thinking of, you 
know, Starbucks, I am thinking of--
    Chairman Manzullo. Build-A-Bear.
    Ms. Moore. Build-A-Bear, you know. I am thinking of these 
companies that just really, you know, if we wait until they 
start succeeding before we are willing to invest in them, or if 
we start calling in their equity after five years, I am 
wondering where we are headed in terms of our ability to be 
competitive globally. Considering that 90 percent, some 
astronomical number of small businesses keep our boat afloat.
    Mr. Mercer. I agree with what you said, and I would like to 
go back. In addressing your question, I would like to do a 
couple things.
    One, HR 3429 tries to strike a balance by deferring, first 
of all, the legislation was restrained by the Credit Reform Act 
in that, for subsidy purposes, for creating a subsidy program, 
it had to be a debt security.
    A debt security could exist with interest deferred for the 
full 10 years, still chargeable against capital, still a debt 
instrument in the eyes of the law, the tax law, the GAAP 
accounting rules, and I think would pass Credit Reform Act.
    The longer interest is deferred, the more likely it is that 
those who are involved in the program can make early-stage 
investments. No question about it. If interest is not deferred 
at all, like in the current straight debenture program, that is 
not a program for early-stage investments.
    The longer you defer the interest in a debt instrument, the 
more you encourage people to be able to make early-stage 
investments.
    In terms of, to go back to Ms. Velazquez's question about 
is start-up capital the biggest gap in the country. In a 
certain sense, the overall answer to that is yes. But as 
experts testified in April, there are other gaps that exist, 
such as in manufacturing, venture capital for small 
manufacturing companies. That capital for those companies is 
generally for later-stage companies.
    So there is different kinds of gaps that are at work here. 
And HR 3429 would be attractive to venture capitalists 
investing in small manufacturing companies, because those 
companies do have cash flows, and by the fifth year they should 
be able to do it.
    So it is a balance. And there is no perfect answer. I am a 
sailor, and there is no perfect boat, you know? You just keep 
tinkering with the design. There is no perfect tennis racquet. 
Mrs. Velazquez is an adamant tennis player, and I know she 
knows there is no perfect tennis racquet.
    Ms. Moore. Mr. Chairman, will you indulge me just to ask 
the panel another question? Ms. Velazquez really embarked upon 
a discussion that I would like you guys to respond to.
    You know, minority businesses are very, very volatile. In 
my home state, in my home town, I think Hispanic companies in 
Wisconsin are like--African-American and Hispanic companies in 
my town--
    Chairman Manzullo. Mrs. Moore, would you want a minute to 
regroup your thoughts for that question? Would that be okay? 
And then I have just got a very short question here, and then 
we can go to you, and then back to Mrs. Velazquez again.
    I am going to draft a letter that Mrs. Velazquez and I will 
sign, that I am going to direct the SBA to come up with a legal 
opinion as to whether or not this is within the parameters of 
the Credit Reform Act. And I am going to give you a drop-dead 
deadline to answer that question.
    And if it is not answered, I am going to have a hearing 
here. And you can bring your lawyer here, and OMB can bring 
their lawyer here, and we will have somebody else here. I want 
to get this thing answered.
    Because I just have the gut feeling that the SBA wants to 
deep-six this thing, and not come to a conclusion, based upon 
the fact that we had given three weeks to the SBA to respond. 
And on Friday, this past Friday, came back with 35 questions. 
And those were answered over the weekend by Mr. Mercer.
    Ms. Velazquez. Mr. Chairman?
    Chairman Manzullo. Yes, go ahead.
    Ms. Velazquez. I would like to mention in the letter to 
include a response from the Administration whether or not they 
support or oppose this legislation, the proposed--
    Chairman Manzullo. We can do that. That would be fine.
    And the other question is, how many attorneys at the SBA 
are working on this issue?
    Mr. Guzman-Fournier. How many attorneys?
    Chairman Manzullo. Yes.
    Mr. Guzman-Fournier. Not many.
    Chairman Manzullo. Well, how many?
    Mr. Guzman-Fournier. Do you need a number?
    Chairman Manzullo. Yes, I need to know. I mean, I want an 
answer to this.
    Mr. Guzman-Fournier. I tell you, my staff is leading this, 
the Investment Division. It is not being led by attorneys.
    The proposal has, obviously, legal ramifications--
    Chairman Manzullo. That is correct.
    Mr. Guzman-Fournier. --and they are looking at those, 
because we are not legal experts.
    Chairman Manzullo. Right.
    Mr. Guzman-Fournier. But the way we work is, the Investment 
Division leads, in terms of the policy analysis. And we have 
lawyers that assist us on the legal side of it. Which is like I 
think any other Committee works.
    Chairman Manzullo. Sure. Okay, Mrs. Velazquez.
    Ms. Velazquez. I gather that not too many, Mr. Guzman, 
since the budget has been cut by almost 50 percent. You can't 
have that many. Yes, sure.
    Chairman Manzullo. Ms. Moore, do you want to finish up? Go 
ahead.
    Ms. Moore. Thank you so much, Mr. Chairman. I have 
regrouped.
    I represent Milwaukee, Wisconsin; it is the largest city in 
my district. And the city of Milwaukee, among the 50 largest 
metropolitan areas in terms of black-owned businesses, ranks 
48th for African-American-owned businesses. And, sorry about 
this, 49th for Hispanic-owned firms.
    So by definition, if there were any venture capitalists 
that were going to help Hispanic- and African-American-owned 
businesses, they would, by definition, be start-ups.
    And so to the extent--I mentioned the new market venture 
capital program, which, you know, the Administration rescinded 
the funding for any new projects for that program. And then 
this proposed debenture program is more geared toward medium-
size already-generated businesses.
    What commitment does the federal government have to helping 
minority-owned businesses, when you are scaling back and 
destroying those programs that have the potential to enable, to 
build the capacity for those businesses?
    And we have got 59-percent unemployment rate among African-
American men and men of color. So to the extent that we don't 
have businesses generating, those minority, you know, there is 
a correlation between the unemployment. This is a real crisis. 
This is why I am here.
    They elected me to bring some resources to town. And what 
can I tell them that the Administration is doing specifically 
to help minority unemployment, ultimately?
    Thank you, Mr. Chairman.
    Mr. Guzman-Fournier. Well, I would go back to the programs 
that SBA has and its ability to--
    Ms. Moore. You rescinded the funding for the New Markets 
program.
    Mr. Guzman-Fournier. Right. No--
    Ms. Moore. So there is no new round of funding for any 
Latino business in Milwaukee, under that program.
    Mr. Guzman-Fournier. No, but we do have folks that are 
serving Latino communities within the regular, traditional SBIC 
under both the Participating and the Debentures program.
    But going back to your question, we do have other access to 
capital at the agency. And we are proud of our record. And I 
know some people might disagree, but we are very proud of our 
record in terms of the loan programs in this agency since this 
Administration took over.
    We have increased the number of loans going into these 
segments of the population that you mentioned. And there has 
been a concerted effort within the agency to look at this area.
    So we are proud. I can tell you personally that I am 
committed, also, within the SBIC structure, to look at this 
area. And I have been--
    Ms. Velazquez. Would the gentlelady--
    Mr. Guzman-Fournier. --committed for the last two and a 
half years.
    Ms. Velazquez. --yield to me? What programs? Prime, 
Business Link. Every single program that has been crafted and 
designed to help low-income minority businesses has been zeroed 
out, or their funding cut. So what programs?
    Chairman Manzullo. Ms. Moore, could I ask you a question?
    Ms. Moore. Yes, sir.
    Chairman Manzullo. Could you give me that statistic again, 
and try to explain that?
    Ms. Moore. The top 50 cities--
    Chairman Manzullo. You mean in terms of population.
    Ms. Moore. The largest metropolitan areas in terms of 
black- and Hispanic-owned firms, according to the Center for 
Economic Development at the University of Wisconsin, Milwaukee, 
Milwaukee ranks 48th among the 50 largest metropolitan areas 
for black-owned businesses--I have got a friend who went to 
Marquette who is an engineer thinking about just moving out of 
Milwaukee--and 49th for Hispanic-owned businesses.
    Chairman Manzullo. Could you quantify?
    Ms. Moore. Provide the study? Yes, sir.
    Chairman Manzullo. Is there a reason for that within 
Milwaukee? Milwaukee is a great city.
    Ms. Moore. Well, for one thing, you know, it had a 
manufacturing base. And to the extent that venture capitalists 
are moving away from manufacturing--we still have many small 
manufacturers that are trying to generate business--you know, 
that could be one of the explanations.
    But just those data that the staff for this Committee 
provided is a key. That Massachusetts, California--I mean, the 
midwest is being ignored.
    Chairman Manzullo.
     We had a situation in Rockford, Illinois, with Ingersoll 
Production Line--this was about 130 years ago. This is the 
company that actually invented the assembly line. I mean, this 
is what Henry Ford had used as a prototype. It was in the 
process of going under. And we had lost Ingersoll Cutting Tools 
Division to bankruptcy--then an Israeli firm came in. Ingersoll 
Machine Tools eventually was sold to an Italian firm.
    And here was Ingersoll Production Line, this wonderful 
company, and the man who had run it came out of retirement. We 
went to 10 joint venture capital firms and banks. No one was 
interested in buying it.
    And so he went to Dalian which was a wholly-owned, state-
owned, Chinese company, that came to Rockford, Illinois, bought 
this company, and has a very hands-off attitude. I mean, it 
allows the people in Rockford to run this. And they are making 
machine tools for production lines, and exporting those to 
China.
    I mean, this is extraordinary. And the problems that we are 
seeing--and you can't tell investors where to put their money, 
because there is always a risk, including the taxpayers. 
Everything seems to go into high tech. And that is why you have 
the Massachusetts and the California experience. But our basic 
industries are just really hurting. Could that be one of the 
reasons?
    Ms. Moore. Yes, I couldn't agree with you more. I mean, as 
a State Senator, I focused on venture capital. And I was a 
little bit protectionist. I am trying to make sure that those 
investors would receive a 50-percent tax credit for investments 
in firms in Wisconsin.
    Because the closest new market firm to Milwaukee, Wisconsin 
is in Ohio. That is like an eight-hour drive.
    So when you say that they are helping, we have a strong 
manufacturing base. Harley Davidson--I know you have heard of 
Harley Davidson, a very successful company. But when they were 
in trouble, they were out there with a tin cup trying to get 
banks to help bail them out. Manufacturing.
    We have J. I. Case, the farm equipment producer, 
headquartered right in Racine, Wisconsin, where I was born, 27 
miles from Milwaukee. And eventually a foreign company 
purchased J. I. Case.
    But we are having problems with the transitioning in our 
manufacturing culture. Because we still have many small tooling 
places, and we are being vastly ignored.
    Now, to the extent that the SBA had been the primary source 
of venture capital for manufacturing-type companies, you are 
the first and last hope. So that if there is an unwillingness 
on the part of SBA to continue accepting that risk, we are in a 
lurch in Milwaukee, Wisconsin.
    And I would love it, Mr. Chairman and Madame Ranking 
Member, if we can be involved in the letter, and some of the 
appendices, to demonstrate the crisis that we are in.
    Mr. Guzman-Fournier. I wanted to add that for manufacturing 
in particular, the structure of the debenture program is 
suitable. So--
    Ms. Moore. For start-ups.
    Mr. Guzman-Fournier. I would be interested in--
manufacturing start-ups, or just manufacturing, period?
    Ms. Moore. Well, start-ups. We have some, I am thinking 
right now of some small companies that are making tools and 
small parts. And they are essentially start-ups, in terms of 
their generation.
    And I am concerned--and they are also operating in these 
low-income geographic areas. Milwaukee, the city of Milwaukee 
qualifies. And the reason that I prioritized getting here today 
is because I wanted to hear how flexible this new proposal is.
    And to the extent that you are so risk-averse--and if I am 
wrong, Mr. Mercer, please correct me--I think that you 
apologized almost for the program, saying that we are 
constrained by some prior law that has been passed. But it 
seems that we need to revisit that, as well. Because I don't 
know how flexible this new program will be in terms of helping 
a place like Wisconsin.
    Mr. Mercer. Well, I mean, it can help. It can't solve all 
problems, there is no question about it.
    But if you look at the Participating Security program which 
it would replace, about 35 percent of investments made in that 
program over the past several years have been in manufacturing 
companies.
    Now, those are not all in start-up manufacturing companies. 
Because, as you know, manufacturing companies, even after they 
have been in existence for a while, often need an infusion of 
additional equity to build a balance sheet that will allow them 
to put on senior debt for expansion, and things like that.
    So the structure in 3429 can encourage, and would 
encourage, that kind of investing.
    But Ms. Velazquez is correct when she says the structure in 
3429, which has only a five-year deferral rate for interest, 
would make it difficult for funds to focus on start-up 
businesses. There is no question about that. That is the 
balancing.
    And that is why I say if the Committee wants to focus more 
on start-ups and still meet Credit Reform Act, then it has to 
consider deferring interest a little bit longer, because it is 
a cash-flow game.
    Ms. Moore. Right.
    Mr. Mercer. That is what it is. And that is a balancing act 
that will impact subsidy rates and other things. And I am not 
here to tell you that I know what the right answer is. It 
really depends on how the Committee wants to focus.
    Ms. Moore. Thank you for your indulgence, Mr. Chairman. And 
I really, really appreciate Mr. Mercer being here.
    I think often of a company in Milwaukee that was a meat 
manufacturer, very small, black-owned business, that got a 
lucrative contract with McDonald's to produce the sausage for 
their sausage breakfast sandwich. And they made tremendous 
investments, capital investments in order to be able to conduct 
this contract. Only to have their notes called--you know, their 
loans and equity investments being called too early. So that 
they found they didn't have the cash flow. Even though they had 
a lucrative contract. And it really destroyed, you know, the 
lucrative contract almost destroyed their business, because 
they couldn't keep pace, because they had to be repaying these 
debentures.
    So that is what I am concerned about. We have got to be 
patient. Because, you know, I want to win this globalization 
thing. You know, I want my kids and grandkids to be able to 
work here. I don't want them to have to move to China in order 
to have a job.
    Thank you, Mr. Chairman.
    Ms. Velazquez. I would like for you to give us some 
background in terms of where we find ourselves, the Committee, 
the SBIC companies and the program, and the proposal that we 
have before us.
    Can you provide the Committee with what NASBIC took, once 
they recognized the challenges that the participating 
securities faced? In particular, can you tell us about the 
Administration's role in the process?
    Mr. Mercer. Well--
    Ms. Velazquez. I just want to know, did you reach out to 
them?
    Mr. Mercer. Yes.
    Ms. Velazquez. Have any conversations? And what the 
Administration told you, in terms of coming up with solutions 
to deal with the challenges that you were facing?
    Mr. Mercer. Well, we have asked repeatedly to be able to 
sit down to design a successor program to the Participating 
Security program, in a collaborative environment. And the 
Administration has said that it is not necessarily absolutely 
opposed to a successor program, but that it would respond to 
proposals; it would not participate in the process of 
developing the proposals.
    That is why I said I was heartened by reading Mr. Guzman's 
testimony today, where it seemed to indicate for the first time 
that they might be willing to sit down with members of the 
Committee and their staffs, and hopefully to start to get into 
the intricacies of the structure. Because it is a technical 
area, and it is very difficult for one side to come up with a 
proposal that meets everybody's needs.
    Ms. Velazquez. So Mr. Guzman, is his assessment correct?
    Mr. Guzman-Fournier. Yes. We have said that we are willing 
to work with the Committee.
    Ms. Velazquez. So you are going to sit down with NASBIC and 
discuss the proposal, and come up with solutions?
    Mr. Guzman-Fournier. In a way we are already doing it. 
Because, you know, the Committee was offered our response to a 
proposal. And our response was that, as Lee just said, this is 
a complex legislation which requires complex analysis, which--
    Ms. Velazquez. I heard that before.
    Mr. Guzman-Fournier. --in our case is, it came up to 35. We 
weren't meaning to have 35 questions, but that is the extent of 
what we thought was important to--
    Ms. Velazquez. That doesn't tell me much.
    Mr. Guzman-Fournier. It is a technical, as Lee said, a 
technical proposal. So we definitely want to look into each 
aspect of it. But that--
    Ms. Velazquez. Okay, so the Administration is willing to 
sit down, discuss this complex proposal, and reach whatever 
compromise or solution, so that we can move this thing forward.
    Mr. Guzman-Fournier. At this point, we are already doing 
it. We are in discussions with the Committee.
    Ms. Velazquez. Mr. Lee, what is your estimate of how often 
the SBA will receive a profit participation under your 
proposal?
    Mr. Mercer. If, I am trying to now recall industry 
statistics over the past 20 years. Industry tracks funds by 
quartiles. So if the licensing is good, and I think SBA has 
improved its licensing criteria over the years, so they are 
picking very qualified investment professionals, these funds 
should perform to industry averages. Which would mean the top 
three quartiles of funds are profitable. The bottom quartile of 
funds are not profitable.
    So in three quarter of the funds, there should be at least 
some profit participation.
    Now, what the Committee should understand is the top 
quartile of funds is the one that drives the biggest returns in 
venture capital. So the reason the proposal suggests a higher 
profit participation in the most successful funds is to enable 
SBA to take advantage of that top quartile of funds. And that, 
we hope, would do it.
    Ms. Velazquez. Mr. Guzman, what is your assessment of that?
    Mr. Guzman-Fournier. Well, this is an area where we have 
some concerns, in the sense that we are looking at it as a 
potential cross-subsidization of non-performing SBICs by high-
performing SBICs.
    And it is something that, again, I think in a cash flow 
scenario, when you see the scenario analysis, you might have a 
better sense of the numbers. But it is something that worries 
use, that Lee just mentioned.
    Ms. Velazquez. Mr. Lee, can you further explain the 
conditions that private investors will be able to receive a 
distribution before the SBA is paid back?
    Mr. Mercer. The first thing that would happen is that 
interest would be paid back before anybody gets anything. And 
after that, amounts distributed would be distributed pro rata. 
In other words, if SBA had 50 percent, had provided, the SBA 
had guaranteed money, because it is not a direct-funded 
program. But if SBA guaranteed money was 50 percent, they would 
get 50 percent of the distribution. If it was greater than 50 
percent, they would get greater than 50 percent of the 
distribution.
    So the repayment of debt, if you will, on the SBA-
guaranteed capital, and the repayment of private investors on 
their equity accounts, would occur on a pro rata basis. And 
that, as you correctly stated in your opening statement, there 
has to be, in the development of any program, there has to be a 
balance that will keep the private investors attracted, as well 
as balancing the risk of the taxpayers. And that is one of 
those balancing--
    Ms. Velazquez. But let me ask you, could private investors 
receive distributions ahead of SBA?
    Mr. Mercer. No.
    Ms. Velazquez. And my last question, Mr. Chairman. Given 
the role that the pension funds play and university endowments 
plays on financing the program, have these major investors 
endorsed this proposal?
    Mr. Mercer. They have not taken a position on the proposal, 
no.
    Ms. Velazquez. Well, I have some other questions that are 
important, and I will submit those in writing.
    Mr. Mercer. One interesting note, I think, and it has been 
mentioned before, that you bring up pension plans. The biggest 
pension plan, of course, is CalPERS, a huge investment in 
venture capital funds.
    And if you recalculate the Participating Security returns 
for the vintage years 1994 through 2000, and calculate what SBA 
would have gotten if it had been a regular limited partner, 
like CalPERS was in the funds it invested in, the SBICs 
performed exactly the same, if not a little better, than the 
non-SBIC venture funds that CalPERS invested in.
    So that is why I think I am confident in saying that these 
funds should perform to industry averages.
    Ms. Velazquez. Mr. Chairman, I have another question for 
you.
    Chairman Manzullo. I have got another meeting at 1.
    Ms. Velazquez. I would just like to know if we could have 
another hearing where we could have OMB and all these 
investors, so that they could comment.
    Chairman Manzullo. Well, we may end up with a hearing with 
all the lawyers here, if we don't get some answers on it. But 
we will take that under consideration. We obviously both have 
an interest in this.
    You have both been very generous with your time. And this 
hearing is adjourned.
    Mr. Mercer. Thank you, Mr. Chairman. Thank you, Ms. 
Velazquez.
    Mr. Guzman-Fournier. Thank you.
    [Whereupon, at 11:40 a.m., the Committee was adjourned.]
    [GRAPHIC] [TIFF OMITTED] 23182.001
    
    [GRAPHIC] [TIFF OMITTED] 23182.002
    
    [GRAPHIC] [TIFF OMITTED] 23182.003
    
    [GRAPHIC] [TIFF OMITTED] 23182.004
    
    [GRAPHIC] [TIFF OMITTED] 23182.005
    
    [GRAPHIC] [TIFF OMITTED] 23182.006
    
    [GRAPHIC] [TIFF OMITTED] 23182.007
    
    [GRAPHIC] [TIFF OMITTED] 23182.008
    
    [GRAPHIC] [TIFF OMITTED] 23182.032
    
    [GRAPHIC] [TIFF OMITTED] 23182.033
    
    [GRAPHIC] [TIFF OMITTED] 23182.034
    
    [GRAPHIC] [TIFF OMITTED] 23182.035
    
    [GRAPHIC] [TIFF OMITTED] 23182.036
    
    [GRAPHIC] [TIFF OMITTED] 23182.037
    
    [GRAPHIC] [TIFF OMITTED] 23182.038
    
    [GRAPHIC] [TIFF OMITTED] 23182.009
    
    [GRAPHIC] [TIFF OMITTED] 23182.010
    
    [GRAPHIC] [TIFF OMITTED] 23182.011
    
    [GRAPHIC] [TIFF OMITTED] 23182.012
    
    [GRAPHIC] [TIFF OMITTED] 23182.013
    
    [GRAPHIC] [TIFF OMITTED] 23182.014
    
    [GRAPHIC] [TIFF OMITTED] 23182.015
    
    [GRAPHIC] [TIFF OMITTED] 23182.016
    
    [GRAPHIC] [TIFF OMITTED] 23182.017
    
    [GRAPHIC] [TIFF OMITTED] 23182.018
    
    [GRAPHIC] [TIFF OMITTED] 23182.019
    
    [GRAPHIC] [TIFF OMITTED] 23182.020
    
    [GRAPHIC] [TIFF OMITTED] 23182.021
    
    [GRAPHIC] [TIFF OMITTED] 23182.022
    
    [GRAPHIC] [TIFF OMITTED] 23182.023
    
    [GRAPHIC] [TIFF OMITTED] 23182.024
    
    [GRAPHIC] [TIFF OMITTED] 23182.025
    
    [GRAPHIC] [TIFF OMITTED] 23182.026
    
    [GRAPHIC] [TIFF OMITTED] 23182.027
    
    [GRAPHIC] [TIFF OMITTED] 23182.028
    
    [GRAPHIC] [TIFF OMITTED] 23182.029
    
    [GRAPHIC] [TIFF OMITTED] 23182.030
    
    [GRAPHIC] [TIFF OMITTED] 23182.031
    
    [GRAPHIC] [TIFF OMITTED] 23182.039
    
    [GRAPHIC] [TIFF OMITTED] 23182.040