[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/
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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 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.]
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