by David Gerogosian, PEF Services LLC
There are a number of changes either finalized or proposed by SBA in recent weeks and many of you have probably seen these announced in various publications from the industry. We want to consolidate these here for you in a manner that helps you understand those that are immediate and those that you need to plan for.
When regulation changes are finalized, SBA posts this information in the Federal Register or in some cases in technical policy statements known as TechNotes. We’ll address these in the order of rules that have been implemented and then those that are still in comment stages.
PASSIVE INVESTMENT INVESTING STRUCTURE
On December 28, 2016, the U.S. Small Business Administration (SBA) released a Final Rule modifying its regulations on the ability of a small business investment company (SBIC) to finance passive businesses.
This amended rule affects the holding company and the blocker corporation exceptions for SBICs’ financing passive businesses.
While we assumed that upon publication of this File Rule, the industry would be operating under these new guidelines, we were made aware in a communication from SBA on January 26, 2017, that:
“… a memorandum dated January 20, 2017, from the Assistant to the President and Chief of Staff, entitled ‘Regulatory Freeze Pending Review’ calls for agencies to temporarily postpone the effective date of rules not yet effective and invite new public comment.” The SBIC Passive Business rule (81 FR 95419), with an original effective date of January 27, 2017, is subject to this guidance. “In view of this development, SBA is delaying the effective date of this rule until March 21, 2017, and is inviting additional public comment on the final rule.” You may read the full notice here.
As a reminder, all financings are subject to current regulations until new rules are effective.
While it may be necessary to await the final approval for using this new structure, below are high-level points on the changes and how this can affect investments structured under this new rule:
Passive Business Investment Exceptions
The “Holding Company” Exception
The holding company exception currently permits an SBIC to structure a financing through up to two tiers of passive businesses (holding companies) so long as the holding company financed by the SBIC passes substantially all of the financing proceeds through to one or more “subsidiary companies” that are eligible small businesses and not themselves holding companies (operating companies). A “subsidiary company” is an operating company in which the financed holding company either:
- directly owns at least 50 percent of the outstanding voting securities, or
- indirectly owns at least 50 percent of the outstanding voting securities (by directly owning the outstanding voting securities of another holding company that is the direct owner of the outstanding voting securities of the operating company).
Until now, an SBIC could only use a Blocker to prevent UBTI from being passed to the SBIC’s tax-exempt limited partners, and even then, only with the SBA’s prior approval. An SBIC was not permitted to use a Blocker to prevent effectively connected income (ECI) from being passed to its foreign limited partners.
The Final Rules no longer require SBA approval to form Blockers and also permit an SBIC to form a Blocker to avoid passing ECI to the SBIC’s limited partners. In lieu of obtaining the SBA’s prior approval, an SBIC must maintain a certification in its files that the Blocker was formed for one of these permitted purposes.
Current Standards for the Holding Company exemption:
Under the existing holding company exception, an SBIC can finance a holding company (Holdco 1) if the Holdco 1 directly owns at least 50 percent of the outstanding voting securities of the operating company or if Holdco 1 directly owns a sufficient percentage of the outstanding voting securities of an intermediate holding company (Holdco 2) that would enable Holdco 1 to own indirectly through its ownership of Holdco 2 at least 50 percent of the outstanding voting securities of the operating company.
As modified in this FINAL RULE:
The Final Rule includes technical modifications to codify SBA’s existing interpretation of the holding company exception to (1) permit an SBIC not only to finance a holding company in accordance with the exception, but also to form the holding company being financed and (2) enable a holding company not only to pass substantially all of the financing proceeds through to the operating company, but also to use substantially all of the financing proceeds to acquire the operating company either directly or indirectly through an intermediate holding company in which the holding company owns a sufficient percentage of the outstanding voting securities that would enable the holding company to own indirectly (through its ownership of the intermediate holding company) at least 50 percent of the outstanding voting securities of the operating company.
THE MAJOR IMPACT ON FEES CHARGED BY ASSOCIATES
The Final Rule has included a new pay-over requirement that will treat fees received by an SBIC’s associate in a financing completed by the SBIC utilizing the holding company or the blocker corporation exceptions differently than the manner in which those fees would be treated if the SBIC had completed the financing directly to the operating company without using either exception.
As a result under this new rule once finalized, new financings made by SBICs through holding companies are on a different footing than financings made directly because fees received by an SBIC’s associate in financings made directly can be offset against the management fee paid by the SBIC, while fees received in financings made through holding companies must be paid over in cash by the associate to the SBIC.
SBA REQUIRED REPORTING CHANGES
Changes to SBA Form 1031 for Holding Companies vs. the Operating Company
The Final Rule provides new guidance that implements changes to SBA’s Form 1031 (Portfolio Financing Report) that must be submitted by SBICs to SBA within 30 days after the completion of each financing. These changes do the following:
- SBICs should report data on the operating company when reporting information on financings using holding companies in Part A, Part B and, with the exception of the amount of financing dollars in Question 29, Part C of Form 1031 (for Question 29 of Part C, the amount of the financing dollars provided by the SBIC should be included regardless of whether the financing dollars were provided directly or indirectly to the operating company)
- Incorporates an additional question regarding whether the financing utilizes one or more holding companies as part of the financing
- Require SBICs to upload an information file in PDF format that:
- Identifies whether the SBIC is utilizing the holding company or the blocker corporation exceptions and, if so, the name and employer ID number for each holding company used in the financing
- Describes the financing structure, including the flow of money between the SBIC and the holding companies that receive the proceeds (including amounts and the types of securities between each entity) and the ownership from the SBIC through each entity to the operating company
- Identifies whether the financing is an SBIC-identified impact investment or an SBA-identified impact investment (for Impact SBICs).
SBA Releases Proposed Rule Raising Licensing & Examination Fees for SBICs
On December 16, 2016, the SBA also released a new administrative fee rule, with comments due on February 14, 2017. We know that SBIA intends to comment on the proposed rule and is seeking member feedback, so we encourage you to review these changes and provide and feedback you feel is appropriate. The proposed rule suggests changes to the current fee structure including the following:
- Raises Licensing and Examination Fees for SBICs, pegged to inflation going forward – raising an additional $3-4 million per year for the SBA;
- Explains what resources the SBA intends to spend these new resources on;
- Formalizes the MAQ process and places it into the licensing regulations;
- Provides a discount on examination fees for funds engaging in LMI investing;
- Removes the “fully responsive” examination fee discount.
Technical Changes WIND DOWN OF A FUND
The Final Rule issued in December also incorporated several technical changes that are unrelated to the passive business SBIC program regulations. These technical changes:
- Implement SBA’s current oversight practices that allow the minimum $5 million regulatory capital and $2.5 million leverageable capital requirements for SBICs to be less if the reductions are performed in accordance with an SBA-approved wind-up plan
- This change will remove the risk of transfer to liquidation while liquidating the SBIC’s remaining assets due solely to the reduction of Regulatory Capital below the minimum the stated minimum capital requirements which were intended for licensing the fund
Technical Changes Maximum Leverage for Family of SBIC Funds
- Reflect the increase in the maximum amount of SBA leverage available to SBICs under common control from $225 million to $350 million that was implemented by congressional legislation passed in December 2015.
SBA HOLDS EXAMINER WORKSHOP & PROVIDES INSIGHT INTO EXAM PRIORITIES
On December 14, 2016, the Small Business Administration held an Examiner’s Workshop to which PEF and a number of legal and accounting firms were invited to participate. A number of issues were discussed that impact those operating in the SBIC space, including the current priorities for SBA in ensuring that examinations are conducted in an efficient and complete manner. They introduced us to the new Director of SBIC examinations and provided a forum for open dialogue between everyone in attendance.
It is clear that SBA is adopting a new philosophy on their approach to examinations and verbally committed to ensuring “consistency” across their interpretations on regulations and rulings. They are committed to moving to a “paperless” approach on the examination process, the details of which are still to be completed.
Of particular interest to all should be that SBA is now more focused on fees earned from all sources including those outside of the SBIC by fund managers and their associates. This is addressed in part through the expansion of the standard examination schedules 1 – 4 to now include 5 and 6. Schedule 5 is new schedule addressing partners’ capital reconciliation during the examination period while Schedule 6 is a new fee disclosure schedule that some of you may have seen in most recent exam and also noted in the summary points on fees earned by associates through holding company structures.
We are still awaiting the updated TechNote from SBA regarding their clarification of management fees and fees and expenses that may be considered a fund expense for existing SBIC funds. We were told on Monday, January 23, 2017, in a discussion with senior SBA personnel, that they are still in review on this matter and have targeted a release date of this guidance by the end of this current quarter for review and comment by the industry.
If you have any questions about the above changes, please contact a member of your PEF team.