Farragut Capital Partners Featured in Washington Business Journal Article on SBICs

Got moola? A long-standing, but little-known funding source for small businesses is seeing a resurgence.  As seen in the Washington Business Journal, Oct. 18, 2012.  By Bryant Ruiz Switzky, Senior Staff Reporter.

If the emaciated roster of potential funding sources has got you down, take note. A rapidly expanding, but little-known sector of the financial world is dispensing billions of dollars to small businesses that can’t get the love they need from banks.

They are called small business investment companies.

SBICs are licensed by the Small Business Administration to make debt and equity investments in small businesses. They raise money privately and then receive at least a 2-to-1 match in additional funds from the SBA. And they are carrying ever-larger buckets brimming with money, looking for companies to invest in.

SBICs were on pace to dole out some $2.9 billion to small businesses nationally in fiscal 2012, which ended Sept. 30, more than double 2008 levels. And the number of SBIC licenses granted across the country has more than quadrupled in the past four years to about 28 — so there is sure to be even more growth in years to come, as newly licensed funds ramp up their investments.

About a dozen of the roughly 300 SBICs nationwide are based in the Washington area. At least three have been licensed since 2010.

Interest in the program has grown exponentially,” said Trevoir Gregg, managing partner of Bethesda-based RLJ Credit Opportunity Fund, one of the region’s newest SBICs.

Although SBIC funding is getting a lot of new attention, it has had a long history.

Some of America’s best-known companies got SBIC dollars when they were just pipsqueaks, including Apple Inc., FedEx Corp., Costco Wholesale Corp., and Outback Steakhouse.

“SBICs have been around since 1958, but nobody talks about them because planes landing don’t make the news,” said Brett Palmer, president of the D.C.-based Small Business Investor Alliance, a trade group that tracks the industry.

Things haven’t always been rosy for the program. “Participation securities” SBICs, a particular kind of license that allowed funds to invest heavily in startups, got into trouble in the middle of the last decade after a cascade of problems with their early-stage tech investments. Amid the turmoil, the number of new SBICs plunged, and the participation securities license was discontinued in 2004 — though there are still more than 80 of them nationwide in wind-down mode.

The Great Recession, however, brought a new appeal to SBICs. In the wake of the financial crisis, hedge funds and private equity firms took a beating when scores of their investors asked for their money back. In addition, it became nigh impossible to raise much capital for new investments. That upheaval sent a host of high-finance types looking for another home. For a lot of those folks, SBICs, with their 2-to-1 match of capital, grew mighty attractive.

Gregg was one of those new supporters. After his previous employer, private equity firm Allied Capital Corp., was acquired by Ares Capital Corp. in 2010, he jumped to Robert Johnson's RLJ Cos. empire, where he began the tedious work of securing an SBIC license, which was received this past June.

Gregg argues that high-finance types just want a stable pool of money, whether it comes from private investors, the public markets or the SBIC program.

“For someone like me, I’m less concerned with how I fund my liabilities,” he said. “I want to have access to capital that allows me to do deals.”

In an SBIC’s case, it ends up being rather cheap capital. Today’s rock-bottom interest rates are making SBICs more attractive because the price of the 2-to-1 leverage that the SBA puts up is tied to the U.S. Treasurys market. That means SBICs are paying a very low premium for that debt leverage, which they must repay in full.

It also helps that the 2009 American Recovery and Reinvestment Act raised the amount of leverage SBICs can get to $150 million from about $137 million.

RLJ Credit Opportunity Fund focuses on loans to minority businesses and others in underserved communities. The fund has raised $23 million so far and expects to raise $100 million by the middle of next year. With the leverage, RLJ will have a $250 million pot of money to invest.

RLJ’s sweet spot will be loans of $3 million to $8 million to companies with $3 million to $8 million in annual cash flow.

The fund is looking primarily in the Mid-Atlantic, Northeast and Midwest for companies in business services, value-added distribution and manufacturing/industrial services. It hasn’t made its first deal, but hopes to get one soon.

Chevy Chase-based Farragut Mezzanine Partners III LP also got licensed this summer as an SBIC. It is part of Farragut Capital Partners LLC and essentially makes high-interest loans secured by corporate borrowers’ equity, which is known in financial parlance as mezzanine debt.

Two of its founders are industry veterans, Phil McNeill and Cabell Williams, who ran the SBIC program at Allied Capital a decade ago.

The SBIC program “was something we were very familiar with,” McNeill said. “It made a lot of sense for us, given the kinds of deals we wanted to do.”

Farragut has raised about $25 million so far. McNeill declined to talk about total capital goals, but a source familiar with the Farragut fund said it plans to raise about $35 million, which would provide a total fund size of more than $100 million once the SBA’s 2-to-1 leverage is tacked on.

The fund is targeting companies that have $10 million to $100 million in revenue, mostly in the Mid-Atlantic and East Coast, a strata McNeill says is underserved by banks.

“There’s a lack of capital available at the lower end of the middle market,” he said. “That’s really our target market: those companies that are growing, creating a lot of jobs and are good, strong companies, just don’t have a couple of extra zeros at the end of all their numbers to be attractive to the larger banks.”

Mezzanine funding is often part of an event-driven transaction, such as an acquisition or retiring CEO who wants to pass the company along to a junior partner, McNeill explained.

“If you think about how many baby boomers own a company and have grown it to a point where they need to start thinking about transition, there are hundreds or thousands of companies out there that are going to need some mezzanine-type of financing in order to create one of those transitions,” he said.

Farragut did its first deal for a Dallas-based company. It also has a local transaction and a Baltimore deal in the pipeline.

For borrowers, SBICs tend to be more expensive than banks. There is a statutory interest rate cap of 19 percent for straight debt from an SBIC and 14 percent if the financing has an equity feature to it.

Most companies are willing to pay a little more if it means they will get the funds they need when the bank says no, said Palmer, of the Small Business Investor Alliance.

“Banks are very good at lots of things,” he said, “but one of the things they’re not always great at is figuring out what to do with a small business that meets nine of their loan requirements, but not all 10.”

What are SBICs?

Small business investment companies, or SBICs, are private companies that raise money from private investors. The Small Business Administration then matches up to $75 million of that money 2-to-1, though the match sometimes can be as high as 3-to-1, effectively tripling the money in the pool.

Those matching funds are called “leverage.”

For example, if the SBIC raises $75 million,the SBA would pony up $150 million in leverage, jacking the fund to $225 million.

The SBIC then uses that money to make loans or equity investments in small businesses. To qualify for SBIC funding, companies must have a tangible net worth of less than $18 million and after-tax earnings of less than $6 million for the prior two years or have fewer than 500 employees.

The interest companies pay on SBIC financing may be higher that of bank loans. SBICs have a statutory interest rate cap of 19 percent for straight debt and 14 percent if there is an equity feature to it.

How to open an SBIC

Because SBICs are putting millions of publicly guaranteed dollars at risk, the SBA won’t give a license to just anyone. After raising a minimum of $5 million in private capital, applicants must survive an extensive review process that takes more than six months. The SBA scrutinizes applicants’ management, performance analysis, strategy and fund structure. Only about a quarter of first-time applicants get a license. The SBIC must ultimately repay the leveraged amount from the SBA in full.

About Farragut Capital Partners

Founded in 2011, Farragut Capital Partners, LLC is a private investment management firm providing mezzanine debt and equity capital to finance leveraged and management buy-outs, generational transfers, growth capital financings, and recapitalizations. The firm is actively investing out of its latest investment vehicle, Farragut Mezzanine Partners III, LP.  Farragut seeks to invest up to $10 million in established small and middle market companies with proven business models and stable cash flows.  The firm targets companies with strong, committed management teams and the potential for significant growth in equity value.

Farragut specializes in asset-light businesses with unique and defensible market positions, stable business models, and reasonable capital expenditure and working capital needs. The firm works with owners (family businesses, equity sponsors, and fundless sponsors), senior lenders, and directly with management teams to create and build value in its portfolio companies over time.