Specialized Small Business Investment Companies

SMALL BUSINESS ADMINISTRATION

Specialized Small Business Investment Companies

AGENCY: Small Business Administration.

ACTION: Notice.

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SUMMARY: The Small Business Administration (SBA) has completed the 3%

Preferred Stock Repurchase Pilot Program for Small Business Investment

Companies licensed under section 301(d) of the Small Business

Investment Act (15 U.S.C. 681(d)) (Specialized SBICs or SSBICs), and

now will offer each currently licensed SSBIC that was not in the Pilot

Program the opportunity to apply for the repurchase of its 3% preferred

stock held by SBA. This Notice sets forth the guidelines SBA is

intending to follow in its implementation of this Repurchase Program.

DATES: This Notice is effective on April 1, 1994 Written comments on

this Notice must be received no later than May 2, 1994.

ADDRESSES: Written comments should be sent to Robert D. Stillman,

Associate Administrator for Investment, U.S. Small Business

Administration, suite 6300, 409 Third Street SW., Washington, DC 20416.

FOR FURTHER INFORMATION CONTACT:George Dale, Investment Division, U.S.

Small Business Administration, 409 Third Street SW., Washington, DC

20416, (202) 205-7595.

SUPPLEMENTARY INFORMATION: On June 19,1992, SBA published a Notice in

the Federal Register (the Pilot Notice) announcing the commencement of

the 3% Preferred Stock Repurchase Pilot Program for Small Business

Investment Companies licensed under section 301(d) of the Small

Business Investment Act of 1958, as amended (Specialized SBICs or

SSBICs). See 57 FR 27503.

Policy Statement

The policy for the Repurchase Program was stated in the Pilot

Notice, and is repeated verbatim as follows:

``SBA's policy is to administer the Repurchase Program in such a

way as to maximize the capacity of SSBICs to provide financing to

businesses owned by persons whose participation in the free enterprise

system is hampered by social or economic disadvantage

SBA will structure each transaction with the aim of:

1. Encouraging and facilitating the investment of new private

capital into SSBICs;

2. Conserving the cash resources of each participant;

3. Conserving the borrowing potential of each participant;

4. Conserving the direct and guaranty budget of the Specialized

SBIC program;

5. Improving the financial status of the participating SSBICs;

6. Rehabilitating (where necessary) weak SSBICs to improve their

financial and operating effectiveness without undue risk to SBA; and

7. Discouraging voluntary liquidations of SSBICs and the premature

surrender of licenses.

The methodology of computing the price at which the 3% preferred

stock is sold back to an SSBIC will be a function of four factors

independent of any SSBIC, and four factors that are variable with each

SSBIC. The independent factors are:

1. Average SBIC Treasury-based 10 year rate,

2. Barron's Junk Bond Spread over Treasury,

3. Preferred stock dividend rate (3%), and

4. The adjustment to the price for non-marketability of shares.

The four factors that are variable with each individual SSBIC are:

1. Number of years that dividends are in arrears,

2. Financial rating of SSBIC, as rated by SBA,

3. Ability of SSBIC to have paid dividends, and

4. Par value of stock to be purchased.

The above policy will be executed in such a way as to prevent

windfall opportunities to SSBICs, their managements, or owners; and to

avoid transfer of cash flows from SSBICs into SBA to the detriment of

the program's effectiveness and liquidity.''

Implementation of the Repurchase Program

In accordance with the Pilot Notice, SBA selected nine Specialized

SBICs which had indicated an interest in participating in the Pilot

Program. The nine licensees represented a cross-section of the

industry, including both financially distressed and non-distressed

companies. SBA considered and structured each repurchase transaction in

accordance with the policy restated above.

Of the nine companies selected to participate in the Pilot Program,

six have completed the repurchase of their stock. Of the remaining

three companies, one withdrew voluntarily, one never submitted an

application, and one was denied participation because of regulatory

violations which would not have been cured by the repurchase.

As stated in the Pilot Notice, the objective of the Pilot Program

was to test SBA's Repurchase Program procedures and to suggest changes

that might facilitate future transactions. Many of the issues raised

during the Pilot Program concerned the following:

1. Development of a formula for determining the repurchase price;

2. Special considerations dependent on the financial condition of

SSBICs;

3. Application of the Repurchase Program to companies which are

involved in change of ownership transactions; and

4. Methods and conditions of financing the repurchase. Approaches

to these issues, and their resolution for the Repurchase Program, are

described below:

1. Repurchase Price Formula

A repurchase price formula was developed in general accordance with

the methodology included in the policy statement repeated above, and

applied to the particular situation of each of the pilot participants.

The formula for the preferred share price was a substitute for fair

market value, since there is no market for these shares. Based on the

recommendations of two independent expert studies, the formula for

computing the percentage of par value to be used in the Pilot Program

was the sum of three elements:

(1) The percentage of par which represented the differential

between an instrument paying 3% and the ``all-in'' cost of the June

1991 SBIC funding rate. This differential represented a discount from

par, since a 3% return was significantly below the market rate at June

1991. The percentage of par value remaining after subtracting the

discount computed to 32.05%.

(2) An adjustment based on the financial rating of the particular

SSBIC, plus an adjustment based on a junk bond spread over Treasures,

plus an adjustment for lack of marketability of the 3% preferred stock.

In practice, these adjustments added only 2% to 4% to the price for

individual companies in the Pilot Program.

(3) The third element represented the present value of the benefit

to the SSBIC from deferring payment of preferred dividends which it had

the capacity to pay.

In view of the very small effect of the second element on overall

valuation, the complexity of its computation, and the extent of

financial data and analysis required for its determination, SBA has

decided to substitute a fixed input of 3% for the Repurchase Program.

This was the midpoint of the range of adjustments for this element in

the Pilot Program.

SBA also determined that the third element may be duplicative of

the continuing obligation of a licensee to pay accrued dividends under

certain conditions enumerated herein. Consequently, only the first two

elements will be utilized in determining the price for the preferred

shares being repurchased.

For the Repurchase Program, SBA intends to fix the sum of the two

elements at 35% of par value, using the June 1991 interest rate inputs

in recognition of the extended delay in completing the Pilot Program.

Thus, the price to be paid by any SSBIC repurchasing 3% preferred stock

under this Program will be 35% of par. This compares with a range of

repurchase prices calculated for all of the pilot participants of

34.6554% to 36.2257% of par value.

To avoid a windfall, and to assure the desired result of retaining

funds in an active SSBIC program, repurchases below par during the

Pilot Program were made on condition that if the licensee became

inactive or was liquidated during a five year period following the

repurchase, SBA would have a preferred liquidating interest in the

licensee. SBA intends to continue this practice for the remainder of

the Repurchase Program, as described below under ``Other critical terms

of the repurchase transactions.''

2. Special Considerations Dependent Upon Financial Condition of SSBIC

SBA's evaluation of the Pilot Program has led it to conclude that

in order to be consistent with the stated policy objectives of the

Program, the amount and the timing of any required payment of accrued

dividends should be related to the financial strength of the particular

SSBIC purchasing its preferred stock from SBA.

For an SSBIC which has no practical prospect of making dividend

payments, the Repurchase Program will assist in strengthening the

licensee's financial condition and enabling it to attract new capital.

For those SSBICs which are financially strong enough to make

dividend payments, the program objectives are met if the deferral or

reduction of dividend payments provides an incentive for the SSBIC to

remain active in its investment program, and to defer distributions to

its shareholders.

Accordingly, the following guidelines have been developed to

distinguish between the two categories of SSBICs and to provide for the

treatment of accrued dividends for each category:

(a) Companies which lack any reasonable prospect of paying accrued

dividends are defined as those which, as of the licensee's fiscal year

end immediately preceding the publication of this Notice, have

undistributed realized losses and a capital impairment percentage (as

defined in 13 CFR part 107) of at least 10%. These licensees are

referred to as ``distressed'' for purposes of the Repurchase Program.

For distressed licensees, the accrued dividends will be extinguished

completely at the time of repurchase. This will remove a contingent

liability which would otherwise impede their efforts to raise new

capital. In the distressed licensee's repurchase agreement with SBA,

the company will agree to remain active for a five year period and to

be subject to the guidelines for change of ownership transactions

discussed below.

(b) For the remaining ``non-distressed'' SSBICs, which have a

reasonable prospect of being able to pay accrued dividends, forgiveness

of the dividends by SBA will be used as an inducement to defer

distributions of cash out of the program, either to SBA or the owners.

In these cases, forgiveness is conditioned on their agreement to remain

active in the SSBIC program for a five year period, during which time

the accrued dividends are reduced on a straight-line basis over a

period of five years or the term of any debt incurred to finance the

repurchase, whichever is longer. Distributions to owners may be made

only after paying the remaining dividends payable to SBA. The licensee

will agree to be subject to the guidelines for change of ownership

transactions discussed below.

3. Change of Ownership Transactions

For SSBICs that engage in a change of ownership either before or

after the repurchase of their 3% preferred stock, it is necessary to

avoid having the benefits of the repurchase result in a windfall to the

seller or buyer, rather than increasing the funds available for

investment by the SSBIC. To avoid having a prospective repurchase of 3%

preferred stock affect the purchase price of the company, the following

policy has been adopted:

(a) Where the selling SBIC is ``distressed'', the dividends accrued

at the time of repurchase will be forgiven. The preferred stock may be

repurchased at the formula price, subject to the agreement of the

purchaser to operate as an active SSBIC, and if operations are

discontinued or the SSBIC liquidated within five years, to pay SBA the

amount of its liquidating interest, as described under ``Other critical

terms of the repurchase transactions'' below.

(b) Where the selling SSBIC is not ``distressed'', the remaining

balance of accrued dividends as of the date of the change of ownership

must be paid before any future distributions are made by the licensee.

In addition, the purchaser must agree to the conditions concerning

active operation described in the preceding paragraph.

4. Financing the Repurchase

Since the purpose of the Repurchase Program is to strengthen the

financial condition of SSBICs, the most desirable source of financing

for the repurchase transaction is new capital invested in the SSBIC.

Financing with cash already in the SSBIC is inconsistent with the

policy of avoiding the transfer of cash flows from SSBICs into the SBA.

Experience in the Pilot Program, however, confirmed that new capital is

not available to all participants, particularly those which are in

financial distress. Consequently, payment of the repurchase price for

the participating companies was structured in one of four ways: (1) All

cash, following the raising of new capital, (2) a promissory note

payable to SBA in exchange for the preferred stock, (3) all cash, from

third-party unsecured financing, or (4) a combination of any of the

above.

Where borrowings from SBA or third parties are used to finance the

repurchase, they are intended to provide interim financing while

permanent equity capital is raised. SBA loans made for this purpose

will be at an interest rate which is 2% higher than the Treasury rate

for a comparable maturity, and any such loans must fully amortize if

longer than five years. SBA loans will provide the Agency with a

security interest in the licensee's assets and will contain restrictive

covenants and conditions.

Long-term financing by SBA in the form of guaranteed debentures or

4% preferred stock is intended to be used to increase the capacity of

SSBICs to invest or lend money to small businesses; consequently, it is

inappropriate to use these as sources of financing for the preferred

stock repurchase.

SBA shall, in its sole discretion, determine the form of payment it

will accept for a licensee's 3% preferred stock, including cash or an

amortizing or non-amortizing note, or a combination thereof.

Third party debt used for the repurchase must be unsecured since

granting a security interest in the SSBIC's assets reduces the value of

SBA's liquidating interest.

For licensees financing their repurchase through SBA or a third

party, the liquidating interest held by SBA will amortize over a period

of five years or the term of the repurchase debt, whichever is longer.

It is contemplated that the SSBIC will increase its private capital

by an amount equal to the repurchase price, either from the proceeds of

new capital invested in the SSBIC since April 1, 1993 or through the

permanent capitalization of retained earnings available for

distribution as permitted under program accounting rules. The amount

that may be capitalized for this purpose is limited to profits

generated since the licensee's fiscal year end immediately preceding

the publication of this Notice.

Other terms required in connection with the use of debt financing

of the repurchase are included in ``Other critical terms of the

repurchase transactions'' below.

Further Discussion of the Repurchase Program

The Repurchase Program is intended to strengthen the SSBIC Program

and enable it to provide additional financing to small businesses. It

is not intended to transfer value from SBA to the owners of SSBICs

without consideration. The proposed terms of the Repurchase Program

assure these intentions are fulfilled.

It should be noted that the 3% preferred stock to be repurchased

under the Repurchase Program has no provision for a ``put'' by SBA or

mandatory redemption by the SSBIC. Further, the SSBIC is not required

to pay accrued dividends to SBA; however, distributions to other

shareholders may not be made until any such dividends have been paid.

The repurchase price to be paid for the preferred stock is based on

actual market indicators, and is intended to represent a reasonable

substitute for fair market value, since these securities are not

publicly traded. For an SSBIC which does not intend to liquidate or

transfer ownership in the foreseeable future, the difference between

par value and the repurchase price is an unrealized loss already

sustained by SBA. In this case, the sale itself does not create the

loss.

An SSBIC which intends to liquidate or transfer ownership would be

required, in the absence of the Repurchase Program, to pay its accrued

dividends and repurchase its 3% preferred at par before any liquidating

distributions could be made to its other shareholders. Nevertheless,

there is often insufficient value in the licensee under such

circumstances for SBA to recover the full amount due.

To avoid the opportunity for a windfall through repurchase at a

price below par value and/or the forgiveness of accrued dividends, the

Repurchase Program requires that as consideration for the repurchase,

the SSBIC agree to remain active for a five year period. If the SSBIC

liquidates or becomes inactive prior to the end of this period, it is

required to pay a declining proportion of the difference between the

par value and the repurchase price of the shares. This is consistent

with the purpose of the Program: To encourage SSBICs to continue

investing or lending funds to small businesses.

Similarly, the terms of forgiveness of accrued dividends are

designed to further the purpose of the Program without providing a

windfall to the SSBIC, its owners or management.

In the case of an SSBIC in financial distress, with no reasonable

prospect of paying its accrued dividends, SBA is not surrendering value

when it forgives such dividends. At the same time, the SSBIC program

benefits from such forgiveness because it strengthens the financial

condition of the SSBIC and increases the licensee's opportunities to

secure additional financing or to be acquired by owners who would

commit to remain active in the program.

A non-distressed SSBIC can gain the benefit of the dividend

forgiveness only by agreeing to remain active in the program for five

years, and to pay the dividends on a declining scale during that period

(or during the term of any repurchase debt, if longer) as a

precondition to any distributions to its other shareholders. This

should encourage these SSBICs to defer distributions, and therefore

have greater resources available for investments or loans to small

businesses. Should the SSBIC become inactive, SBA will have the right

to demand payment of the accrued dividends as of the end of the fiscal

year for which the licensee became inactive.

In the event of a change of ownership of an SSBIC, the potential

forgiveness of accrued dividends would be a factor in determining the

purchase price to the new owner. To avoid the possibility that the

benefit of such forgiveness might therefore benefit buyer or seller,

without increasing the financial strength of the SSBIC, the terms of

the repurchase provide that in this case the remaining balance of

dividends accrued as of the date of the ownership change (which may

have been reduced by the terms of the preferred repurchase, if

completed earlier) must be paid, either at the time of sale, or later,

but before any distributions are made by the new owner.

It should also be noted that SSBICs with regulatory violations that

would not be cured by repurchasing their stock at a discount will be

ineligible to participate in the Repurchase Program.

Other Critical Terms of the Repurchase Transactions

SBA has determined that it is necessary to include the following

provisions in the agreements to repurchase 3% preferred stock:

1. To evidence the agreement of the SSBIC to remain active as a

consideration for the opportunity to repurchase, an SSBIC repurchasing

its preferred stock at a discount will be required to grant SBA a

preferential limited ownership interest (the ``liquidating interest'')

in a newly created capital account. As soon as the repurchase is

completed, this account will be credited by the SSBIC in an amount

equal to the discount at which the stock was repurchased. The value of

SBA's liquidating interest in the account will decline on a straight

line basis over time (generally five years or the duration of any

repurchase financing, whichever is longer). In the event of a change of

ownership of the licensee, SBA's liquidating interest continues in

effect on the same terms as would have applied had the change of

ownership not taken place.

The balance in the new capital account may be included in the

licensee's private capital only for purposes of calculating the

licensee's ``overline'' limitation and its capital impairment

percentage.

In order to make the SBA liquidating interest a matter of public

record, the SSBIC will be required to evidence it by an amendment to

its Articles of Incorporation.

2. An SSBIC that finances its repurchase through SBA or a third

party lender will be expected to agree that, during the term of the

financing, or until private capital in the amount of the repurchase

price is raised (whichever is earlier), it will not:

a. Make any distribution in favor of any non-SBA shareholder or

associate (as defined in 13 CFR 107.3) of the licensee, except with the

prior approval of SBA. This is to protect the value of SBA's

liquidating interest.

b. Prepay the financing without SBA's approval. This is intended to

conserve the cash resources of the SSBIC, avoid the use of its idle

funds for the repurchase, and avoid the transfer of cash resources from

the SSBIC to SBA.

c. Apply for new leverage from SBA. This is meant to encourage the

SSBIC to raise new capital for the repurchase. Refundings of existing

leverage would not be restricted by this provision.

d. Grant a security interest in its assets to any party other than

SBA. This is to protect the value of SBA's liquidating interest.

Application Procedure

After considering any comments received concerning this Notice, SBA

will distribute a Policy and Procedure Release to all SSBICs announcing

the commencement of the Repurchase Program and explaining the

application procedures. All licensees with outstanding 3% preferred

stock will then have one year to apply to repurchase their stock from

SBA. No applications will be accepted after that date.

SBA intends to consider applications and process repurchases in the

order in which the applications are received, subject to any special

needs of severely distressed licensees. SBA anticipates that all

repurchases will be completed within three years from the effective

date of the final rule.

Authority: Title III of the Small Business Investment Act, 15

U.S.C. 681 et seq.; 15 U.S.C. 687(c); 15 U.S.C. 683; 15 U.S.C. 687d;

15 U.S.C. 687g; 15 U.S.C. 687b; 15 U.S.C. 687m, as amended by Pub.

L. 102-366.

Dated: March 24, 1994.

Erskine B. Bowles,

Administrator.

[FR Doc. 94-7847 Filed 3-31-94; 8:45 am]

BILLING CODE 8025-01-M