Small business investment gets a boost from capital call lines of credit
Capital call lines of credit are useful tools for Small Business Investment Companies, investors and lenders. Here's why.
In fiscal year 2022, Small Business Investment Companies (SBICs) provided U.S. small businesses with $7.9 billion in financing, a record high for the 65-year-old SBIC program1. While $2.8 billion of that total was funded through Small Business Administration (SBA) loans, more than $5 billion came from private equity2. One of the facilities SBICs can use to optimize this private funding is a capital call line of credit3. Capital call lines of credit, also known as subscription lines, provide SBICs with a method of funding investments that’s quicker and easier to execute than the traditional approach of calling capital directly from limited partners (LPs)4. The fund deposits are held at the bank providing the capital call line, which makes the relationship much more lucrative.
Capital call lines of credit were the focus of a recent meeting of the Small Business Investor Alliance's Women Investors Networking Council. Our own Lisa Kotula, SBIC Investment Manager for KeyBank’s Community Development Corporation, joined her peers to discuss what lenders and general partners (GPs) need to keep in mind when using capital call lines of credit, and why the subscription line landscape may be changing.
The panel started with a brief overview of capital call lines of credit and how they’re used.
The advantages of capital call lines of credit for general partners
Subscription lines allow GPs to draw funds when needed from a bank or other lender rather than being constrained by a capital call schedule. In this way, they act as a bridge loan, providing SBICs with predictable cash flow in between capital calls. Because liquidity from a capital call line of credit can be available in as little as one day – as opposed to a 10-day turnaround for a capital call – GPs using subscription lines can also be more nimble in their investing4. Also, covenants and reporting requirements are typically consistent with existing reporting protocols, so the costs and administrative burden of compliance are usually low.
Subscription lines allow GPs to draw funds when needed from a bank or other lender rather than being constrained by a capital call schedule.
Capital call lines of credit may be used for any SBA-permitted purpose, including financing qualified investments, and can be helpful in shortening a GP’s J curve and enhancing their fund’s internal rate of return (IRR). One panelist explained they use subscription lines mainly to manage cash flow when making an investment and as needed to cover quarterly and management fees. The line of credit has traditionally been a preferred source of funding because it’s less expensive than calling capital from the LPs.
Although subscription lines are unsecured, the lender can compel repayment of the loan by calling LP capital or drawing from the SBA’s loan to the SBIC5. Beyond that, banks providing capital call lines of credit tend to be “hands off” as long as they remain happy with the quality of investors in the borrowing base.
Considerations for lenders and SBICs
The risk of default on capital call lines of credit is low, but it’s not zero. The lion’s share of any risk that does exist comes down to the LPs. That’s why, while there are normally no financial covenants associated with subscription lines, there are many covenants addressing LP investors and how the SBIC allows them to enter or exit the fund, reduce their capital commitment or amend their limited partner agreement (LPA).
“I’m looking for the quality and experience of the LPs. We want to get a sense of their understanding of the market,” said Kotula. “We use Moody's and S&P to make sure we're looking at Investor-grade LPs.”
Kotula acknowledged, however, that it’s a challenging time for even the most seasoned LPs. According to a private equity secondary market report from Jefferies, many LPs are selling their fund stakes to free up cash or rebalance their investment portfolio. In 2022, half of LPs undertaking such sales were doing so for the first time6, 7.
“One of the things I'm including in my loan agreements, especially now, is making sure that if an LP is going to exit or transfer their capital, that they make me aware right away,” Kotula added. “That way, if there's going to be an issue, we can be on top of it and work together to determine what we need to do to minimize any disruption.”
Also stressed was the importance of lenders and GPs being on the same page when it comes to inviting new investors to a borrowing base and that SBICs clarify with their bank ahead of time how that lender will classify new investors.
Kotula agreed. “You’re going to want to review the loan documents – and then your attorneys are going to want to review them,” she said. “It’s a big circle and sometimes it takes longer than you expect. So, get started as early as you can.”
Before the lender receives the SBIC’s application and the clock starts ticking, though, the SBIC first has to decide which bank they want to work with. When choosing a lender, prioritize banks that are already invested and familiar with the firm. It’s important to choose a lender that’s going to be easy to work with, and you should plan that it will be required that the SBIC bank with them as a condition of approving the loan application.
A new opportunity on the horizon for lenders and SBICs
The SBA wants to expand SBIC program participation for funds focused on underserved communities, capital intensive investments and critical technologies. To do that, it recently proposed new regulations that allow for a secured line of credit8, 9.
The SBA wants to expand SBIC program participation for funds focused on underserved communities, capital intensive investments and critical technologies.
This new “qualified line of credit” would exempt SBICs from having to get prior SBA approval if they meet certain conditions:
- The line of credit is limited to 20% of the total unfunded committed capital of institutional investors.
- The term cannot exceed 12 months.
- The third-party debt must be held by a federally regulated financial institution.
These qualified lines can be secured up to 100% of the borrowing and the repayment period is 90 days. All borrowings under the line of credit must be fully paid off for at least 30 consecutive days during the fund’s fiscal year.
While Kotula welcomed the introduction of this new concept, she expressed doubt that it would have an immediate impact on demand for subscription lines – or lead to larger line sizes. “The risk of default is pretty low as it is,” said Kotula, “and I already use that advantage in risk rating my loans and having the lowest cost of capital that I can possibly get.”
Conclusion
Capital call lines of credit are useful tools for SBICs, investors and lenders working together to fulfill the SBA’s mission of supporting small businesses in the U.S. By smoothing out cash flow and providing a readily available, lower-cost source of capital, they allow SBICs to optimize the funding they receive from the SBA and private investors. But until interest rates stabilize and recession fears subside, these stakeholders will continue to face headwinds.
“I have a handful of SBICs that are probably getting their licensing in the fourth quarter of 2023,” said Kotula. “So, fingers crossed, knock on wood, throw the salt over my shoulder, all of it – I hope things are starting to look up for our economy by then.”
To learn more, reach out directly to Lisa Kotula or visit Key.com/affordable.
About KeyBank Community Development Lending and Investment
KeyBank Community Development Lending and Investment (CDLI) finances projects that stabilize and revitalize communities across all 50 states. As one of the top affordable housing capital providers in the country, KeyBank’s platform brings together construction, acquisition, bridge-to-re-syndication, and preservation loans, as well as lines of credit, Agency and HUD permanent mortgage executions, and equity investments for low-income housing projects, especially Low-Income Housing Tax Credit (LIHTC) financing. KeyBank has earned 10 consecutive “Outstanding” ratings on the Community Reinvestment Act exam, from the Office of the Comptroller of the Currency, making it the first U.S. national bank among the 25 largest to do so since the Act’s passage in 1977.
U.S. Small Business Administration. "SBA Announces End-of-Year Capital Benchmarks Showing Historic Support for Small Businesses Under Administrator Guzman." SBA Press Release, Dec. 14, 2022. Accessed 12 July 2023.
U.S. Small Business Administration. "Small Business Investment Company (SBIC) Program Overview Report for the Fiscal Year Ending September 30 2022." Accessed 12 July 2023.
Mascia, Michael C. Fund Finance 2019, 3rd Edition. Debevoise & Plimpton. Accessed 12 July 2023.
Kazemi, Hossein. "Subscription Line of Credit: Benefits, Risks, and Distortions." Portfolio for the Future. Chartered Alternative Investment Analyst Association, 29 Sept. 2020. Accessed 12 July 2023.
"Capital Call Loans to SBICs." Dentons, 20 Feb. 2014. Accessed 12 July 2023.
Private Capital Advisory. "Global Secondary Market Review." Jeffries, Jan. 2023. Accessed 12 July 2023.
Zhang, Hannah. "Investors Are Using the Secondary Market to Fix Their PE Portfolios." Institutional Investor, 23 Jan. 2023. Accessed 12 July 2023.
Rossi, Christopher A., et al. "SBA Proposes New Rules to Strengthen and Diversify Its SBIC Program."Troutman Pepper, 20 Oct. 2022. Accessed 12 July 2023.
U.S. Small Business Administration. "Administrator Guzman Advances New Small Business Investment Company Reforms to Expand Access, Strengthen and Diversify SBA’s Public-Private Investment Partnership Program." SBA Press Release, 18 Oct. 2022. Accessed 12 July 2023.
All credit products are subject to collateral and/or credit approval, terms, conditions, and availability and subject to change. Banking products and services are offered by KeyBank N.A. This article has been prepared and circulated for general information only and presents the authors’ views of general market and economic conditions and specific industries and/or sectors.
