E171: SBIC Funds: How to Raise $175 Million for Private Equity & Credit Funds

Episode Summary

Executive Summary: The conversation explains how SBICs use government-backed leverage to amplify private equity and private credit returns in the lower middle market. Guests Brett Palmer and David Demeter argue that SBICs outperform comparable funds, offer attractive fixed-rate 10-year leverage, and help skilled managers scale while creating jobs and improving small businesses through professionalization.

Main Topics: SBIC structure and leverage mechanics (Priority: 5/5): SBICs raise private capital, receive SBA approval, and borrow fund-level leverage that can double private equity to create larger vehicles with amplified returns. Performance outperformance versus benchmarks (Priority: 5/5): The guests discuss an UNC Institute for Private Capital study showing SBICs outperform comparable non-SBIC funds on both IRR and MOIC metrics. Why the lower middle market is attractive (Priority: 5/5): Lower middle-market businesses are described as inefficient, underprofessionalized, and full of opportunities for operational improvement and value creation. Private credit and equity use cases (Priority: 4/5): SBICs are used across direct lending, senior lending, venture debt, buyouts, growth equity, and even some venture strategies under newer equity-focused rules. Investor base, access, and fundraising constraints (Priority: 4/5): The program is growing, but many large institutions are too big for typical SBIC check sizes, so family offices, endowments, and banks have been key LPs. Endowment portfolio construction and role of hedge funds (Priority: 3/5): David Demeter explains Davidson’s barbell approach, combining hedge funds, venture capital, and private illiquids like SBICs to pursue higher private-market returns. Licensing, diligence, and eligibility hurdles (Priority: 4/5): Managers need relevant track records, U.S.-focused strategies, and clean reputations; licensing can take a year and involves SBA, legal, and FBI review.

Key Arguments: SBICs outperform because leverage amplifies already strong private-market returns, with the UNC study finding about 4% higher net IRR and 0.68x higher MOIC versus matched benchmarks. The leverage is unusually attractive: fixed-rate, 10-year, non-amortizing, and without refinancing risk, making it a powerful return enhancer for LPs. Lower middle-market companies are inefficient and often unprofessionalized, so operational fixes like management upgrades, accounting systems, and KPIs can create substantial alpha. SBIC investing can produce equity-like returns with debt-like risk because the government leverage is cheap and stable while underlying investments remain driven by manager skill. The program supports job growth and business expansion; small-business lending and equity investments can add significant organic employment per transaction. SBICs are especially suited to managers with real sector experience and disciplined operations, not brand-new or speculative strategies. Large institutions often overlook SBICs because fund sizes and check sizes are too small for their allocation constraints, giving smaller investors a relative advantage. The model fits both private equity and private credit managers, as long as they have a demonstrated track record in the specific strategy and stay within U.S.-focused investment rules.

Data Points: SBIC assets in 2008: $2 billion - Brett Palmer says SBIC assets were around this level in 2008. SBIC assets today: north of $50 billion - Current scale of the SBIC market cited by Brett Palmer. Expected new SBIC capital online: $15 billion to $20 billion - Projected coming online in the next 18 months. Maximum leverage per fund: $175 million - Total leverage an individual SBIC fund can borrow. Typical leverage ratio: 2:1 - Two dollars of SBA leverage for every dollar of private capital. Maximum outstanding leverage across funds: $350 million - Total outstanding leverage a single SBIC platform can have across successive funds. Fixed-rate leverage spread: 10-year Treasury + 50 to 80 bps - Described as the approximate cost of SBIC leverage. Trust certificate spread: 10-year Treasury + 45 to 85 bps - Brett Palmer describes the auctioned trust certificates backing the leverage. IPC study outperformance: about 4% net IRR - SBICs versus Burgess benchmarks on a net-of-fee IRR basis. IPC study outperformance: 0.68x higher MOIC - SBICs versus matched benchmarks. Private equity funds hitting 3x net MOIC: about 8% - David Demeter cites the rarity of reaching 3x net returns from 2000 to 2020. Lower-middle-market funds reaching 2.5x gross: about 40% - Used to argue SBIC leverage improves the odds of reaching top-quartile-like outcomes. Davidson hedge fund allocation: 35% - Portion of the endowment in hedge funds. Davidson venture capital allocation: about 25% - Portion of the endowment in venture capital. Davidson other private illiquids allocation: about 20% - Includes SBIC funds and similar private investments. Typical SBIC LP capital raise: $50 million to $200 million - Brett Palmer notes common private capital raise sizes for SBICs. Time to obtain first SBIC license: better part of a year - Estimated timeline for first-time funds. Follow-on license timeline: 3 to 4 months - Subsequent SBIC licenses can be obtained faster. North of new platforms in process: 50+ - Brett says more than 50 new platforms are in advanced licensing stages. Library of Congress job creation estimate for equity-oriented SBIC investments: over 350 jobs per investment - Referenced as organic jobs created per equity-oriented investment. Library of Congress job creation estimate for debt-oriented SBIC investments: about 175 to 180 jobs per investment - Referenced as organic jobs created per debt-oriented investment. Hedge fund gross exposure example: 50% to 80% net long - David discusses the type of hedge fund exposure common in his portfolio.

Pivotal Quotes: "SBICs outperform non-SBICs by about 4% on a net of IRR basis, net of fee IRR basis." — Brett Palmer: Summarizing the UNC Institute for Private Capital study on SBIC performance. "you get sort of equity-like returns for debt-like risk" — Brett Palmer: Explaining the appeal of SBA leverage for LPs. "the net of fee levered returns are frequently higher than the gross of fee unlevered returns" — David Demeter: Describing a key SBIC anomaly created by leverage.

Implications: SBICs appear to offer a rare mix of strong returns, lower-cost leverage, and real economy impact. For managers, they can unlock scale; for LPs, they may improve risk-adjusted returns; for the industry, the model could keep expanding as private credit grows and more capital moves into the lower middle market.