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PRIVATE EQUITY FOR SMALL FIRMS: THE IMPORTANCE OF THE PARTICIPATING SECURITIES

PROGRAM

HEARING

BEFORE THE

COMMITTEE ON SMALL BUSINESS 

HOUSE OF REPRESENTATIVES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

WASHINGTON, DC, APRIL 13, 2005

Serial No. 109–10

Printed for the use of the Committee on Small Business

(

Available via the World Wide Web: http://www.access.gpo.gov/congress/house

COMMITTEE ON SMALL BUSINESS 

DONALD A. MANZULLO, Illinois, Chairman 

ROSCOE BARTLETT, Maryland, Vice 

Chairman 

SUE KELLY, New York 

STEVE CHABOT, Ohio 

SAM GRAVES, Missouri 

TODD AKIN, Missouri 

BILL SHUSTER, Pennsylvania 

MARILYN MUSGRAVE, Colorado 

JEB BRADLEY, New Hampshire 

STEVE KING, Iowa 

THADDEUS MCCOTTER, Michigan 

RIC KELLER, Florida 

TED POE, Texas 

MICHAEL SODREL, Indiana 

JEFF FORTENBERRY, Nebraska 

MICHAEL FITZPATRICK, Pennsylvania 

LYNN WESTMORELAND, Georgia 

LOUIE GOHMERT, Texas 

NYDIA VELA ́ ZQUEZ, New York 

JUANITA MILLENDER-MCDONALD, 

California 

TOM UDALL, New Mexico 

DANIEL LIPINSKI, Illinois 

ENI FALEOMAVAEGA, American Samoa 

DONNA CHRISTENSEN, Virgin Islands 

DANNY DAVIS, Illinois 

ED CASE, Hawaii 

MADELEINE BORDALLO, Guam 

RAU ́ L GRIJALVA, Arizona 

MICHAEL MICHAUD, Maine 

LINDA SA ́ NCHEZ, California 

JOHN BARROW, Georgia 

MELISSA BEAN, Illinois 

GWEN MOORE, Wisconsin 

J. MATTHEW SZYMANSKI, Chief of Staff 

PHIL ESKELAND, Deputy Chief of Staff/Policy Director 

MICHAEL DAY, Minority Staff Director

(II) 

C O N T E N T S 

WITNESSES

Page 

Guzman-Fournier, Mr. Jaime, Associate Administrator for Investment, U.S. 

Small Business Administration (SBA) Speaking on Behalf of SBA Administrator Hector Barreto ........................................................................................... 5

Blaydon, Mr. Colin, Ph.D., Director, Center for Private Equity and Entrepreneurship, Tuck School of Business, Dartmouth University .............................. 7

Preston, Ms. Susan, Director of Attorney Training and Professional Development, Davis Wright Tremaine ............................................................................ 8

Redding, Mr. Mark, President & CEO, Banner Service Corporation .................. 10

Clark, Mr. Redmond, Ph.D., President, Metalforming Control Corporation ...... 11

O’Connell, Mr. Daniel, Director, The Golder Center, University of Illinois 

at Champaign Urbana ......................................................................................... 13

APPENDIX

Opening statements: 

Manzullo, Hon. Donald A. ................................................................................ 27

Prepared statements: 

Talent, Senator James (R-MO) ........................................................................ 30

Guzman-Fournier, Mr. Jaime, Associate Administrator for Investment, 

U.S. Small Business Administration (SBA) Speaking on Behalf of SBA 

Administrator Hector Barreto ...................................................................... 33

Blaydon, Mr. Colin, Ph.D., Director, Center for Private Equity and Entrepreneurship, Tuck School of Business, Dartmouth University ................. 37

Preston, Ms. Susan, Director of Attorney Training and Professional Development, Davis Wright Tremaine ............................................................ 52

Clark, Mr. Redmond, Ph.D., President, Metalforming Control Corporation ................................................................................................................. 68

O’Connell, Mr. Daniel, Director, The Golder Center, University of Illinois 

at Champaign Urbana .................................................................................. 72

Attachments: 

Heesen, Mr. Mark, President, National Venture Capital Association ......... 76

(III) 

(1)

PRIVATE EQUITY FOR SMALL FIRMS: THE IMPORTANCE OF THE PARTICIPATING SECURITIES PROGRAM 

WEDNESDAY, APRIL 13, 2005

HOUSE OF REPRESENTATIVES, 

COMMITTEE ON SMALL BUSINESS, 

Washington, D.C. 

The Committee met, pursuant to call, at 2:15 p.m., in Room 311, 

Cannon House Office Building, Hon. Donald A. Manzullo [Chair of 

the Committee] Presiding. 

Present: Representatives Manzullo, Akin, Velazquez, Bordallo, 

and Moore. 

Chairman MANZULLO. Good, afternoon, and welcome to this hearing on the very important topic for small businesses around the 

country—access to capital. 

A key part of economic security is creating the environment for 

entrepreneurs to take risks in starting or growing businesses, 

thereby creating jobs. The question becomes, what should the Federal Government do to foster a better economic climate for small 

businesses to grow? 

This Committee can play a key role in achieving economic security by ensuring that the Federal Government and America’s small 

businesses work together in a sound partnership to spur growth in 

the economy. 

In February, this Committee held its first hearing of the 109th 

Congress to go over SBA’s budget and key programs within that 

budget. One of the topics dealt with small business investment 

companies, SBIC; specifically the Participating Securities program. 

In the hearing it was noted by SBA’s own analysis that participating securities funds licensed between the years of 1994 through 

2000 have performed as well as non-SBIC venture funds of the 

same vintage years in which CalPERS, the California Public Employees Retirement System was invested. Over $2.5 billion in leverage was invested in 3 years, 1998 to 2000, immediately before the 

collapse of the economy. 

I asked Administrator Barreto how much of the losses in the program can be attributed to the recession. He said, ′′I would be happy 

to go back and research this for you.′′ I expect the SBA to answer 

that question today. 

I also asked him if he would be willing to commit to working towards a solution of this problem, to which he replied, ′′Absolutely.′′

I want to congratulate the Administrator and his team for following through on a commitment to find a solution to this thorny 

2

problem in the Participating Securities program. I will let our witnesses get into the details of how significant the program is for 

start-up and early stage funding. 

The SBA Inspector General’s report for May of 2004 states, ′′Over 

the last 10 to 15 years the General Accounting Office and the Office of Inspector General have found that SBA’s policy of allowing 

extensive time for financially troubled SBICs to attempt rehabilitation has allowed SBIC assets to decrease and reduced SBA’s potential for recovery. SBA’s policies of allowing capitally impaired 

SBICs to charge significant management fees, and the way SBA 

applies distributable gains from SBICs also contribute to program 

losses. 

′′The standard operating procedure for the SBIC program has not 

been revised since March of 1989, and existing guidance does not 

provide a systematic approach for estimating the level of financial 

risk, ensuring the implementation of restrictive operations, transferring capitally impaired SBICs to liquidation status, or liquidating SBICs receiving participating securities.′′

The report goes on to state that, ′′The structure of the SBIC 

funding process for participating securities and the quality of SBA 

oversight have contributed significantly to the losses in the SBIC 

program in recent years.′′

Some believe the notion that if it is a good business plan, then 

someone will fund it. As our witnesses will attest, this simply is 

not true. According to the Council on Competitiveness National Innovation Initiative Report, dated December of 2004, ′′For those 

ideas that are pursued commercially, only 7 out of every 1,000 

business plans receive funding.′′

Mr. Steve Vivian, board member of the National Association of 

Small Business Investment Companies, testified at our hearing on 

the budget back in February that the Participating Securities program accounts for roughly half of all SBIC investment dollars and, 

since inception in 1994, has infused nearly $9 billion into U.S. 

small businesses. In fact, he goes on to note that 35 percent of that 

$9 billion went into small and growing U.S. manufacturing companies. 

[Chairman Manzullo’s statement may be found in the appendix.] 

Chairman MANZULLO. According to Mr. Vivian, these are investments that would not have been made by traditional venture capitalists or banks. But for the equity participation of the SBA, these 

jobs, products, revenues, and taxes would likely not exist. 

Listen to these quotes: 

′′SBIC financings work to fill the gap in private equity markets, 

especially at the earliest stage of a company’s growth.′′

′′By encouraging private risk taking, the program is capable of 

supporting thousands of entrepreneurs through the slow economic 

period with the prospect of growing leading-edge businesses out of 

the down cycle.′′

These comments did not come from a trade association or an industry guru, but from the SBA’s special report on the SBIC program, dated June of 2002. SBA’s report goes on to highlight that: 

‘‘SBIC’s financings represented 64 percent of seed financings during fiscal year 1994 to 2002.’’ 

3

‘‘The SBIC portfolio companies in the year 2002 created 73,000 

jobs, sustained 176,309 jobs, and supported over 1 million jobs.’’ 

‘‘Revenues in the SBIC portfolio companies in fiscal year 2002 

were 14.8 billion.’’ 

‘‘SBICs generated $6 billion in taxes in fiscal year 2002.’’ 

‘‘Between fiscal year 1994 and 2002, SBICs provided 65 percent 

of financing to nontechnology and life sciences as compared to the 

overall venture industry with only 9 percent of venture financing 

dollars in that category.’’ 

The SBA feels pressure to say the program doesn’t work as evidenced by the losses sustained. SBA must take some responsibility 

for how the program currently works. Again, from the IG report, 

and I quote, ′′Capitally impaired participating securities, securities 

SBICs that have been transferred to liquidation, are not being liquidated by the SBA. To improve the program’s ability to limit risk 

and prevent major avoidable program losses, officials should pursue legislative reforms and act in a timely manner in dealing with 

and liquidating capitally impaired SBICs.′′ We are not going to solve all the problems today. Nevertheless, 

my hope is that the SBA would take an open and honest look at 

the program and recognize its necessity. It is an accepted fact that 

there are structural problems in the program, but I believe it can 

be fixed between willing participants. I am willing; industry is willing. According to Mr. Barreto’s previous testimony, the administration is willing. 

One final quote from the SBA report: ′′Our mission is to improve 

and stimulate the national economy in general and the small business segment thereof, in particular, by establishing a program to 

stimulate and supplement the flow of private equity capital which 

small businesses need for the sound financing of their business operation and for their growth, expansion, modernization, and which 

are not available in adequate supply.′′ In light of the SBA’s own words as to the positive aspects of the 

Participating Securities program, they have an obligation to work 

with industry to resolve this problem, and I trust that will take 

place. 

Senator Talent advised me they may not be able to make it, but 

if he does make it, I promised him that we would stop whatever 

testimony is going on, immediately take his testimony, and then resume other testimony. His statement will be made part of the 

record without objection. 

[Senator Talent’s statement may be found in the appendix.] 

Chairman MANZULLO. I now turn to the ranking member for her 

comments, Mrs. Velazquez. 

Ms. VELAZQUEZ. Thank you, Mr. Chairman. 

There is no doubt that our Nation’s small businesses need all the 

help they can get when it comes to accessing affordable capital. 

Being able to successfully secure capital is what allows our nation’s 

entrepreneurs to reach their goals, stimulate economic growth, and 

create jobs. 

The challenges in accessing capital are not easier with venture 

capital; it is extremely difficult for start-ups to get capital, and this 

is a key area where demand is greatest. This is of particular concern in minority equity investment. Minority-owned businesses 

4

have traditionally had a more difficult time accessing venture capital. Currently, minorities only get 3 percent of venture capital investment. Clearly, there is a need for getting seed venture capital 

in the hands of start-ups. 

We are here today to look at the SBIC Participating Securities 

program, which is the program that has filled this gap in the past 

and has been internationally proclaimed as innovative. The SBIC 

Participating Securities program has also been credited as being 

the most reliable source of equity capital during times of recession. 

Despite the obvious need for start-ups to access venture capital, 

the administration wants to take away the only program that 

makes that possible. We are hearing today from the administration 

that there is no longer a demand for the SBIC Participating Securities program; it is showing huge losses and is costing the American 

taxpayer too much money. The administration blames the industry 

and the program, but in the midst of these excuses, it fails to accept any of the blame themselves. The administration has yet to 

step up and take responsibility for the poor management and lack 

of leadership in this program. 

It is evident that this program has deteriorated over the past 4 

years. From 1994 through 2000, the SBIC Participating Securities 

program received $225 million in profits and no defaults occurred. 

But 4 years later, under the Bush administration, it was taken to 

a zero subsidy rate and placed costs on the small businesses and 

lenders; and there has been $1.1 billion in losses since then. Clearly, this program has been mismanaged to the point where it is 

functioning far below its capacity. 

The fact is that the administration has been negligent in intervening with the SBIC Participating Securities program. The Agency should have stepped in, liquidated investment—and liquidated 

investments in the program. Instead, they choose to take no action 

when companies were struggling, which only caused the program 

to decline further. 

What this Committee needs to know is that if the SBIC Participating Securities program is not the right way to get seed venture 

capital to start-ups, then what is? In the past, it seems as if the 

answer from the administration was to simply do nothing. 

Well, let me tell you, that is not an option. The bottom line is 

that our Nation’s small businesses are not getting the venture capital they need. We clearly cannot expect the capital market to be 

relied upon solely to fill this gap on its own. Given the tacit support that has been shown for the New Markets Venture Capital 

program in the past, I want to know what the options are. If it isn’t 

the New Markets Venture Capital program that can serve this 

vital program and it isn’t the SBIC Participating Securities program that can provide seed capital to start-ups, then tell me what 

can. 

We cannot afford to not take action right now. There is a need 

from start-up firms across the country to tap into the venture capital market, and these needs deserve to be met. As the main job 

creators, our Nation’s small businesses require that venture seed 

capital be available to them. This Nation’s entrepreneurs already 

face enough challenges accessing capital. By working to repeal this 

5

program and explore our options, we are broadening the availability of venture capital to small businesses across the country. 

Thank you, Mr. Chairman. 

Chairman MANZULLO. Thank you. 

Chairman MANZULLO. Our first witness is Jaime A. GuzmanFournier, who is speaking on behalf of Administrator Hector 

Barreto. He is the Associate Administrator For Investment at the 

U.S. Small Business Administration. 

We have a 5-minute clock, and if you could follow that, it would 

be okay. But because you have got a load here, I am going to set 

your clock at 7 minutes and the rest would be at 5. But you can 

end any time before 7 if you want, okay? 

Thank you. 

STATEMENT OF JAIME GUZMAN-FOURNIER, ON BEHALF OF 

U.S. SMALL BUSINESS ADMINISTRATION ADMINISTRATOR 

HECTOR BARRETO 

Mr. GUZMAN-FOURNIER. Mr. Chairman, Ranking Member Velazquez, members of the Committee, my name is Jaime GuzmanFournier, Associate Administrator for Investment in the Office of 

Capital Access at SBA. Administrator Barreto asked me to testify 

on his behalf, and I appreciate the opportunity to discuss with you 

today the Small Business Investment Company Participating Securities program. 

I know the Committee shares the President’s goal of a fiscally responsible government, and understands why we cannot continue 

operating a structurally flawed program that loses taxpayers’ 

money. At the end of fiscal year 2004, 2.7 billion of losses were projected on the more than 6 billion disbursed. As shown in chart 

number 1, you can see it to the right here, the cash flow minus appropriations was a negative 1.3 billion; 29 percent of participating 

securities SBICs licensed prior to fiscal year 2001 have failed to 

repay their obligation to the Federal Government. In contrast, only 

5 percent have fully repaid their leverage. 

While fund performance is part of the problem, the fact that several failed SBICs were able to pay back their private investors, but 

not the taxpayers, demonstrates the flawed structure of the program. In fact, of the SBIC funds that fully repaid their private investors, over 75 percent had not fully repaid SBA as of the end of 

fiscal year 2004. 

Let us look at the Participating Securities instrument. In essence, the Federal Government borrows money by guaranteeing 

SBICs on the securities they issue to the public. Then SBA pays 

the associated interest on behalf of the SBICs and is paid back only 

if and when they become profitable. The SBICs invest that money 

in long-term equity investments such as patient capital for seed 

and early-stage companies. The SBA is supposed to be paid back 

out of the returns of these investments. 

We have identified several problems with the structure I have 

just described. One problem is that SBA defers interest on the 

money SBA borrows. This accumulated interest can often exceed 

the original investment and is often never repaid. In fact, we have 

one fund that owes the SBA approximately 25 million in interest 

payments, but owes less than 20 million in principal. 

6

Another flaw in the program is the profit distribution formula. 

SBA typically contributes two-thirds of the capital of an SBIC, but 

receives less than 10 percent of the profits, if any, of the fund. 

Moreover, Participating Securities SBICs distribute capital based 

on a formula that allows SBICs to minimize distributions to the 

SBA and maximize profit to private investors. 

The key problems with this formula are, number one, profits to 

all investors are paid before SBA leverage; number two, SBICs can 

make optional tax distributions providing even more of the profits 

to the private investor at the expense of the taxpayer; and number 

three, when SBA is less than 50 percent of the capital in the fund, 

it gets only its profit participation, typically less than 10 percent. 

For example, as shown on chart number 2 here to the right, one 

SBIC made a single distribution of $207 million. Because the SBA 

percentage of outstanding leverage to total capital was only 49.5, 

the SBA received less than $18 million, while 189 million went to 

the private investors and general partners of the fund. This was a 

650 percent return on their initial investment. 

While this distribution, by itself, is disconcerting, the SBA’s percentage of outstanding capital was under 50 percent only because 

2 weeks prior the SBIC had made a distribution of less than 37 

million which dropped the SBA’s percentage. Had the SBIC made 

a single distribution, SBA would have been paid back all leverage 

plus a profit distribution, and the private investors would still have 

had a 400 to 500 percent return. 

As shown in chart number 3 to the left, on a community basis 

this structure has allowed private investors to receive 1.9 times 

their paid investment, where the taxpayers have lost 50 percent of 

their investment. As of the end of fiscal year 2004, Participating 

Securities SBICs had 4.9 billion in outstanding leverage and 5.7 

billion in unfunded commitments. 

The important issue that the administration must continue to 

address is: How do we manage this program in order to minimize 

losses? SBA, in consultation with outside experts, is implementing 

clearer policies to ensure all necessary steps will be taken to protect the taxpayers’ money. 

Finally, I want to say that SBA’s role in venture capital is not 

ended. We continue to support and encourage the SBIC debenture 

program. While it focuses on later-stage financing, it produces results without the fiscal difficulties inherent in the Participating Securities program. 

I thank you again for the opportunity, and I look forward to your 

questions. 

Chairman MANZULLO. Thank you. 

[The Honorable Barreto’s statement may be found in the appendix.] 

Chairman MANZULLO. Our next witness is Professor Colin 

Blaydon. He is the Buchanan Professor of Management and Founding Director of the Center for Private Equity and Entrepreneurship 

at the Tuck School of Business at Dartmouth. We look forward to 

your testimony. 

7

STATEMENT OF COLIN BLAYDON, TUCK SCHOOL OF 

BUSINESS, DARTMOUTH UNIVERSITY 

Mr. BLAYDON. Thank you, Mr. Chairman, Ranking Member 

Velazquez, and members of the Committee. My center—and I am 

accompanied today by our Executive Director, Fred Wainwright, 

who is here with me—was asked by the National Association of 

SBICs to examine the data from the SBA and data available about 

private investment and venture capital, and to compare the patterns to see what gaps might be present. 

One thing I would say at the outset is that it is well known in 

academic research that the private equity markets for venture capital are inefficient. Those inefficiencies are one of the contributors 

to the very high returns that people expect from these high-risk investments. But inefficiencies, while also indicating the presence of 

high possible returns, also, almost by definition, assure that there 

will be gaps. The question is, where do those gaps exist? 

The preliminary data that we have been able to look at so far 

would say that there are gaps in three areas, and I think you will 

hear some of my fellow panel members discuss them in more detail 

in their testimony. The three areas are in financing, in geography, 

and in industry sectors. 

The financing comes about really in both the size of the investments that are made in companies and the stage at which investments are made. The private venture capital funds have raised 

enormous money in recent years. They have also become newly 

cautious after the bursting of the tech bubble. As a result, they are 

trying to put to work very large amounts of money, and they are 

trying to put them to work much more safely. As a result, their investment in seed and early-stage investments has fallen to about 

2 percent of the total amount of investing capital that they are 

making today, down from 16 to 20 percent in the mid-1990s. 

In addition, the idea that this will be made up by angel investors 

or by a large overhang of capital that these venture funds still have 

to invest, I think you will hear other panel members talk about. 

I won’t say anything about the angel investors here because I know 

my colleagues will say something more about it. But I would like 

to say something about the venture capital overhang. 

It is pointed to a great deal in the press, but our research indicates that much of this overhang is, in fact, money that these funds 

have reserved for follow-on investments in their portfolios. So while 

it is not yet spent, it certainly is not available and certainly is not 

available for the kinds of businesses that we are talking about and 

are concerned with here today. 

The second area in which there is a gap is geography. The venture capital industry, the private venture capital industry, is 

bicoastal, with a few other centers that are much smaller around 

the country, but basically Silicon Valley and Route 128, the Boston/

New England area. By contrast, the criteria that have been used 

for funding SBICs have permitted SBICs over the last 20 years to 

grow from being in about 25 States to being in 45 of the 50 States 

today. So the geographic coverage and availability of this type of 

private capital goes places where the private venture capital industry simply does not operate. 

8

The third area is by sector. The private venture capital arena invests heavily in high tech, in life sciences, in software, biotech, 

medical devices. The SBICs, by contrast, are much more broad in 

their investment. They are investing heavily in manufacturing; 28 

percent of SBIC’s investment post-bubble has been in the manufacturing sector, one that is almost totally ignored by the private venture capital funds. 

Lastly, I would want to say something about what the bubble 

did. The bubble did the same thing for SBICs that they did for private funds. 

Chairman MANZULLO. How are you doing? Your bubble is about 

ready to burst. 

Mr. BLAYDON. My bubble is about to burst. I will reserve the rest 

of my comments, Mr. Chairman, for questions that you may have 

for me. 

Chairman MANZULLO. Thank you very much. I appreciate it. 

[Dr. Blaydon’s statement may be found in the appendix.] 

Chairman MANZULLO. Our next witness is Susan Preston who, 

like my wife, is a microbiologist. She also has her J.D. She is currently an Entrepreneur-in-Residence at the Kauffman Foundation. 

Ms. Preston, we look forward to your testimony. 

STATEMENT OF SUSAN PRESTON, DAVIS WRIGHT TREMAINE 

Ms. PRESTON. Thank you very much. 

Chairman Manzullo, Ranking Member Velazquez, and members 

of the Committee, thank you very much for inviting me here to testify today before the Committee on this important issue of the continuance of the SBIC Participating Securities program. I am going 

to speak to you specifically regarding angel investing and the funding gap. 

To define the funding gap for you, historically we have looked at 

in the early 1990s a funding gap that was between a half million 

and 2 million. That funding gap has extended to between $2 million and $5 million, and that number of the funding gap is supported when you look at some of the statistics that have already 

been noted of the move of the venture capitalists out of funding 

anything in the seed and start-up stage. In fact, in 2004, only 1.7 

percent of the dollars invested by venture capitalists went into seed 

and start-up stage, in only 171 deals. That is a 90 percent decrease 

in the last 6 years in seed and start-up stage. 

In addition to that, if you look at the average investment amount 

that venture capitalists make, it is around 7 million—$6 million to 

$7 million per deal—clearly, again, above the funding gap that we 

are looking at of 2 to 5 million or half a million to $5 million. 

Now, let us look at the angel investors. Angel investors have become very active in recent—and I will talk in a moment about the 

Angel Capital Association. But if we just look at the specific numbers, it is estimated last year, in 2004, that angels invested around 

$22.5 billion. 

To put that into context, that was into 48,000 deals. We are early 

stage investors, clearly, but if you do your simple mathematics, 

48,000 deals into $22.5 billion comes up with an average investment of just under half a million dollars, clearly under the range 

of the funding gap that we are talking about. 

9

What is important to understand about angel investors—and is 

important to understand also for the SBIC program—is it is patient money. These are very early-stage investors. We understand 

the need to wait up to 10 years to see return on our investments 

and understand that in the earlier stages of possibly a 5-to-7-year 

time frame the return is still going to be negative. And we need 

to understand that we need to allow the companies to grow, but we 

also need to understand that we need the follow-on funding. 

One of the biggest issues for angel investors right now is we look 

at this as the best of times and the worst of times. Valuations are 

very low, but we fear that there is no follow-on funding, because 

our average investment, again, is between 25- and 250,000 for individual angels, and then through angel groups it is up to half a million, but still clearly outside the funding gap. 

Through Kauffman Foundation we have started an organization 

called the Angel Capital Association, which is a professional alliance of angel organizations. We have only been in existence for 

about 1 year, but we already have 85 groups as members. It is a 

phenomenal success for us and a recognition by the Kauffman 

Foundation of the need to finance entrepreneurs in this early stage. 

It also recognizes that angels are not necessarily investing up 

into the funding gap, but that angels understand the potential for 

the lucrative return on early-stage investing. And so we are not 

leaving this funding area, but in fact returning to it and understanding the need to fund into the early-stage companies. 

We are just starting, as angel groups, to talk about syndication, 

which may give the opportunity to build those numbers of investment dollars, but it is clearly not there yet. Most angel groups and 

individual angels are very geocentric in their investing, and only 

invest locally both because of their interest of staying connected 

with the companies they invest in but also because they want to 

give back to their community. So to look to the angel industry to 

fill the gap is unrealistic at this time or anywhere in the near future. 

The other thing that I would like to point out as far as angels 

are concerned is that when we invest, we are much more sophisticated about our investment now. And when we look at a company 

that is carrying debentures or debt on their balance sheet, it makes 

for an unattractive company, particularly when money is being 

paid to interest on those debentures. Any money that we put into 

companies or any other early stage, we want that money to work 

to build the company rather than to repay on notes. And so having 

a Participating Securities program is extremely important to do 

that. 

The last point that I want to make is that in order to have the 

ability for the lower and middle class to fund companies rather 

than only the upper class that can self-fund their companies, we 

do need something that fills the funding gap; and the SBIC Participating Securities program does that, particularly for women and 

minorities. 

Thank you. 

Chairman MANZULLO. Thank you. 

[Ms. Preston’s statement may be found in the appendix.] 

10

Chairman MANZULLO. Our next witness is Mark Redding. He is 

the CEO of Banner Service Corporation. 

And, Mr. Redding, we look forward to your testimony. 

STATEMENT OF MARK REDDING, BANNER SERVICE 

CORPORATION 

Mr. REDDING. Thank you, Chairman Manzullo, Ranking Member 

Velazquez, and members of the Committee. I appreciate the invitation to testify at this hearing. 

The Participating Securities program has been of great importance to me. My name is Mark A. Redding; I am the Chairman and 

Chief Executive Officer of Banner Service Corporation in Carol 

Stream, Illinois. Banner is a manufacturing company with about 60 

employees engaged in the precision steel bar industry. 

For the past 30 years, I have worked in the metal products industries, from an early position as a production control analyst to 

now, twice, being a Chief Executive Officer. I have worked in both 

large and small firms. In 2003, I led the effort to purchase Banner 

from its founding family. Two licensed SBIC private equity firms, 

Prism Capital and Alpha Capital Partners joined with me to make 

that purchase and revitalization of Banner possible. 

For one to understand the importance of these issues to us, I 

would like to briefly describe our business. Originally, Banner was 

a small metal distributor. During the course of its history, it expanded many times, added additional equipment, and created new 

jobs. Eventually, it outgrew its facility and began to look for a new 

home. 

In 1997, as the U.S. economy blossomed, Banner relocated to a 

new facility, but at significantly higher cost. As a result of this, 

Banner’s business grew in sales revenue to over $25 million. However, there was trouble ahead for Banner at its new scale. Much 

of that growth was based upon making bars for the office products 

industry, such as computer printers. Much of the demand for these 

bars evaporated as the office product sector moved offshore. Later, 

the recession impacted many other clients, and the result was a serious decline in Banner’s revenues to less than $17 million. Liquidation studies were conducted with the possible result of simply 

ceasing to operate the business. 

Our transaction to buy Banner occurred over a time frame from 

May to September of 2003. During that period, I was working on 

dual fronts to negotiate the terms of the purchase while also attempting to raise equity capital. 

Armed with a letter of intent signed by the seller, I searched the 

financial community to attract investors to combine with capital of 

my own. I contacted more than 8 firms in the greater venture capital market. I committed not only to invest my own personal capital 

in the venture but also my full-time leadership. There was little interest. The investor market for deals of this nature and size was 

very limited. 

I was able to meet Steve Vivian of Prism Capital, who showed 

interest in this opportunity, and he visited the company with me. 

We met with Andrew Kalnow of Alpha Capital and enlisted his 

support to join us, which he did. The transaction closed on September 3, 2003. 

11

What has happened thereafter is quite a success story. During 

what remained of that year, Banner was able to make a profit and 

have a positive cash flow. With a firm financial structure anchored 

by SBIC-backed equity, we had the time to reposition the business. 

By the end of 2004, Banner was able to regrow its revenue back 

to $24 million and more than double its free cash flow. It met every 

one of its debt payments, increased its employment, added new 

products, and invested $600,000 in additional production line. It 

provided work for machine installers, electricians, plumbers, truck 

drivers, and others. New, permanent jobs have been created. 

Also, this transaction supported by the SBIC and Prism created 

a new class of ownership at Banner. Four long-term employees became eligible to participate in the common unit plan. This included 

one gentleman over 60 years of age and one woman over 55. The 

plan also provides for future key members of Banner’s management 

team to qualify for ownership. 

In summary, new life has been given to Banner Service Corporation. It is my opinion much of the success was due to the Participating Securities program and its cooperation with small business—the small business community through SBIC licensees like 

Prism and Alpha. 

With help from the SBIC Participating Securities program there 

could be many more stories like Banner. Please consider us and 

those other small businesses when you consider the future of the 

Participating Securities program. 

Thank you. It has been a privilege to participate in this process. 

Chairman MANZULLO. Thank you very much. 

Chairman MANZULLO. Our next witness is a constituent, Red 

Clark, who has a dual role as a manufacturer and somebody who 

also has had to raise a tremendous amount of money for venture 

capitalist purposes. 

And I have got to get over there and take a look at both of your 

factories. Any time anybody has got a new process—and I want to 

check out this Ford modulator system. I drove General Kinematics 

nuts because I wanted to know how they make objects move uphill 

on a conveyor. They finally gave me a little bit of knowledge as to 

what it was, and I want to see what that system does. 

Red, we look forward to your testimony. 

STATEMENT OF REDMOND CLARK, METALFORMING CONTROL 

CORPORATION 

Mr. CLARK. Thank you. 

Thank you, Chairman Manzullo, Ms. Velazquez, and members of 

the Committee. I appreciate the opportunity to be here. 

I am the guy you are spending money on. I am the guy that receives the money and puts it to use in the field in companies. I am 

a serial entrepreneur. I have been operating and turning around 

venture-backed companies for the last 20 years. The fact that I am 

a serial entrepreneur also means that I am a slow learner. 

I have raised approximately $50 million for the companies that 

I have managed over the years, and a significant fraction of that 

money in two of the most recent deals that I have operated have 

come from the SBIC. 

12

My colleagues have already mentioned some of the trends that 

I have seen in venture capital. I will just touch on them again for 

emphasis. 

Venture capital investment in the private sector is growing. It is 

up 250 percent over the last 10 years. At the same time, seed investment has dropped by 75 percent in the same period. There is 

more money going into venture capital in the private sector, more 

money coming into the public sector, and less money going to seed. 

In addition, you have already heard that it is a bicoastal market. 

Most of the venture capital is available on the East Coast and on 

the West Coast, and there is a very limited amount available in the 

Midwest and in the center of the U.S. as a whole. And I can give 

you some experiential information on what it is like to raise money 

in that marketplace. 

In the last two start-ups that I have run, we were backed by the 

SBIC. We raised $1 million to $3 million for each of the companies. 

They are both headquartered in the Chicago area, and we had to 

go 800 miles from Chicago in order to find capital or investors that 

were willing to place their capital into our organization, into the 

sector that we are working in and into the geography that we are 

working in. The funds that we found which were distant from the 

Chicago area were SBIC funds that were investing in our sector. 

It was very, very difficult to find money in the 1990s; it is very 

difficult to find money in the 2000s, no matter where you are, if 

you are a sector or a geography that is not in favor. The SBIC is 

one of the programs that literally applies capital with a degree of 

quality throughout the U.S. and makes it available and gives us a 

chance to operate. 

Very simply, my experience is a guide, I think, for all of us; and 

that is, if there is no money, there will be no companies. The private sector may supply some of the money, the public sector may 

supply some of the money, but if there is not a sufficient amount 

of money, the companies will not exist. 

What did the SBIC money get in our companies? I will give you 

a brief list here: to date, in excess of $50 million in sales. 

We are actively reducing the weight of vehicles in the United 

States with one of our technologies. And, according to the DOE, if 

we continue to commercialize successfully, we will cut oil imports 

by approximately 1 billion gallons per year. 

We have reduced, eliminated, or recycled somewhere in the area 

of 1 million tons of industrial toxic waste. 

We have removed lead paint from more than 100 million square 

feet of metal surfaces throughout the United States. 

All of these things that have happened over the last decade happened with SBIC money as the lead investor and the lead player. 

Without SBIC, we are not in business. 

Just a few concluding thoughts: As I mentioned a moment ago, 

as I mentioned several times, the SBIC is one of the few programs 

that supplies capital throughout the U.S. It is very important. 

The second comment I would make is that what the SBIC does 

today is not going to bear fruit in our business world for another 

6 to 10 years. That means money that was invested 6, 7, 8 years 

ago is only now beginning to bear fruit. This is a long-term investVerDate 0ct 09 2002 19:16 Aug 24, 2005 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 G:\HEARINGS\21285.TXT MIKE
13

ment. It is unusual that governments get involved at this level at 

this length of time, but it is very important for us. 

The SBIC funds are biased towards seed. The gap is real. We 

need to continue to address that gap wherever possible. If you look 

at the total amounts of dollars that the SBIC has invested in what 

we would call ′′seed areas′′ over the past 7, 8, 9 years, you find that 

they are a major, major player in this sector of investment. 

Lastly, the venture capital community passes through cycles of 

good and bad times. Companies pass through cycles of good and 

bad times. The SBIC program, from where I am sitting, is no different. There have been wonderful times to invest, there are poor 

times to invest, and there will be in the future. But the continuity 

of the program I think gives you a greater opportunity to get an 

acceptable rate of return as long as you, in fact, do structure the 

programs so that you share in the successes just as you share in 

the losses. 

Just one last concluding remark, and that is, we all understand 

how important small businesses are to our economy. We are a job 

creation engine. We make things happen. We make things change. 

We keep our economy competitive. We need whatever support the 

government can offer in this area. 

Thank you very much. 

Chairman MANZULLO. Thank you. 

[Mr. Clark’s statement may be found in the appendix.] 

Chairman MANZULLO. Our next witness is Daniel O’Connell, who 

joined the College of Business at the University of Illinois at Urbana-Champaign with nearly 30 years of venture capital and small 

business investing experience. 

We look forward to your testimony. 

STATEMENT OF DANIEL O’CONNELL, UNIVERSITY OF ILLINOIS 

AT CHAMPAIGN URBANA 

Mr. O’CONNELL. Thank you, Mr. Chairman, Ms. Velazquez, and 

members of the Committee. I am the guy who has written checks 

to the people such as the two people next to us over all the years. 

And I can tell you that it is people like this that make our job both 

infuriating, but so satisfying when you pick the right team, and 

you are able to support them. 

More than 30 years ago I was introduced to the venture capital 

industry when, as a summer intern, I was at the then-First National Bank of Chicago. Over the ensuing years I have been all 

around the venture table, acting at various times as a general partner, a limited partner, or an investor in a wide range of private equity situations. 

In the early 1990s, I was a NASBIC governor, and I had the 

honor to serve on a Committee whose work ultimately led to the 

creation of the Participating Securities program. So I was kind of 

here before this got started. 

By any measure, these past 30 years have been a time of incredible expansion for our industry. During this period, there has also 

been a huge broadening of possible investment vehicles that get defined as private equity. 

Today, broadly defined private equity includes a wide spectrum 

of possible investments ranging from angel and earliest-stage startVerDate 0ct 09 2002 19:16 Aug 24, 2005 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 G:\HEARINGS\21285.TXT MIKE
14

ups through and including international multibillion dollar 

buyouts. Yet while the industry has expanded dramatically, it remains fundamentally granular. And what I mean by that is that 

there exists an immense matrix of possible investment strategies 

that a private equity group might choose to execute, and these 

strategies are described across multiple dimensions—size of the 

company, stage of the company, the industry, the geography, to 

name just a few. 

Competition for the available limited partner dollars, the private 

equity part of the SBIC program, encouraged general partners to 

identify niches in which they feel they can compete most successfully. I can only see this trend towards specialization continuing. 

And it has always been true that successful execution of a private 

equity group’s business strategy requires an underlying match of 

its human and financial capital to the needs of its chosen niche. 

So what do these things have to do with the Participating Securities program? In my experience, it was conspicuous to those of us 

using SBA debentures that there was a problem when we wanted 

to invest in situations characterized by high risk, high growth, and 

potentially high returns, i.e., venture or growth companies. 

There was a fundamental mismatch between our sources of funds 

and our uses of those funds. At one level it made little sense for 

us to borrow money to make an equity investment in a company. 

But did we make those investments anyway? Yes, we did, but in 

less than optimal ways. 

In my opinion, a Participating Securities program was intended 

to provide a better match between the nature of the funds provided 

to the SBIC and the realistic demand of the businesses into which 

the SBIC would invest. 

So is there still a need today for this kind of program? Absolutely. If anything, the increasing specialization of our business 

suggests an even greater need. 

From my experience, SBICs fill important pieces of the private 

equity matrix. They tend to be more geographically focused in regions underserved by other sources. Because we have learned how 

to prosper from other than the public markets, we are more comfortable with smaller businesses and with businesses and industries, or niches, of a size that typically does not represent IPO potential. And, once in an investment, SBIC principals often add 

value in somewhat different ways than traditional VCs. 

Could traditional venture funds and larger buyout groups make 

these kinds of investments? Yes. And from time to time they do, 

but only when it is easy for them to do so. It is just not time- or 

dollar-efficient for them to aggressively make the kinds of investments that an SBIC is formed to make. 

Regarding how the program might be more effective going forward, I would like to make a couple of observations. First, I believe 

it is absolutely critical that there be a match between private equity fund sources of capital and its uses as seen in the investments 

it intends to make. If you expect the SBIC managers to make relatively high-risk, low-liquidity, long-term but potentially high-return, i.e., equity type investments, then the SBA dollars that might 

be used should be patient, long-term, and risk-tolerant. 

15

In any company situation seeking funds from a diverse set of 

players—and when you have the SBA limited partners and general 

partners, that is a pretty diverse group—there are pricing and 

term issues. To be successful, all parties to a transaction must feel 

there is a fair and reasonable sharing of risks and rewards, and 

that there are reasonable oversight and controls consistent with 

the players’ position in the transaction. 

Chairman MANZULLO. You have got a red light there. How are 

you doing? 

Mr. O’CONNELL. All right. I will just finish. Let me talk to two 

things. 

I think it is important that a pool of private equity investments 

at the SBA be properly diversified across both character and time, 

and I think that the money must be patient. And in order to be 

patient, that requires those with largely portfolio management 

issues, and those are best met by having a staff of professionals 

that I think requires a commitment to the SBA itself. 

Chairman MANZULLO. Thank you very much. 

[Mr. O’Connell’s statement may be found in the appendix.] 

Chairman MANZULLO. I have the first question here to ask of our 

Deputy Administrator. From the documents I have seen generated 

by the SBA, it appears the SBA was aware of problems with the 

Participating Securities program as far back as the summer of 

2003, but it submitted a proposal to modify the program to the 

House and Senate Small Business Committees. 

Furthermore, the SBA was aware that the Inspector General had 

issued a report in May of 2004 concerning problems with the Participating Securities program. Nevertheless, the SBA licensed more 

than 30 new Participating Securities SBICs in September of 2004. 

My question is if the program was such a problem, why did the 

SBA license and, in fact, work overtime to do so many new Participating Securities SBICs? 

Mr. GUZMAN-FOURNIER. I appreciate the question. 

The Agency basically made a determination to continue to operate the program through the period of the authorization. There was 

a decision made that we had a statutory obligation to carry out the 

program. We intend to fulfill our obligations with the outstanding 

commitments, but we need to continue to monitor the risks with 

this money that we have already committed. 

Chairman MANZULLO. The problem is that your J-curve, or your 

turnaround, is 5 years, and you had come to the conclusion an entire year before this thing was a black hole, and yet—I mean, it 

is not cheap to set up a participating securities SBIC. It is a tremendous amount of money in attorneys’ fees and accounting fees, 

et cetera. It seems inconsistent. 

You have a statutory obligation to continue the program now, but 

you have decided that you do not want to. It just does not make 

sense that in September of last year, what, 6 months ago, you gave 

the nod to 30 new companies, SBICs, to go ahead and start new 

programs. 

Mr. GUZMAN-FOURNIER. Part of the problem was that we also 

had—the industry noticed that the program was going to be terminated, and we had a lot of private investors’ capital interest, as this 

16

chart shows. If you are making 1.9 times your money in profits, 

you would really be interested in participating in such a program. 

Chairman MANZULLO. But you fueled that. You could have said, 

‘‘Look, it is going to be our intent to zero this thing out.’’ 

Mr. GUZMAN-FOURNIER. We had a lot of debate about that internally in the Agency, and the decision was made we had to fulfill 

our obligation. 

Chairman MANZULLO. But at that time you knew you wanted to 

terminate the program; isn’t that correct. 

Mr. GUZMAN-FOURNIER. As I said, we had a lot of private interest 

in the program. 

Chairman MANZULLO. That does not answer the question. The 

question is, at the time that you authorized and licensed 30 new 

participating security SBICs, you knew at that time that you wanted to eliminate the program. 

Mr. GUZMAN-FOURNIER. Actually, we knew at the time that the 

program was not going to continue, and we knew that that was the 

main reason we were going to be getting a lot of demand for our 

leverage. Again, this was an Agency decision. 

Chairman MANZULLO. I do not care if it was an Agency decision 

or not. You still have not given me the reason why at a time when 

you knew that you—when a decision had been made to end the 

program, nevertheless you told 30 new SBICs to go ahead and start 

new programs. 

Mr. GUZMAN-FOURNIER. And we have commitments until fiscal 

year 2008 for those. They will have money for the next 5 years, and 

we intend to fulfill our obligation to them. But they are going to 

have their 5-year cycle, so we are not shutting them down. When 

we made the decision that we were going to fund them, we said we 

are funding you with alongside commitments, and those are 5-year 

commitments. 

Chairman MANZULLO. Were they aware of the fact they were 

going to have one shot at it and that was it. 

Mr. GUZMAN-FOURNIER. I believe they did, because if the program was going to be—pretty much everybody at that time within 

licensing was, and we were, internally letting funds know that this 

was pretty much termination of a program. So I think so. 

I think people knew. Most of the funds applying knew. 

Chairman MANZULLO. Were you at the SBA at the time in September of 2004? 

Mr. GUZMAN-FOURNIER. I was. 

Chairman MANZULLO. Okay. Thank you. 

Ms. Velazquez. 

Ms. VELAZQUEZ. Thank you. 

Mr. Guzman, the lack of availability of venture capital for minority women and veteran entrepreneurs is near crisis level. Overall 

it is estimated that minority entrepreneurs receive 3 percent of all 

venture capital investment and women get only 2 percent. 

What is the SBA going to do to increase veterans’, minorities’, 

and women’s access to this form of capital? 

Mr. GUZMAN-FOURNIER. We have a debenture program, and we 

also have something called the LMI debenture, which is part of the 

debenture program, and that is focusing more on the lower- and 

middle-income areas of the United States. The key difference with 

17

that debenture is that whereas with the normal debenture, you 

have to repay interest back to us semiannually, on the LMI debenture, you get a 5-year period. It is a zero coupon bond. 

Ms. VELAZQUEZ. But, sir, answering my question, I am telling 

you that only 3 percent of all venture capital is going to minorities. 

Apparently, what you are doing is not working. So what is it that 

you are going to do to make it work? 

Mr. GUZMAN-FOURNIER. We have been trying. Within the past 2 

years, we have had an initiative within the SBIC to try to reach 

out to more minorities and women fund managers, which I think 

is the critical thing you are mentioning here. You want to have 

fund managers that know their communities so that this money 

can spread to different areas that are not being served, as you said. 

But I think—and let me just speak based on fact here. Unfortunately, the LMI debenture, we have not had a lot of interest in that 

debenture from the current funds. 

Ms. VELAZQUEZ. Does that mean that you are going to support 

the new market venture capital program? 

Mr. GUZMAN-FOURNIER. That program, it still has—we did not 

see a lot of interest in that program when it was created. In fact, 

we had fewer applicants than— 

Ms. VELAZQUEZ. So what you are trying to tell me is that the 

SBA is not going to support the new market venture capital and 

that you are going to try to get rid of that program, too? 

Mr. GUZMAN-FOURNIER. No, I am not saying that. 

That program has commitments from us, as well as the regular 

SBIC; and we are going to commit to fulfilling that obligation as 

well. Up until the time those commitments expire, we will be funding those companies. 

Ms. VELAZQUEZ. How long did it take for the administration, 

SBA in this case, to issue the regulations on the new market venture capital? 

Mr. GUZMAN-FOURNIER. I would need to get back to you on that. 

Ms. VELAZQUEZ. Two years? So it showed a lack of interest and 

leadership coming from the administration to support the program. 

Sir, the SBA is responsible for managing the SBIC program so 

that it is implemented in a prudent manner. However, SBA took 

back and let many SBICs flounder, losing much of their leverage 

extended. Why did SBA not intervene sooner in so many of the 

cases where it was evident that the SBA was highly likely to take 

a major loss? 

Mr. GUZMAN-FOURNIER. That is a good question. We have venture capital, as was said in this panel, has a long-term view of 

things. So we have what is called a forbearance in our program. 

And what that means is for a fund that is a vintage year 1994 fund 

that started operating in that year, you give them between 4 and 

5 years of operations without us intervening. Even if they are capital impaired, we give them a forbearance time because there might 

be a possibility, as was said here, that some companies are going 

to exit or come to fruition with the funds. 

So the way we look at it—and I am going to be up front about 

this—we do not disagree that we could have done somewhat more 

at some periods, but if you think about who are the funds in liquidation that we have currently, they are mostly 1994 through 

18

1998 funds. We were not here at that time. Those funds, 75 percent 

of the funds in liquidation currently are from those years. 

When you get to your job and you see that you have some failed 

funds from those years, there is not much you can do about it. 

Ms. VELAZQUEZ. I do not have much time, but you clearly admit 

the poor mismanagement of the program on the part of the administration. 

Thank you, Mr. Chairman. 

Chairman MANZULLO. Mrs. Moore, do you have any questions. 

Ms. MOORE. Well, thank you, Mr. Chairman, and thank you 

ranking member. I feel very privileged to be here this afternoon, 

and I have enjoyed both panels. 

I guess the question that I have is for Mr. Guzman-Fournier, because the rest of the second panel seems to believe that you have 

indeed succeeded. 

You say that the program is structurally flawed. Is it possibly 

structurally flawed because you are not patient? You talked about 

a 5-year window, and we know that that is not a big enough window for venture capital. 

You also complained about the distribution of profits to investors. 

Well, according to the testimony we have had here today, we have 

had millions, billions of dollars of angel investors come to the table 

because of this program. And if in fact our goal—and of course, 75, 

80 percent of the businesses in our country are small businesses so 

that if we want to continue to be globally competitive, if we want 

to continue to encourage investors here on our shores to invest, 

how can we do it without this instrument? 

All of the structural flaws that you have talked about tend to reflect on a lack of patience, which all of our other witnesses have 

talked about as being absolutely necessary. 

Also, the investment in seed capital in early ventures will be severely hampered if, in fact, we close down the SBIC program. And, 

of course, we have heard from our other witnesses that there would 

be a geographic mismatch if you were to pull out. In other words, 

only those businesses that were willing to locate on the coasts 

would be able to attract private venture. 

So I am wondering about that old saying that you should not 

throw the baby out with the bathwater. Is it not possible to structure our investments for longer terms and really see the benefit of 

investing in our economy, so that we do not continue to be the 

highest debtor Nation in the world? 

And please excuse my voice. I am just kind of sick today, but this 

was so important that I thought I should come. 

Mr. GUZMAN-FOURNIER. Thank you. Thank you for the question. 

Let me talk a little on the not being patient enough. In fact, as 

I mentioned to Ranking Member Velazquez, we have probably 

erred more on the side of being too patient in this program. When 

the program started, the deal was made that we were not going to 

receive up-front profits in the same way as private investors, but 

that on the back end, which is when a fund failed, we could take 

action and get some of those creditor rights to move on funds. Part of the reason why we have the $1.3 billion in the cash flow 

right now is because we had a lot of failures in the program of 

funds, that we had to repurchase their securities. And as I menVerDate 0ct 09 2002 19:16 Aug 24, 2005 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 G:\HEARINGS\21285.TXT MIKE
19

tioned, 75 percent of those come from 1994 through 1998, their beginning years. And we are already into 2005, so it has been a 

while; and we have given funds time to prove if exits are going to 

come. But we have also some regulatory ways that we need to comply with the regulation. 

We have a forbearance period. And once a forbearance period 

ends is when we need to move and take some action. We do it—

I mean, we have discussions with management. We bring people 

for portfolio management meetings, and we have discussions to find 

out if this portfolio is going anywhere, if their companies have any 

chance of succeeding. And if not, then we move. 

I agree with you that—I did not come here to say that there is 

not a need for equity investing. What we are saying is that the 

structure of this program is flawed, and it is so flawed that we are 

experiencing huge amounts of losses because of the way it is structured; and that is our main point today. 

Chairman MANZULLO. We will have time for another round. Did 

you have a short follow-up? Go ahead. 

Ms. MOORE. Thank you, Mr. Chairman. 

I guess if we are experiencing losses on paper through SBIC, are 

we not recouping those investments by the economic impact of creating all the jobs and creating the businesses that are reflected 

here? Is that not part of the balance sheet—I mean, a governmental program should not operate like a private firm—that what 

you are calling losses are actually investments? 

I mean, all these companies, obviously, do not succeed, but are 

you not experiencing losses because you have in fact generated 

thousands of jobs and created businesses, and you basically have 

subsidized the growth of our economy? 

Mr. GUZMAN-FOURNIER. I wish I could come here today and tell 

you that this program has been a success, but from a financial 

standpoint it has not been a success, and the taxpayer has got the 

burden of $1.3 billion now in liquidation and potentially more. We 

have projections of $2.7 million in losses right now. 

Ms. MOORE. Can I direct the question to someone else on the 

panel? 

Chairman MANZULLO. You are over time. Let me go to Ms. 

Bordallo, and then we will have time to come back. Thank you. 

Ms. BORDALLO. Thank you very much, Mr. Chairman. I will 

make mine very quick. 

I want to thank you and Ranking Member Velazquez for holding 

this hearing. I also thank the witnesses. 

In reading some of the testimonies, it seems we are all in a consensus that the SBIC program is important to small businesses 

and the economic growth, but because of the erosion of small businesses across the Nation and because of foreign competition, it 

seems to me that this is a program that should be maintained. If 

it is flawed, we should fix it. And I would like to continue working 

with the committee to see that we fix this program. 

Certainly, we cannot allow our small businesses just to go out 

there and try to work their way up. This is a tough business right 

now. And all we hear at this Committee on Small Business with 

our hearings is one small entrepreneur after another saying how 

they have gone broke, they have had to close family businesses. So 

20

we need to give them programs that will assist them and help 

them get on their feet and continue to grow. 

So, Mr. Chairman, I support the program, and if it is broken, let 

us fix it. 

Chairman MANZULLO. Thank you. 

Congressman Akin. 

Mr. AKIN. I do not really have any questions at this time, Mr. 

Chairman. 

Chairman MANZULLO. I want to get back to Dr. Blaydon. 

Just as you got to the bubble, the time bubble burst. Do you 

want to pick up at that point? 

And anybody else who wants to add about the bubble just feel 

free to jump in. 

Mr. BLAYDON. Thank you, Mr. Chairman. 

What I was going to say is that the bubble hit everybody; it hit 

SBICs; it hit private venture capital firms. And the private venture 

capital firms of vintage year 1999, if one of those funds breaks 

even, returns its capital, it is going to be in the top tenth percentile 

of all funds. 

Most of those funds from 1999 vintage year are going to lose 

money. The same is true of the 1999 vintage year of the SBICs. 

However, the difference is that the funds that have resources that 

are able to go in and try to work out their portfolios are, in fact, 

going to be the ones that are at least going to get back to breakeven, and a lot of those funds are doing that. Those are funds that 

typically have been around for several years before, have reasonably large pools of capital to invest in restructuring and working 

out in restructuring their portfolios. 

The people who are going to lose are the people who had funds 

that were out of money and cannot invest in restructuring those 

portfolios that suffered in the down economy. There are going to be 

those who are not willing to go forward. Those are largely the corporate venturers who, when they saw the downturn, also, you 

might say, panicked and pulled out. People are going to make 

money off of their portfolios because others are going to come in 

and take over those companies. They are going to restructure them; 

they are going to put more capital into it. 

What it appears is going on with the SBIC is that the SBIC—

apropos of the question of patience, the SBIC sees 5 years in a program, a vintage year, late 1990s, that is not doing well, and if they 

do not permit them to continue to invest, to restructure them, they 

are almost assuring that these companies may well fail, cannot be 

restructured; and the government, as well as the companies and 

the private investors, are going to lose money. 

Chairman MANZULLO. Anybody else want to comment. 

Red? Go ahead. 

Mr. CLARK. The Federal Government is using the SBIC program 

not only to encourage innovation and encourage small business development; they are discussing—we are discussing the program 

today as a failed investment vehicle. If you are going to invest 

money in the venture capital industry, I think it is fair to ask the 

question, Why are you doing so with a different set of rules? 

If you take a look at the rates of investment from the private sector in the institutional venture capital industry over the last 10 

21

years, remove the bubble and what you see is a steady, increasing 

trend of investment. It has gone from $8 billion to $22 billion, $23 

billion over the last 10 years. If you track the performance of those 

funds, when you cut the bubble out, what you find is that there 

are—the industry as a whole is making an acceptable rate of return. 

And what you also find is that the way the returns come in varies a great deal from firm to firm, but more often than not you get 

very large returns on a very small number of investments; you get 

average returns on a modest number of investments; and you break 

even or lose money on a handful of investments. Your existing program cuts off the upside. 

You cannot participate in the upside the way that it is structured 

right now. You have changed the rules. If you change the rules, it 

does not matter how much money you pour in. If you cannot win, 

you cannot win. You have rigged the game in the way the program 

has been put together right now. 

So if there is an awareness that you can take away from this 

hearing, it is not that you cannot invest money and show an acceptable rate of return, it is not that you cannot invest money and 

encourage innovation and encourage new business development; it 

is that if you change the rules and you make it a loser, you are 

going to lose. 

Chairman MANZULLO. One rule is that I am out of time. 

Ms. Velazquez. 

Ms. VELAZQUEZ. Mr. O’Connell, we have clearly indicated today 

that the greatest shortage for capital is for early- stage companies, 

correct? 

Mr. O’CONNELL. Yes, ma’am. 

Ms. VELAZQUEZ. The participating securities programs investment in start-ups has declined from 50 percent in the 1990s to 30 

percent today. Do you think the SBIC will continue to shy away 

from start-ups, just as traditional venture capital has done? 

Mr. O’CONNELL. I have always looked at the venture business as 

a business, and our goal is to take capital from whatever source, 

and to effectively deploy it and generate capital gains, and to do 

that by creating companies or expanding companies that are worthy of investment. 

Those dollars ebb and flow. And, at times, earliest-stage companies are always the hardest thing to fund, and they are sometimes 

less attractive than later-stage things. 

We react to the sources of capital that are available to us. And 

if the limited partners, who are a primary source, whether they are 

pension funds or institutional investors, or whoever they might be, 

if they are risk averse, then we tend to do investments that reflect 

their risk aversion as well. I think those things ebb and flow. 

So what you have seen is, the bubble spooked everybody. Looking 

at my industry, I felt at one point that I had become a dinosaur, 

because the way that investments were made reflected an aggressiveness that was inconsistent with the due diligence and the patience we needed during the bubble. And I think we paid for that 

exuberance that we had. 

Ms. VELAZQUEZ. But given the fact that there is an abundance 

of late-stage funding, but a lack of early-stage funding for start-up, 

22

do you think it would be appropriate to tailor the SBIC program 

so that it really serves more start-ups? 

Mr. O’CONNELL. I think that what I was trying to say is that we, 

as the marketplace, will flow to the opportunity. And if, in fact, we 

have capital available—and I think that is what the SBIC program 

has done historically, the participating preferred program has done 

historically is, it has encouraged general partners, who have a specialty, and who want to invest in a region or a stage of company, 

as you are suggesting, that is out of favor, it does that. 

I think if you encourage that kind of investment, you will get 

that result. 

Ms. VELAZQUEZ. Okay. 

I would like to ask this question of every witness, with the exception of the administration, because I know the answer. 

Do you believe there is a need for the government to continue to 

play a role in making venture capital available? Yes or no? 

Mr. O’CONNELL. Yes. 

Mr. CLARK. Yes. 

Mr. REDDING. Yes, I do. 

Ms. PRESTON. Absolutely. 

Mr. BLAYDON. Definitely. 

Ms. VELAZQUEZ. Thank you. 

Ms. Preston, do you believe the Federal Government, specifically 

SBA, should help in strengthening the angel investment community, such as by providing leverage to angel networks? 

Ms. PRESTON. Absolutely, there is no question about it. There are 

a number of different ways to provide advantages to angel investing, and to support the entire process of angel investing. Whether 

or not they ever walk up into and fill that funding gap is a complete unknown, and nothing that we should have as an assurance 

of a bet on that. Because I think that is a long shot of looking at 

angel investors filling up to $5 million. 

Ms. VELAZQUEZ. And I know some States are experimenting with 

angel investment tax credits. 

Ms. PRESTON. We have 18 States that currently have tax credits 

for angel investors. 

Ms. VELAZQUEZ. And do you think that has been helpful in stimulating investment? 

Ms. PRESTON. It has been helpful. But still when we look at the 

statistics, and even when we have done it through the Angel Capital Associations, surveyed our own members, the average investment by the groups themselves, not just individuals, has been between $100,000 and $500,000. So I think we do have a definitive 

issue still that the SBIC needs to address. 

Ms. VELAZQUEZ. Thank you. 

Mr. Blaydon, do you believe the participating securities program 

would be better implemented as a grant program; that is, if the 

funds were invested with no intention of repayment to the Federal 

Government? 

Mr. BLAYDON. That certainly would remove many of the conflicts 

that are going on here, Ms. Velazquez. But I think, as some of my 

other colleagues mentioned here too, there is the possibility of designing the program also so that when the risks are shared approVerDate 0ct 09 2002 19:16 Aug 24, 2005 Jkt 000000 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 G:\HEARINGS\21285.TXT MIKE
23

priately with the rewards, that the program can succeed and be a 

self-funding program going forward into the future. 

A grant program would absolutely assure that it would not be a 

question of how the risk is going to play out in the future, but I 

do think the program can be restructured in a way, with appropriate risk sharing and profit sharing, it could be self-funding over 

the long term. 

Ms. VELAZQUEZ. Thank you, Mr. Chairman. 

Chairman MANZULLO. Thank you. 

I have an idea. We have a lot of brainpower here with all six of 

you. Would you all be willing to stick around after the hearing to 

sort of jam and put out some ideas on how to fix the program? 

Would that be okay with you? 

Mr. GUZMAN-FOURNIER. For how long would that be? 

Chairman MANZULLO. As long as you can stay. If it is a halfhour, that would be sufficient. Or have somebody here in your 

stead. 

Mr. GUZMAN-FOURNIER. We have always said that we are willing 

to listen and to work with the committee. The question is the timing here. 

Chairman MANZULLO. Well, if you cannot stay, Tee can stay. We 

will commit him. Is that okay with you, Tee? 

Mr. ROWE. Anything you say, sir. 

Chairman MANZULLO. Okay, thank you, appreciate that. And we 

can work with your plane schedules. But I just thought that since 

we want to get this thing fixed, why not take advantage of a very 

informal situation afterwards. 

I have noticed, coming from a background of somebody who 

spends most of his time in Congress working on manufacturing 

issues, you are partners with Andrew Kalnow, are you not, at 

Alpha? You helped them start? 

Or you did, Mark? 

Mr. REDDING. Alpha Capital is a member of the investor group 

in Banner Service Corporation. 

Chairman MANZULLO. Okay. Andrew Kalnow has a very interesting background. I met him when his family stepped in the 

breach when National Machinery from Tiffin, Ohio, went into 

Chapter 11. And National Machinery was the last, or is the last, 

coal-forming machine tool company in the United States. It is important because that machine tool makes bullets, and it went 

under. The Pentagon did not know about it. 

I find it very interesting that Mr. Redding and Dr. Clark, both 

of you have this manufacturing background. I know the answer to 

it. But could you lay out before us the extra difficult time that 

manufacturers have in getting venture capital? What is it about 

the nature of manufacturing that makes it extra difficult? 

Mr. REDDING. I think in my case, Congressman, when we did 

this transaction, the Banner business was in decline, like many, 

and the debt financing that was available was very restrictive and 

nervous. Equity investment continues to be an important part of 

any of these transactions; and the suggestion that the debenture 

program is a substitute, I think, is incorrect. 

Manufacturing is a difficult business, thought to be going overseas, and not particularly attractive to many people who make 

24

these decisions. Those of us who have been in it all our lives see 

it differently. 

Mr. CLARK. In addition to having a bad public profile as an investment opportunity, just as an industry, the U.S. manufacturing 

industry is generally very capital intensive, very mature, and it 

tends towards being resistant to change. The people that are driven 

into the industry by available venture capital are agents of change. 

They are the antithesis of the way the industry works. 

So while the investment community tends to resist the manufacturing community as an investment opportunity because of those 

issues, in fact, it is a necessary marriage. And what we are beginning to see is that there are a limited number of firms that are 

looking at specific dealings inside the manufacturing community. 

They see a tremendous opportunity for change and profitability, 

and they are beginning to back those. But they have to really be 

exceptional opportunities right now because of the negative profile 

the industry has. 

Chairman MANZULLO. We had a situation in Rockford, when Ingersoll Milling Machine burst into—I guess that is the word—into 

several different areas. The cutting tool division was sold to an 

Israeli company. The milling machine company, the one that makes 

the seven-axis machines that wrap stealth material on aircraft, 

ended up in Chapter 11. And the stalking horse was a Canadian 

company, but the successful bidder was an Italian company, 

Camozzi Brothers. 

Phil James came out of retirement, lives in Rhode Island, and 

tried to save the company, that division. He went to 10 banks and 

joint venture capital companies—I do not think he went to an 

SBIC—but he could not find anybody interested. 

So he went to the Chinese to a company called Dalian, which is 

a wholly state-owned Chinese company, who bought the Ingersoll 

production line in Rockford where they manufacture machine tools 

and export them back to China. Now, you figure that one out. But 

what it showed is the fact that it was just desperation looking for 

that type of capital. 

Now, when we reauthorized the SBA, we made it so that the 504 

program could go up to $4 million for the purpose of infusing more 

money into the manufacturing sector. And I just bring that out because it is so difficult, if not impossible, to get that money into the 

hands of the manufacturing sector. 

Mrs. Moore, did you have any further questions over there? 

Ms. MOORE. Thank you, Mr. Chairman. I was particularly interested in a couple of people’s testimony, and I just want to thank 

Mark Redding for all the work he did in Wisconsin. Franklin, Wisconsin, literally is across the street from my district. 

And I also wanted to revisit some statements that were made by 

Ms. Preston regarding angel investors. I tried to look through your 

testimony here to see if I could glean the answer, and of course, 

I cannot. 

And I also wanted to ask Dr. Clark about the economies that we 

have realized. You talked about the fuel efficiency and a number 

of others—increases in sales, and reducing our reliance on fossil 

fuels, and lead paint, and other things. I was very interested in 

that. 

25

But first, Ms. Preston, I wanted you to explain the $22 million 

of new angel investors that have come in. It is not clear to me 

whether in 2004 that was because of SBIC’s involvement. 

Ms. PRESTON. Their estimation is being made by the Center for 

Venture Research at the University of New Hampshire, which has 

been doing research on angel investors for a number of years. And 

for 2004, the estimation was that angel investors invested $22.5 

billion into entrepreneurial ventures, primarily at the early stage 

in the United States. And that was into an approximate 48,000 different ventures. So that is where the number comes from. 

We estimate there are approximately 225,000 active angel investors in the United States at this time. That is a very small number 

compared to who has the ability to be angel investors. But, again, 

they are primarily at the very early seed-stage investing and understand the need, as you pointed out, of the patience of dollars. 

And an expectation, as an angel investor myself, and others who 

are angel investors, is that we do not expect to see necessarily a 

return on our investment for 7 to 10 years because we understand 

that we are investing at that earliest stage, but at an incredibly 

vital stage of a company’s development because there is no other 

source of financing if we lose the SBICs. 

Ms. MOORE. So you were really just comparing the patience and 

the productivity of those investments in contrast with the impatience of the SBIC program? 

Ms. PRESTON. That is exactly right. 

Ms. MOORE. I also am very excited about the economies, and I 

believe it was Dr. Clark. Could you please share a little bit more 

about that, how we have reduced our reliance on a billion dollars 

in gasoline? I want to hear more about that. 

Mr. CLARK. The technology that we have developed allows the 

companies that stamp metal to use thinner, stronger, lighter metals in order to manufacture anything that is made out of stamped 

steel, stamped aluminum, stamped titanium. 

In the U.S. auto and truck market, we are currently deploying 

technologies. We have not fully penetrated the market, but we are 

deploying technologies that allow the auto industry to essentially 

reduce the weight of its parts, frame and body parts, by somewhere 

in the area of 10 to 20 Percent. 

What that means is that for the weight of a car, if you have a 

2,000- or 3,000-pound car, body and frame, you can cut, let us say, 

300 to 400 to 500 pounds of weight out of that frame by using these 

new, advanced steels. Industry does not know how to form them. 

We have given them a technology that allows them to form them 

with fewer defects and make the parts faster. 

When you calculate the impact of the reduced weight on the vehicles, that is where the fuel savings come from. The numbers I gave 

you were numbers that were calculated by DOE, based on full deployment of the technology. 

We are just beginning to write up what we call the ′′hockey stick′′ right now in deployment of the technology within Chrysler, to a 

lesser extent within Ford; and we are just beginning to work on 

GM, and then we are working in the supply chain. 

So as we continue to deploy, and if other technologies come along 

and do the job better than we do in specific circumstances, we will 

26

see reduced fuel demand and improved vehicle mileage per vehicle 

because the cars are lighter. We can push them with less energy. 

So that is where that figure came from. 

Ms. MOORE. And that would be impossible without venture capital? 

Mr. CLARK. I guarantee you this technology never would have hit 

the street if we did not have the backing of the venture capital, 

first, angels and then the institutional venture funds backed by 

SBIC. We would not be here. 

Ms. MOORE. Thank you very much. I think that is the wave of 

the future. 

Thank you, Mr. Chairman, for your indulgence. 

Chairman MANZULLO. Well, thank you for those excellent questions. I want to thank all of you; and we will come down there in 

a minute and sit down and chat with you informally. 

Again, thank you for coming here, especially those of you who 

have come in from long distances. This hearing is adjourned. 

[Whereupon, at 3:55 p.m., the committee was adjourned.]

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