June 6, 2025 • 34 mins
This episode is a masterclass on one of the most powerful — and under-the-radar — capital structures in private markets: Small Business Investment Companies (SBICs).
I’m joined by Brett Palmer, President of the Small Business Investor Alliance, and David Demeter, who helps manage Davidson College’s endowment. We dive deep into the SBIC program — a unique public-private partnership that lets private equity and credit funds access 2:1 fixed-rate, non-recourse leverage from the U.S. government.
The result? LPs can access equity-like returns for credit-like risk, and fund managers gain scale without sacrificing strategy. Most people haven’t heard of it. That’s exactly why we did this episode.
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Transcript
Episode Transcript
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(00:00):
Today, we're unpacking how SBIC funds work andwhat it takes to raise 175,000,000 for private
equity and private credit strategies from thegovernment.
My guests are Brett Palmer, president of SmallBusiness Investor Lines, and David Demeter,
managing director at Davidson's CollegeEndowment.
We'll cover why SBICs consistently outperformother funds, how government leverages Amplify's
(00:24):
returns for both GPs and LPs, and what makesthe lower middle market so attractive.
Without further ado, here's my conversationwith Brett and David.
Brett, tell me about the Institute for PrivateCapital study done by the University of North
Carolina.
Sure.
The Institute for Private Capital is anonpartisan consortium of universities, Duke
(00:47):
University, UNC, Stanford, Chicago, a wholebunch of them that get together and study
finance issues.
It's a phenomenal organization.
And last year, they did a study on smallbusiness investment companies and their
performance.
And their performance that they've they foundwas was was surprising to them, not to us, but
just how much better SBICs perform because it'snot very well known.
(01:10):
They're relatively small.
But they really do perform better than mosteverything else they see out in the market.
SBICs represent a variety of differentinvestment strategies.
But once they were benchmarked against theirappropriate strategy, SBICs outperformed non
SBICs by about 4% on a net of IRR basis, net offee IRR basis.
(01:36):
And on an MOIC basis, you know, theyoutperformed by about point six eight x larger.
So it was a meaningful, outperformance of thefrom the Burgess benchmarks that they looked at
for several hundred funds.
Point six eight x is certainly no small number.
Talk to me about who's outperforming.
(01:59):
SBICs are small business investment companies.
So they're private, equity and private creditfunds.
They raise private capital, from institutionalinvestors.
They go through a licensing process at thegovernment.
Then they can access leverage at the at the,from the federal government, from the small
business administration at the fund level, notan individual, deal level, but at the fund
(02:20):
level.
That's very attractive leverage as far as theterms go.
There's no guarantee on the performance of theSBIC.
If you invest poorly, you lose money.
If you invest wisely, you make money.
But, you know, leverage is an amplifier.
And so the the government has this program tohave small business investors amplify the
capital where the private capital leads, thisSBA leverage follows, and that is incredibly
(02:44):
beneficial to the LPs, and to the GPs as well.
Let small funds get scale, and it gets, letsLPs have leveraged returns, on their
investments.
Tell me about the function of leverage in SBIC.
What kind of quantity of capital are we talkingabout?
These are smaller tend to be smaller fundsbecause as funds scale up larger, they have to
(03:05):
write bigger checks and small businesses wouldlove giant checks, but they really can't use
them.
They need check sizes that really are fittingto their scale.
So the total amount of leverage that anindividual fund can borrow is $175,000,000 And
it's generally done on a ratio of two to one,dollars two of leverage for every dollar of
private capital.
(03:25):
So the fund sizes are generally below$350,000,000 but some are significantly larger.
But these funds also can have multiple funds insuccession.
And so you have, like all funds, you have aninvestment period and then you have a
harvesting period and you never want to be outof the market.
So when you finish or finishing up yourinvestment period of one fund, start another
(03:46):
one.
So the total amount of outstanding leveragethat a small business investment company can
have outstanding at any given time is$350,000,000 across all of its funds.
I'll just add these these strategies.
These strategies range across asset classes.
So there's a lot of direct lending in SBICs.
(04:08):
There's senior lending.
There's even venture debt, but they also godown into equity, buyouts and growth equity.
And now with a newer program that's focused onequity strategies, you're seeing even some
venture in SBIC.
So let's talk brass tacks.
So if you raised $80,000,000 in equity, you cannow borrow two x that one sixty.
(04:29):
So you're basically going around with a$240,000,000 fund.
Let's say that $240,000,000 fund returns two xnet to investors.
Tell me about how the different parties benefitfrom that structure.
The fund managers, general partners benefitfrom getting scale.
They have a larger fund to work with.
They get to do more deals.
They get to write more checks.
And, yes, that also means that a bigger feebecause the SBICs generally, not always, but
(04:52):
generally get management fees on the projectedleverage as well as the private capital they
have.
And the LPs get levered returns.
And so for, say, an SBIC is gonna be making a$9,000,000 investment, they'll pull 3,000,000
from their LPs.
They'll pull 6,000,000 from this SBA creditfacility at a very low cost and very, very
attractive terms.
(05:14):
And then they make that investment.
And so, you know, you really, get significantlyamplified returns for the LPs.
And so in many cases you get sort of equitylike returns for debt like risk, which is a
different model than you can get anywhere elsebecause the way this leverage works is it's a
fixed rate leverage.
You know, you have for a ten year period, it'sbasically the ten year treasury plus a, you
(05:37):
know, 50 to 80 basis points.
And there's no prepayment penalty.
It's non amortizing.
And so it's very attractive leverage that youcould never get anywhere else in the market.
And so that's really advantageous to the LPs.
And that's how endowments like DavidsonCollege's endowments and others get really
attracted to this this model because one, it'sa very inefficient market in the lower middle
(05:59):
market.
And two, you get this leverage amplification,which is really attractive.
Before this, the podcast, you mentioned that ithad grown from 2,000,000,000 to 50,000,000,000.
Double click on where that growth has comefrom.
So I've I've been president of this tradeassociation for about seventeen years.
And in 02/2008, the SBICs were about2,000,000,000 in assets.
(06:20):
And today, they're north of 50,000,000,000.
And there's probably 15 to 20,000,000,000 more,coming online in the next eighteen months or
so, I would imagine.
You know, you really have a significant growthin the private credit markets during that
period, which this dovetails with.
You also have significant regulatory changes inthe banking world where the banks aren't
(06:42):
allowed to do a lot of things they used to beable to do.
And so the SBICs are filling some of that gap.
I think there's also been a significantdiscovery of the lower middle market and the
opportunities for a relatively inefficientmarket.
Once you get to the upper middle market, it's avery efficient market, even if it's still a
private market.
(07:02):
The lower middle market is still veryinefficient.
There's still lots of value to be created.
There's still a lot of growth to be had.
And so you've really seen a very significantinflux of investors that performing well and
LPs that are getting interested.
The biggest challenge to further growth reallyis just the scale.
(07:23):
These are relatively small funds and a lot ofthe big platforms who have the huge dollars
can't write check sizes that small to a fund.
And so for some of them that's limiting, butfor smaller platforms, it works family offices,
smaller university endowments.
It's really attractive.
Brett, the SBIC funds are not only for privateequity funds, but also for private credit
(07:47):
funds.
Tell me about that.
And how do managers use SBIC funds for privatecredit?
You have to have a track record of investingthis way.
And you have to propose to the Small BusinessAdministration that, hey, we're going to
continue to invest the way we were.
You have to have an analogous record and we'regonna raise private capital.
(08:08):
And then we're going to amplify that with yourleverage.
Now, if you can't raise your private capital,if the market doesn't trust you with your
capital, the government's not going to either.
And that makes sense.
But most of these fund managers have really,you know, come in and they've said, Hey, look,
this private credit opportunity is verysignificant.
David, you're at Davidson College.
(08:28):
You're an LP in a lot of these structures.
Walk me through the structural alpha that youachieve through investing in an SBIC fund, both
on the credit as well as on the equity side.
The most quantitative way to answer that is torefer to the IPC paper, which found across all
strategies, SBICs outperformed their Burgessbenchmarks by about 4%.
(08:52):
But it's an amplifier.
So, you know, if you have lower gross of feereturns, unlevered gross of fee returns, you're
gonna have less magnification from theleverage.
One anomaly you find with SBICs that peopledon't always pick up on is, the net of fee
levered returns are frequently higher than thegross of fee unlevered returns.
(09:15):
Just to say that again, the net of fee returnswould be higher than the gross of fee returns
because
Give me an example of
that.
I always try to make this argument.
You know, to try to hit a 3x net return in aprivate equity fund is a very difficult thing
that a lot of us aim to do.
Only about 8% of private equity funds from 2000to 2020 have done that.
(09:38):
And even then, a lot of that was luck.
Sometimes you just picked a great vintage year.
To do that in a traditional fund, you probablyhave to earn something like a a three and a
half x gross of fee return, something a bithigher.
In an SBIC, you probably have to hit about atwo and a half x gross unlevered return to hit
(10:01):
a three x net levered return on an MOIC basis.
When you actually look through it, you know,fund returns are a bell curve, right?
You know?
And that three x net return fund is way out onthe right tail.
If all I have to do is hit a two and a half xgross, which in a traditional fund would be
like a two x net, well, something like 40% offunds, private equity funds in the lower middle
(10:27):
market did that from 2,000 to to twenty twenty.
So that increases your odds of picking by likefive x.
Now I'm not trying to pick this outlier that'sit's way out on the right tail.
I actually have a fighting chance inside anSBIC to hit a 3x net MOIC.
Private equity, the returns are much morebanded than maybe a venture capital or a
(10:50):
biotech fund.
So the difference between a medium, medianreturning fund and a top top 10%, in this case,
top 8% fund could literally be one x.
And this can really help you get there withouttaking enormous amounts of risk or trying to
grow companies too exuberantly, tooaggressively.
Last time we chatted, you said that you had abias towards lower middle market even without
(11:14):
the SBIC structure.
Why do you like lower middle market so much?
In the lower middle market, there's just moreinefficiencies.
And a lot of the things our GPs do, it's notrocket science.
It's building out management teams, installingnew accounting software, establishing KPIs.
They're really most frequently building outthese companies that have never had
(11:38):
institutional investment before.
And it's a great place to do that and sell iton to the next private equity owner.
Being the first institutional capital is areally great place to be.
One, there's huge amounts of value to becreated, simple technologies, simple human
resources tools that really amplify it.
(12:01):
It also, a lot of the LPs I talk to, it takesaway some of the reputational risk.
The only way to make money in the lower middlemarket is to grow the business.
You're not talking about, Hey, we invested insomething, they had to slash a bunch of jobs or
they shipped stuff offshore.
The only way to make money is to grow it andyou can grow it.
And it's a proven business model, very, verylow strikeout numbers.
(12:23):
You know, it's unusual to have a failedinvestment, very unusual, because these are
proven models, they just haven't beenprofessionalized in some cases.
And so it's a win win reputationally, it's awin win from a financial standpoint, and
there's frankly a lot more choice as far as thenumber of deals.
I mean, funds are looking at four to 500opportunities for every one they actually
(12:48):
invest in.
It's that inefficient of a market.
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We like to romanticize small businesses in ourculture, but there is a reason small businesses
stay small.
They may be operating on clipboards literally,they're not even an Excel, let alone AI, not
(13:10):
have a CRM, they might just have a a file withtheir customers or just know them by name.
So coming in and picking up those low hangingfruit could be a great source of alpha versus
the upper middle market.
Oftentimes, you have to rely on leverage andother kind of more riskier investment
strategies than just fixing the business.
(13:30):
And you've also squeezed out some of thoseprofits and those efficiencies early and you've
sort of what you paid for as you've gone along.
As it relates to small businesses, I mean, mostsmall businesses in The United States, the vast
majority, it's over 90% of small business inThe United States have zero employees.
And that's not what we're talking about here.
We're not talking about, some guy who's aloneand just a consultant.
These are businesses that are meant to outlastthe founder.
(13:53):
And so it really is making sure that itmaintains itself as an ongoing enterprise.
And so it really is taken sort of the cream ofthe crop and then making sure that it just,
they keep ramping up and going.
So the bigger platforms that have sort ofstretched down to the smaller part of the
market are sometimes surprised about theprofessionalization that's needed.
(14:15):
No, your sister can't be your auditor.
Your girlfriend cannot be your secretary.
These small businesses have real humancomponents to them that need to be
professionalized.
And that's why I say like HR components are areally big thing with these smaller platforms.
These smaller platforms are so busy operating,they're often growing, but they don't really
have time to think strategically or don't havethe networks across the industry, across
(14:38):
geographies to go from a small player to aregional player, to maybe even a national
player.
And that's what these fund managers do, notjust with money, but also with expertise and
networking.
We have to remember that this program existsfor job growth.
We we romanticize small businesses because thatis where a lot of American job growth comes
(14:59):
from.
These groups need capital, and then thisprogram provides that, without a cost to the US
government.
There was a study done by the Library ofCongress a couple of years ago, a nonpartisan
research division, Library of Congress.
And for SBICs, the equity oriented investmentsadded, I think it was number was north of three
fifty new jobs per organic jobs per investment.
(15:22):
And the debt oriented ones were 175 or 180, Ithink something along those lines per
investment.
Those are big numbers for small businesses.
That's not going to be GM, that's not going tobecome Tesla, Though Tesla was an SBIC
investment back in the day, that's sort of anoutlier.
Don't have to go public to make money withthese.
But there really are meaningful growth that inboth in revenue and earnings and in employment
(15:49):
that, really is something that takes away somerisk for the LPs from a reputational
standpoint.
You get this money from the government.
What, where does that money come from and whobacks the leverage?
So you raise private capital, you get gothrough this licensing process, you get
(16:10):
approved by the SBA.
Then when it's time to make investments, youdraw it just in time.
You don't get all the money at once.
So if you have a fund where you're borrowingyou have $150,000,000 of leverage capacity, you
don't get that 150 at once, you're doing, youget it on a deal by deal basis and you pull the
leverage from the Federal Home Loan Bank ofChicago, At the same time, you're pulling
(16:34):
leverage from your LPs.
And so that money comes from the Federal HomeLoan Bank of Chicago.
And then every six months it gets put into atrust certificate and auctioned off.
And when it gets auctioned, the buyers arefixed income funds and insurance companies and
hedge funds and all the big financial playersbecause these trust certificates have the full
(16:59):
faith and credit of The United States behindthem.
So they're not guaranteeing any individualperformance for the SBIC, but they guarantee
that trust certificate will perform.
And it's generally the ten year treasury plus45 to 85 basis points.
And again, the nature of that leverage isreally attractive.
(17:19):
No prepayment penalty, you can pay it backwhenever you want.
You know, it's a fixed rate, it's not going togo up or down.
You know, it's non amortizing.
So it's, you're just making interest for tenyears, then you have a big slug at the end and
that's how it works.
And so the pool sizes generally are around$2,000,000,000 plus or minus every six months.
(17:42):
I would add the most attractive feature of theleverage is that there's no refinancing risk.
It's ten year leverage.
There's a lot of investors that are wary ofleverage leverage and rightly so.
I always remind people that, you know, WarrenBuffett, fundamental value investor, you know,
rightly argues that, you know, margin debt isdangerous because it can be pulled from you at
any time.
(18:04):
But I also remind people he has an insurancefloat that's also very special leverage that is
low cost and has no refinancing risk.
When you take away the refinancing risk fromfrom leverage, you take away a huge portion of
that risk.
And so this this leverage is very special inthat it does not have refinancing risk if you
manage it properly.
(18:24):
And, David, you're essentially a buyer of thesetype of funds at Davidson.
Why do you think this hasn't become a biggerprogram?
Well, it has become bigger over time.
But these are smaller funds.
They typically only raise 50 to 200,000,000 inLP capital.
That's usually below the threshold that mostplacement agents are willing to work.
(18:46):
These funds historically have been the largestLP base is from banks.
Banks get special treatment under Dodd Frank toinvest in these, and they get community
reinvestment act credits that they need underregulation.
So banks don't talk, as LPs don't really existoutside of SBICs, So there isn't a lot of cross
(19:09):
communication between that investor base andother investor bases.
So there just isn't a lot of people talkingabout it.
I mean, that's why we're here today on yourpodcast to try to get the word out because this
program really is growing and we see a lot moreGPs coming into the market.
Yeah, I'd add to that, David, you're not theonly one asking that question.
We gave a presentation to a group of 75, 80five family offices down in Texas late last
(19:34):
year.
And that was the first question, like, if thisis real, you know, if this isn't just some
brand new flash in the pan, why haven't weheard of it before?
And this has been around since 1958.
This has been around for a long time.
It just really has been reinvented and reallygrown dramatically since, you know, the
financial crisis and Dodd Frank alongside theprivate credit markets growing.
(19:57):
And so it's getting the attention of folks ishard when you're smaller platforms, but it's
getting a lot more attention from familyoffices.
It is getting more attention from universityendowments.
But again, there's just that scale issue thatDavid touched on a little bit.
It's just large check sizes.
If you don't want be more than 10% of a fundand you have to cut a minimum $50,000,000 check
(20:19):
or $25,000,000 check, that just excludes a lotof the very large institutional LPs that get a
lot of the attention.
That is a big problem.
Investment offices that have the staff andsophistication to go do the work on the space
generally cut larger checks, and then theystill see it as an opportunity.
Smaller groups like myself, we're very timeconstrained.
(20:43):
Trying to get a small investment office to golook at something new is difficult.
But we, at Davidson, find that's ourcompetitive advantage.
We're a smaller group.
We're going to use our size to accessinteresting investments like these.
Would there be anything that keeps an emergingmanager from utilizing this capital for their
(21:05):
first couple of funds and then going off thiscapital as they get bigger?
People do that all the time.
But a lot of funds, so these are not rookiesthat are running these funds.
And I think that's one of the things in thelarger private equity and private credit space.
When you look at smaller funds like, oh, you'rejust emerging, you're just starting out in your
career.
These are really established people that areprofessionalized at this level.
(21:28):
And some of them have grown and some of themhave grown to multi billion dollar platforms,
but a lot of them actually dislike this part ofthe market.
You know, they really know this part of themarket.
They like having the choices they have in thispart of the market.
And so, you you can grow up and there arecertainly some funds that have grown so large
that it just stops being a meaningful portionof them.
(21:50):
And a number of the, for example, a number ofthe BDCs, the business development companies
started as SBICs like Main Street Capital.
I think, I don't know, they're an eight or ninebillion dollars BDC and they still have a
couple of SBICs, but they started as I think a$50,000,000 SBIC and they took it and they
grew.
And there are a number of folks who have donethat Hercules Capital, big venture lender in
Silicon Valley similar.
(22:12):
There are others.
But the program has grown both in the amount ofinstitutional investment coming in, as well as
the leverage caps themselves.
Now Congress controls those leverage caps.
And one of the things I do that's kind ofunusual in finance is I regularly talk to the
government, whether it be the treasurydepartment, the White House, the SBA, the
(22:32):
people writing laws in the house and Senate tohelp them understand private credit and private
equity policy.
And we're trying to work with them to raisesome of these leverage caps to let the market
really fill because there's a lot more demandfor slightly larger checks and this program
(22:52):
works very well.
So I think we're going to be successful ingetting that a little bit bigger and making it
so that funds don't have to leave the programbecause it is so attractive to them and to the
job creation across the country.
Generally speaking, I think the managers thatenter the program send a great signal to LPs
because they're willing to do the work to goget one of these licenses, but also their fund
(23:16):
growth is probably going to be a little bitmore moderate than you would see outside of an
SBIC because they want to keep that leveragerelevant to their fund size.
There's a licensing process.
How difficult is it to become an SBIC backedmanager?
You have to have real experience and realsuccessful experience investing in the strategy
that you're going to pursue with the SBA.
(23:37):
So if you're going to form an SBIC license andyou're be doing private credit, you've got to
have private credit experience in a similarsize.
You can't say, Hey, I've got private creditexperience.
I'm not going to go do venture capital.
Not going to happen.
They're looking at it from both the financialreturn standpoint to make sure that the
taxpayer is protected, that these loans arepaid back.
But they're also looking at it from thereputational side.
(24:00):
You know, if you've made lots of money, butyou've left a trail of lawsuits and wreckage
and companies going bankrupt behind you,they're not gonna license you.
It's just not gonna happen.
Doesn't can't go bankrupt that you've investedin before, that happens.
Or there can't be a lawsuit, that happens.
(24:21):
But if there's a negative pattern, they justdon't wanna deal with it and they're not going
to.
And so that is a limiting factor.
It also takes some time.
Takes the better part of a year for a firsttime fund to be able to do this.
And it costs a lot of legal fees.
We're trying to do some things to take thosecosts down a little bit, but it is a barrier.
(24:46):
But that being said, we have currently north of50 new platforms that are in the advanced
stages of getting licensed right now.
And then your average fund size of two hundredto three hundred some odd million, that's a
pretty big number as far as what's coming on.
And that's just already what's in the process,you know, have gone through the interviews,
(25:07):
gone through the FBI background checks, becausethat's the other thing from an LP perspective
that's different.
Not only I've had the LPs done the diligence onthe fund managers and the government's done the
diligence on the managers, they've actually runthe applicants through the FBI to make sure,
Hey, are we good?
You know, and if the answer is no, you're notgetting a license.
And so that gives a number of LPs an addedlayer of comfort in investing in this space.
(25:32):
But it takes the better part of a year to getone of these things.
But the return ultimately is very attractive.
And once you've had one, the second and thirdand fourth and fifth and sixth and seventh
licenses are moving much faster than they havein the past, now running around three or four
months to get your follow on license.
What's the main reason that an otherwisequalified fund typically does not become
(25:55):
eligible for SBIC funding?
There
are a
couple of reasons.
One, some people just don't like the idea ofworking with the government and where the
government's gonna be a creditor, a lender toyou.
Two, a number of platforms like to investinternationally and you can't.
So the investments you make via the SBIC, onehundred percent of those businesses have to be
(26:18):
primarily inside The United States.
And so a number of funds will say, hey, we wantto do 20% in Canada, can't.
You can do a parallel fund and do that, butthat's just not an option.
So when you're investing in these businesses,they have to be small enough to qualify.
This isn't going to, if you're focusing on 20to $25,000,000 EBITDA companies, it's just too
big.
(26:38):
And this is called the small businessinvestment company program, not the medium or
middle market business investment companyprogram.
So you have to be really focused on this partof the market.
You have to be willing to invest exclusivelyinside The United States.
Again, those businesses might have salesoffices, other parts of the world, but you have
to have at least 50 of the employees inside TheUnited States.
(27:00):
And then you have some folks who just franklyhave a lot more lawsuits on some ugly stuff
that can be hindering.
And so when they discover that, hey, they can'tget, they might not get through because of some
previous, you know, unpleasantries, we shallsay, you know, they just don't go in.
But I think the government aspect ofinternational aspect of it, the size aspect of
(27:23):
it, and the deeper diligence is one that arethings that sometimes steer people away.
Taking a step back, Davidson has a barbellapproach to investing.
Talk to me about the Davidson endowmentinvesting strategy.
We invest like a lot of endowments.
But I'd say where we differ is we tend to havea larger hedge fund program.
(27:46):
Today, that's about 35% of the endowment.
And within that hedge fund program, we tend tohave we tend to have a lot less market risk, a
lot less beta, and a lot more a lot lower crosscorrelation among funds.
That allows us to take a lot more risk on theprivate side.
(28:06):
Today, about a quarter of the endowment is inventure capital and another 20% is in other
private liquids like SBIC funds.
We really want our capital on the private sideto deliver, you know, high returns.
We want all of those liquid commitments tocompete for capital so can get the best
(28:27):
returns.
And like we said earlier, there's a widerstandard deviation of returns in the private
markets.
There's a much greater ability to add valuethere.
And so we want to emphasize that.
So you also invest 25% into venture capital.
Given that you have the SBIC part of yourportfolio, why also invest in venture capital?
(28:50):
In venture capital, if you can, you know,through luck or skill, pick the best funds, you
will have the highest returns.
So it's the highest returning part of theprivate markets.
On average, venture returns have typicallyequaled private equity returns over a long
period of time.
But there's a much greater tail, positive tailin venture capital where if you get in the best
(29:15):
ones, can be truly extraordinary returns.
And you mentioned 35% of your money is in hedgefunds.
That's a pretty high number.
And hedge funds are these kind of black boxinstruments at least to the outside world.
Double click on some of the strategies in yourhedge fund portfolio.
As a smaller investor, we have a little bit ofan advantage investing in hedge funds.
(29:37):
We can invest in smaller ones where there cantypically be more alpha.
About half of our capital and half of ourrelationships in the hedge fund book are with
fundamental long short, hedge funds.
These are typically lower net funds with andhigher gross exposure funds.
Our goal across all of hedge funds is to hitsomething like a low double digit net return on
(30:04):
a five year plus time horizon.
If we can do that, we can keep up with longonly public equity markets, I feel, and do so
with much more diversification, providingliquidity in times of stress to the portfolio.
And why is there more diversification in thesestrategies?
Just because you emphasize stock picking andyou get away from the market risk.
(30:25):
Just keeping that net exposure low and usingyour gross exposure to take on more
idiosyncratic risk.
Within long short, you're taking onidiosyncratic risks related to the individual
companies that you're going long or short.
So you're you're long part of the market,you're short part of the market.
So what remains is manager skill.
(30:46):
Yeah.
And hopefully, you picked right.
We don't always do that, but the goal is to getthe whole portfolio in that sort of low double
digit net return area.
So we can, like I said, keep up with publicmarkets in the long run.
So this diversification doesn't drag performour long term performance down.
And I failed to speak earlier.
The other half of our hedge fund book tends tobe more quantitative, doing similar things, but
(31:11):
in a more quantitative manner.
Talk to me about portfolio construction ofquant strategies within your portfolio.
We tend to pick managers that are smaller thatwe can have a trusted relationship with.
And we do that across all asset classes, andthat's a little tougher in the quantitative
space.
We we've specifically looked at managers thatare typically under 5,000,000,000 in AUM, where
(31:34):
we can have that better relationship.
You know, we're never gonna fully understandwhat all the algorithms are doing.
We'll have some sense of it, have some logicbehind it.
But we're not there looking at, you know, thedaily numbers or anything.
We're we're trying to find really experiencedprofessionals that we can trust and have an
(31:55):
open dialogue with, where everything isn't justa black box.
Why do you think a lot of your peers and otherendowments have much less allocation to hedge
funds?
As your asset size increases, the number ofdifferent hedge funds you can access decreases.
And then you start getting into problems over,you know, how much are hedge fund fees
(32:18):
capturing the alpha versus how much alpha iscoming through in net returns.
I think it's very difficult to run a hedge fundthat's sort of 50 to 80% net long with a two
and twenty or just a 20% performance fee andnot have a lot of the alpha captured by the
managers opposed to the LPs.
(32:40):
So, you know, you typically see as AUMincreases, hedge funds are also gonna be going
up upper going upmarket away from small and midcaps.
And, you know, it just becomes a much toughergame.
Perhaps it's obvious, but why are small hedgefunds more likely to outperform larger hedge
funds?
Just a greater range of investmentopportunities in small and mid cap stocks.
(33:04):
It just becomes more unwieldy to deal withlarge amounts of capital in in the manner I'm
talking about with a high gross exposure.
So it's just this is much tougher game as yougo up upmarket.
And there's more sophisticated competitors aswell.
Oh, totally.
Yeah.
Brett and David, this has been a masterclass onSBIC funds.
If a manager is considering adding SBA fundinginto their fund, what's the best resource for
(33:31):
him or her to go to to find out more?
Www.sbia.org, smallbusinessinvestorallianceOrg.
You know, we're the trade association thatstarted that way.
We're both GPs and LPs.
So if you have LPs that are looking to investin these, we do a lot of matchmaking and help
them find the funds that match their criteria.
(33:52):
As well as, you know, for funds that arethinking about forming an SBIC fund, whether it
be a buyout fund, a mezz fund, whateverstructure they want to be, there's a lot of
information on that website and we can alsotalk to them and help them get them pointed in
the right direction.
David, any parting words?
Thanks for having us on.
We really appreciate It's a topic that might bea little bit dry, but we love it and are always
(34:14):
happy to talk about it.
We were joking that it's a special type ofperson that finds us very exciting, and
thankfully, our audience is that person.
So thank you for jumping on, and I look forwardto sitting down in person soon.
Thank you, David.
Thanks for listening to my conversation.
If you enjoyed this episode, please share witha friend.
This helps us grow.
Also provides the very best feedback when wereview the episode's analytics.
(34:36):
Thank you for your support.
Today, we're unpacking how SBIC funds work andwhat it takes to raise 175,000,000 for private
equity and private credit strategies from thegovernment.
My guests are Brett Palmer, president of SmallBusiness Investor Lines, and David Demeter,
managing director at Davidson's CollegeEndowment.
We'll cover why SBICs consistently outperformother funds, how government leverages Amplify's
(00:24):
returns for both GPs and LPs, and what makesthe lower middle market so attractive.
Without further ado, here's my conversationwith Brett and David.
Brett, tell me about the Institute for PrivateCapital study done by the University of North
Carolina.
Sure.
The Institute for Private Capital is anonpartisan consortium of universities, Duke
(00:47):
University, UNC, Stanford, Chicago, a wholebunch of them that get together and study
finance issues.
It's a phenomenal organization.
And last year, they did a study on smallbusiness investment companies and their
performance.
And their performance that they've they foundwas was was surprising to them, not to us, but
just how much better SBICs perform because it'snot very well known.
(01:10):
They're relatively small.
But they really do perform better than mosteverything else they see out in the market.
SBICs represent a variety of differentinvestment strategies.
But once they were benchmarked against theirappropriate strategy, SBICs outperformed non
SBICs by about 4% on a net of IRR basis, net offee IRR basis.
(01:36):
And on an MOIC basis, you know, theyoutperformed by about point six eight x larger.
So it was a meaningful, outperformance of thefrom the Burgess benchmarks that they looked at
for several hundred funds.
Point six eight x is certainly no small number.
Talk to me about who's outperforming.
(01:59):
SBICs are small business investment companies.
So they're private, equity and private creditfunds.
They raise private capital, from institutionalinvestors.
They go through a licensing process at thegovernment.
Then they can access leverage at the at the,from the federal government, from the small
business administration at the fund level, notan individual, deal level, but at the fund
(02:20):
level.
That's very attractive leverage as far as theterms go.
There's no guarantee on the performance of theSBIC.
If you invest poorly, you lose money.
If you invest wisely, you make money.
But, you know, leverage is an amplifier.
And so the the government has this program tohave small business investors amplify the
capital where the private capital leads, thisSBA leverage follows, and that is incredibly
(02:44):
beneficial to the LPs, and to the GPs as well.
Let small funds get scale, and it gets, letsLPs have leveraged returns, on their
investments.
Tell me about the function of leverage in SBIC.
What kind of quantity of capital are we talkingabout?
These are smaller tend to be smaller fundsbecause as funds scale up larger, they have to
(03:05):
write bigger checks and small businesses wouldlove giant checks, but they really can't use
them.
They need check sizes that really are fittingto their scale.
So the total amount of leverage that anindividual fund can borrow is $175,000,000 And
it's generally done on a ratio of two to one,dollars two of leverage for every dollar of
private capital.
(03:25):
So the fund sizes are generally below$350,000,000 but some are significantly larger.
But these funds also can have multiple funds insuccession.
And so you have, like all funds, you have aninvestment period and then you have a
harvesting period and you never want to be outof the market.
So when you finish or finishing up yourinvestment period of one fund, start another
(03:46):
one.
So the total amount of outstanding leveragethat a small business investment company can
have outstanding at any given time is$350,000,000 across all of its funds.
I'll just add these these strategies.
These strategies range across asset classes.
So there's a lot of direct lending in SBICs.
(04:08):
There's senior lending.
There's even venture debt, but they also godown into equity, buyouts and growth equity.
And now with a newer program that's focused onequity strategies, you're seeing even some
venture in SBIC.
So let's talk brass tacks.
So if you raised $80,000,000 in equity, you cannow borrow two x that one sixty.
(04:29):
So you're basically going around with a$240,000,000 fund.
Let's say that $240,000,000 fund returns two xnet to investors.
Tell me about how the different parties benefitfrom that structure.
The fund managers, general partners benefitfrom getting scale.
They have a larger fund to work with.
They get to do more deals.
They get to write more checks.
And, yes, that also means that a bigger feebecause the SBICs generally, not always, but
(04:52):
generally get management fees on the projectedleverage as well as the private capital they
have.
And the LPs get levered returns.
And so for, say, an SBIC is gonna be making a$9,000,000 investment, they'll pull 3,000,000
from their LPs.
They'll pull 6,000,000 from this SBA creditfacility at a very low cost and very, very
attractive terms.
(05:14):
And then they make that investment.
And so, you know, you really, get significantlyamplified returns for the LPs.
And so in many cases you get sort of equitylike returns for debt like risk, which is a
different model than you can get anywhere elsebecause the way this leverage works is it's a
fixed rate leverage.
You know, you have for a ten year period, it'sbasically the ten year treasury plus a, you
(05:37):
know, 50 to 80 basis points.
And there's no prepayment penalty.
It's non amortizing.
And so it's very attractive leverage that youcould never get anywhere else in the market.
And so that's really advantageous to the LPs.
And that's how endowments like DavidsonCollege's endowments and others get really
attracted to this this model because one, it'sa very inefficient market in the lower middle
(05:59):
market.
And two, you get this leverage amplification,which is really attractive.
Before this, the podcast, you mentioned that ithad grown from 2,000,000,000 to 50,000,000,000.
Double click on where that growth has comefrom.
So I've I've been president of this tradeassociation for about seventeen years.
And in 02/2008, the SBICs were about2,000,000,000 in assets.
(06:20):
And today, they're north of 50,000,000,000.
And there's probably 15 to 20,000,000,000 more,coming online in the next eighteen months or
so, I would imagine.
You know, you really have a significant growthin the private credit markets during that
period, which this dovetails with.
You also have significant regulatory changes inthe banking world where the banks aren't
(06:42):
allowed to do a lot of things they used to beable to do.
And so the SBICs are filling some of that gap.
I think there's also been a significantdiscovery of the lower middle market and the
opportunities for a relatively inefficientmarket.
Once you get to the upper middle market, it's avery efficient market, even if it's still a
private market.
(07:02):
The lower middle market is still veryinefficient.
There's still lots of value to be created.
There's still a lot of growth to be had.
And so you've really seen a very significantinflux of investors that performing well and
LPs that are getting interested.
The biggest challenge to further growth reallyis just the scale.
(07:23):
These are relatively small funds and a lot ofthe big platforms who have the huge dollars
can't write check sizes that small to a fund.
And so for some of them that's limiting, butfor smaller platforms, it works family offices,
smaller university endowments.
It's really attractive.
Brett, the SBIC funds are not only for privateequity funds, but also for private credit
(07:47):
funds.
Tell me about that.
And how do managers use SBIC funds for privatecredit?
You have to have a track record of investingthis way.
And you have to propose to the Small BusinessAdministration that, hey, we're going to
continue to invest the way we were.
You have to have an analogous record and we'regonna raise private capital.
(08:08):
And then we're going to amplify that with yourleverage.
Now, if you can't raise your private capital,if the market doesn't trust you with your
capital, the government's not going to either.
And that makes sense.
But most of these fund managers have really,you know, come in and they've said, Hey, look,
this private credit opportunity is verysignificant.
David, you're at Davidson College.
(08:28):
You're an LP in a lot of these structures.
Walk me through the structural alpha that youachieve through investing in an SBIC fund, both
on the credit as well as on the equity side.
The most quantitative way to answer that is torefer to the IPC paper, which found across all
strategies, SBICs outperformed their Burgessbenchmarks by about 4%.
(08:52):
But it's an amplifier.
So, you know, if you have lower gross of feereturns, unlevered gross of fee returns, you're
gonna have less magnification from theleverage.
One anomaly you find with SBICs that peopledon't always pick up on is, the net of fee
levered returns are frequently higher than thegross of fee unlevered returns.
(09:15):
Just to say that again, the net of fee returnswould be higher than the gross of fee returns
because
Give me an example of
that.
I always try to make this argument.
You know, to try to hit a 3x net return in aprivate equity fund is a very difficult thing
that a lot of us aim to do.
Only about 8% of private equity funds from 2000to 2020 have done that.
(09:38):
And even then, a lot of that was luck.
Sometimes you just picked a great vintage year.
To do that in a traditional fund, you probablyhave to earn something like a a three and a
half x gross of fee return, something a bithigher.
In an SBIC, you probably have to hit about atwo and a half x gross unlevered return to hit
(10:01):
a three x net levered return on an MOIC basis.
When you actually look through it, you know,fund returns are a bell curve, right?
You know?
And that three x net return fund is way out onthe right tail.
If all I have to do is hit a two and a half xgross, which in a traditional fund would be
like a two x net, well, something like 40% offunds, private equity funds in the lower middle
(10:27):
market did that from 2,000 to to twenty twenty.
So that increases your odds of picking by likefive x.
Now I'm not trying to pick this outlier that'sit's way out on the right tail.
I actually have a fighting chance inside anSBIC to hit a 3x net MOIC.
Private equity, the returns are much morebanded than maybe a venture capital or a
(10:50):
biotech fund.
So the difference between a medium, medianreturning fund and a top top 10%, in this case,
top 8% fund could literally be one x.
And this can really help you get there withouttaking enormous amounts of risk or trying to
grow companies too exuberantly, tooaggressively.
Last time we chatted, you said that you had abias towards lower middle market even without
(11:14):
the SBIC structure.
Why do you like lower middle market so much?
In the lower middle market, there's just moreinefficiencies.
And a lot of the things our GPs do, it's notrocket science.
It's building out management teams, installingnew accounting software, establishing KPIs.
They're really most frequently building outthese companies that have never had
(11:38):
institutional investment before.
And it's a great place to do that and sell iton to the next private equity owner.
Being the first institutional capital is areally great place to be.
One, there's huge amounts of value to becreated, simple technologies, simple human
resources tools that really amplify it.
(12:01):
It also, a lot of the LPs I talk to, it takesaway some of the reputational risk.
The only way to make money in the lower middlemarket is to grow the business.
You're not talking about, Hey, we invested insomething, they had to slash a bunch of jobs or
they shipped stuff offshore.
The only way to make money is to grow it andyou can grow it.
And it's a proven business model, very, verylow strikeout numbers.
(12:23):
You know, it's unusual to have a failedinvestment, very unusual, because these are
proven models, they just haven't beenprofessionalized in some cases.
And so it's a win win reputationally, it's awin win from a financial standpoint, and
there's frankly a lot more choice as far as thenumber of deals.
I mean, funds are looking at four to 500opportunities for every one they actually
(12:48):
invest in.
It's that inefficient of a market.
Thank you for listening.
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We like to romanticize small businesses in ourculture, but there is a reason small businesses
stay small.
They may be operating on clipboards literally,they're not even an Excel, let alone AI, not
(13:10):
have a CRM, they might just have a a file withtheir customers or just know them by name.
So coming in and picking up those low hangingfruit could be a great source of alpha versus
the upper middle market.
Oftentimes, you have to rely on leverage andother kind of more riskier investment
strategies than just fixing the business.
(13:30):
And you've also squeezed out some of thoseprofits and those efficiencies early and you've
sort of what you paid for as you've gone along.
As it relates to small businesses, I mean, mostsmall businesses in The United States, the vast
majority, it's over 90% of small business inThe United States have zero employees.
And that's not what we're talking about here.
We're not talking about, some guy who's aloneand just a consultant.
These are businesses that are meant to outlastthe founder.
(13:53):
And so it really is making sure that itmaintains itself as an ongoing enterprise.
And so it really is taken sort of the cream ofthe crop and then making sure that it just,
they keep ramping up and going.
So the bigger platforms that have sort ofstretched down to the smaller part of the
market are sometimes surprised about theprofessionalization that's needed.
(14:15):
No, your sister can't be your auditor.
Your girlfriend cannot be your secretary.
These small businesses have real humancomponents to them that need to be
professionalized.
And that's why I say like HR components are areally big thing with these smaller platforms.
These smaller platforms are so busy operating,they're often growing, but they don't really
have time to think strategically or don't havethe networks across the industry, across
(14:38):
geographies to go from a small player to aregional player, to maybe even a national
player.
And that's what these fund managers do, notjust with money, but also with expertise and
networking.
We have to remember that this program existsfor job growth.
We we romanticize small businesses because thatis where a lot of American job growth comes
(14:59):
from.
These groups need capital, and then thisprogram provides that, without a cost to the US
government.
There was a study done by the Library ofCongress a couple of years ago, a nonpartisan
research division, Library of Congress.
And for SBICs, the equity oriented investmentsadded, I think it was number was north of three
fifty new jobs per organic jobs per investment.
(15:22):
And the debt oriented ones were 175 or 180, Ithink something along those lines per
investment.
Those are big numbers for small businesses.
That's not going to be GM, that's not going tobecome Tesla, Though Tesla was an SBIC
investment back in the day, that's sort of anoutlier.
Don't have to go public to make money withthese.
But there really are meaningful growth that inboth in revenue and earnings and in employment
(15:49):
that, really is something that takes away somerisk for the LPs from a reputational
standpoint.
You get this money from the government.
What, where does that money come from and whobacks the leverage?
So you raise private capital, you get gothrough this licensing process, you get
(16:10):
approved by the SBA.
Then when it's time to make investments, youdraw it just in time.
You don't get all the money at once.
So if you have a fund where you're borrowingyou have $150,000,000 of leverage capacity, you
don't get that 150 at once, you're doing, youget it on a deal by deal basis and you pull the
leverage from the Federal Home Loan Bank ofChicago, At the same time, you're pulling
(16:34):
leverage from your LPs.
And so that money comes from the Federal HomeLoan Bank of Chicago.
And then every six months it gets put into atrust certificate and auctioned off.
And when it gets auctioned, the buyers arefixed income funds and insurance companies and
hedge funds and all the big financial playersbecause these trust certificates have the full
(16:59):
faith and credit of The United States behindthem.
So they're not guaranteeing any individualperformance for the SBIC, but they guarantee
that trust certificate will perform.
And it's generally the ten year treasury plus45 to 85 basis points.
And again, the nature of that leverage isreally attractive.
(17:19):
No prepayment penalty, you can pay it backwhenever you want.
You know, it's a fixed rate, it's not going togo up or down.
You know, it's non amortizing.
So it's, you're just making interest for tenyears, then you have a big slug at the end and
that's how it works.
And so the pool sizes generally are around$2,000,000,000 plus or minus every six months.
(17:42):
I would add the most attractive feature of theleverage is that there's no refinancing risk.
It's ten year leverage.
There's a lot of investors that are wary ofleverage leverage and rightly so.
I always remind people that, you know, WarrenBuffett, fundamental value investor, you know,
rightly argues that, you know, margin debt isdangerous because it can be pulled from you at
any time.
(18:04):
But I also remind people he has an insurancefloat that's also very special leverage that is
low cost and has no refinancing risk.
When you take away the refinancing risk fromfrom leverage, you take away a huge portion of
that risk.
And so this this leverage is very special inthat it does not have refinancing risk if you
manage it properly.
(18:24):
And, David, you're essentially a buyer of thesetype of funds at Davidson.
Why do you think this hasn't become a biggerprogram?
Well, it has become bigger over time.
But these are smaller funds.
They typically only raise 50 to 200,000,000 inLP capital.
That's usually below the threshold that mostplacement agents are willing to work.
(18:46):
These funds historically have been the largestLP base is from banks.
Banks get special treatment under Dodd Frank toinvest in these, and they get community
reinvestment act credits that they need underregulation.
So banks don't talk, as LPs don't really existoutside of SBICs, So there isn't a lot of cross
(19:09):
communication between that investor base andother investor bases.
So there just isn't a lot of people talkingabout it.
I mean, that's why we're here today on yourpodcast to try to get the word out because this
program really is growing and we see a lot moreGPs coming into the market.
Yeah, I'd add to that, David, you're not theonly one asking that question.
We gave a presentation to a group of 75, 80five family offices down in Texas late last
(19:34):
year.
And that was the first question, like, if thisis real, you know, if this isn't just some
brand new flash in the pan, why haven't weheard of it before?
And this has been around since 1958.
This has been around for a long time.
It just really has been reinvented and reallygrown dramatically since, you know, the
financial crisis and Dodd Frank alongside theprivate credit markets growing.
(19:57):
And so it's getting the attention of folks ishard when you're smaller platforms, but it's
getting a lot more attention from familyoffices.
It is getting more attention from universityendowments.
But again, there's just that scale issue thatDavid touched on a little bit.
It's just large check sizes.
If you don't want be more than 10% of a fundand you have to cut a minimum $50,000,000 check
(20:19):
or $25,000,000 check, that just excludes a lotof the very large institutional LPs that get a
lot of the attention.
That is a big problem.
Investment offices that have the staff andsophistication to go do the work on the space
generally cut larger checks, and then theystill see it as an opportunity.
Smaller groups like myself, we're very timeconstrained.
(20:43):
Trying to get a small investment office to golook at something new is difficult.
But we, at Davidson, find that's ourcompetitive advantage.
We're a smaller group.
We're going to use our size to accessinteresting investments like these.
Would there be anything that keeps an emergingmanager from utilizing this capital for their
(21:05):
first couple of funds and then going off thiscapital as they get bigger?
People do that all the time.
But a lot of funds, so these are not rookiesthat are running these funds.
And I think that's one of the things in thelarger private equity and private credit space.
When you look at smaller funds like, oh, you'rejust emerging, you're just starting out in your
career.
These are really established people that areprofessionalized at this level.
(21:28):
And some of them have grown and some of themhave grown to multi billion dollar platforms,
but a lot of them actually dislike this part ofthe market.
You know, they really know this part of themarket.
They like having the choices they have in thispart of the market.
And so, you you can grow up and there arecertainly some funds that have grown so large
that it just stops being a meaningful portionof them.
(21:50):
And a number of the, for example, a number ofthe BDCs, the business development companies
started as SBICs like Main Street Capital.
I think, I don't know, they're an eight or ninebillion dollars BDC and they still have a
couple of SBICs, but they started as I think a$50,000,000 SBIC and they took it and they
grew.
And there are a number of folks who have donethat Hercules Capital, big venture lender in
Silicon Valley similar.
(22:12):
There are others.
But the program has grown both in the amount ofinstitutional investment coming in, as well as
the leverage caps themselves.
Now Congress controls those leverage caps.
And one of the things I do that's kind ofunusual in finance is I regularly talk to the
government, whether it be the treasurydepartment, the White House, the SBA, the
(22:32):
people writing laws in the house and Senate tohelp them understand private credit and private
equity policy.
And we're trying to work with them to raisesome of these leverage caps to let the market
really fill because there's a lot more demandfor slightly larger checks and this program
(22:52):
works very well.
So I think we're going to be successful ingetting that a little bit bigger and making it
so that funds don't have to leave the programbecause it is so attractive to them and to the
job creation across the country.
Generally speaking, I think the managers thatenter the program send a great signal to LPs
because they're willing to do the work to goget one of these licenses, but also their fund
(23:16):
growth is probably going to be a little bitmore moderate than you would see outside of an
SBIC because they want to keep that leveragerelevant to their fund size.
There's a licensing process.
How difficult is it to become an SBIC backedmanager?
You have to have real experience and realsuccessful experience investing in the strategy
that you're going to pursue with the SBA.
(23:37):
So if you're going to form an SBIC license andyou're be doing private credit, you've got to
have private credit experience in a similarsize.
You can't say, Hey, I've got private creditexperience.
I'm not going to go do venture capital.
Not going to happen.
They're looking at it from both the financialreturn standpoint to make sure that the
taxpayer is protected, that these loans arepaid back.
But they're also looking at it from thereputational side.
(24:00):
You know, if you've made lots of money, butyou've left a trail of lawsuits and wreckage
and companies going bankrupt behind you,they're not gonna license you.
It's just not gonna happen.
Doesn't can't go bankrupt that you've investedin before, that happens.
Or there can't be a lawsuit, that happens.
(24:21):
But if there's a negative pattern, they justdon't wanna deal with it and they're not going
to.
And so that is a limiting factor.
It also takes some time.
Takes the better part of a year for a firsttime fund to be able to do this.
And it costs a lot of legal fees.
We're trying to do some things to take thosecosts down a little bit, but it is a barrier.
(24:46):
But that being said, we have currently north of50 new platforms that are in the advanced
stages of getting licensed right now.
And then your average fund size of two hundredto three hundred some odd million, that's a
pretty big number as far as what's coming on.
And that's just already what's in the process,you know, have gone through the interviews,
(25:07):
gone through the FBI background checks, becausethat's the other thing from an LP perspective
that's different.
Not only I've had the LPs done the diligence onthe fund managers and the government's done the
diligence on the managers, they've actually runthe applicants through the FBI to make sure,
Hey, are we good?
You know, and if the answer is no, you're notgetting a license.
And so that gives a number of LPs an addedlayer of comfort in investing in this space.
(25:32):
But it takes the better part of a year to getone of these things.
But the return ultimately is very attractive.
And once you've had one, the second and thirdand fourth and fifth and sixth and seventh
licenses are moving much faster than they havein the past, now running around three or four
months to get your follow on license.
What's the main reason that an otherwisequalified fund typically does not become
(25:55):
eligible for SBIC funding?
There
are a
couple of reasons.
One, some people just don't like the idea ofworking with the government and where the
government's gonna be a creditor, a lender toyou.
Two, a number of platforms like to investinternationally and you can't.
So the investments you make via the SBIC, onehundred percent of those businesses have to be
(26:18):
primarily inside The United States.
And so a number of funds will say, hey, we wantto do 20% in Canada, can't.
You can do a parallel fund and do that, butthat's just not an option.
So when you're investing in these businesses,they have to be small enough to qualify.
This isn't going to, if you're focusing on 20to $25,000,000 EBITDA companies, it's just too
big.
(26:38):
And this is called the small businessinvestment company program, not the medium or
middle market business investment companyprogram.
So you have to be really focused on this partof the market.
You have to be willing to invest exclusivelyinside The United States.
Again, those businesses might have salesoffices, other parts of the world, but you have
to have at least 50 of the employees inside TheUnited States.
(27:00):
And then you have some folks who just franklyhave a lot more lawsuits on some ugly stuff
that can be hindering.
And so when they discover that, hey, they can'tget, they might not get through because of some
previous, you know, unpleasantries, we shallsay, you know, they just don't go in.
But I think the government aspect ofinternational aspect of it, the size aspect of
(27:23):
it, and the deeper diligence is one that arethings that sometimes steer people away.
Taking a step back, Davidson has a barbellapproach to investing.
Talk to me about the Davidson endowmentinvesting strategy.
We invest like a lot of endowments.
But I'd say where we differ is we tend to havea larger hedge fund program.
(27:46):
Today, that's about 35% of the endowment.
And within that hedge fund program, we tend tohave we tend to have a lot less market risk, a
lot less beta, and a lot more a lot lower crosscorrelation among funds.
That allows us to take a lot more risk on theprivate side.
(28:06):
Today, about a quarter of the endowment is inventure capital and another 20% is in other
private liquids like SBIC funds.
We really want our capital on the private sideto deliver, you know, high returns.
We want all of those liquid commitments tocompete for capital so can get the best
(28:27):
returns.
And like we said earlier, there's a widerstandard deviation of returns in the private
markets.
There's a much greater ability to add valuethere.
And so we want to emphasize that.
So you also invest 25% into venture capital.
Given that you have the SBIC part of yourportfolio, why also invest in venture capital?
(28:50):
In venture capital, if you can, you know,through luck or skill, pick the best funds, you
will have the highest returns.
So it's the highest returning part of theprivate markets.
On average, venture returns have typicallyequaled private equity returns over a long
period of time.
But there's a much greater tail, positive tailin venture capital where if you get in the best
(29:15):
ones, can be truly extraordinary returns.
And you mentioned 35% of your money is in hedgefunds.
That's a pretty high number.
And hedge funds are these kind of black boxinstruments at least to the outside world.
Double click on some of the strategies in yourhedge fund portfolio.
As a smaller investor, we have a little bit ofan advantage investing in hedge funds.
(29:37):
We can invest in smaller ones where there cantypically be more alpha.
About half of our capital and half of ourrelationships in the hedge fund book are with
fundamental long short, hedge funds.
These are typically lower net funds with andhigher gross exposure funds.
Our goal across all of hedge funds is to hitsomething like a low double digit net return on
(30:04):
a five year plus time horizon.
If we can do that, we can keep up with longonly public equity markets, I feel, and do so
with much more diversification, providingliquidity in times of stress to the portfolio.
And why is there more diversification in thesestrategies?
Just because you emphasize stock picking andyou get away from the market risk.
(30:25):
Just keeping that net exposure low and usingyour gross exposure to take on more
idiosyncratic risk.
Within long short, you're taking onidiosyncratic risks related to the individual
companies that you're going long or short.
So you're you're long part of the market,you're short part of the market.
So what remains is manager skill.
(30:46):
Yeah.
And hopefully, you picked right.
We don't always do that, but the goal is to getthe whole portfolio in that sort of low double
digit net return area.
So we can, like I said, keep up with publicmarkets in the long run.
So this diversification doesn't drag performour long term performance down.
And I failed to speak earlier.
The other half of our hedge fund book tends tobe more quantitative, doing similar things, but
(31:11):
in a more quantitative manner.
Talk to me about portfolio construction ofquant strategies within your portfolio.
We tend to pick managers that are smaller thatwe can have a trusted relationship with.
And we do that across all asset classes, andthat's a little tougher in the quantitative
space.
We we've specifically looked at managers thatare typically under 5,000,000,000 in AUM, where
(31:34):
we can have that better relationship.
You know, we're never gonna fully understandwhat all the algorithms are doing.
We'll have some sense of it, have some logicbehind it.
But we're not there looking at, you know, thedaily numbers or anything.
We're we're trying to find really experiencedprofessionals that we can trust and have an
(31:55):
open dialogue with, where everything isn't justa black box.
Why do you think a lot of your peers and otherendowments have much less allocation to hedge
funds?
As your asset size increases, the number ofdifferent hedge funds you can access decreases.
And then you start getting into problems over,you know, how much are hedge fund fees
(32:18):
capturing the alpha versus how much alpha iscoming through in net returns.
I think it's very difficult to run a hedge fundthat's sort of 50 to 80% net long with a two
and twenty or just a 20% performance fee andnot have a lot of the alpha captured by the
managers opposed to the LPs.
(32:40):
So, you know, you typically see as AUMincreases, hedge funds are also gonna be going
up upper going upmarket away from small and midcaps.
And, you know, it just becomes a much toughergame.
Perhaps it's obvious, but why are small hedgefunds more likely to outperform larger hedge
funds?
Just a greater range of investmentopportunities in small and mid cap stocks.
(33:04):
It just becomes more unwieldy to deal withlarge amounts of capital in in the manner I'm
talking about with a high gross exposure.
So it's just this is much tougher game as yougo up upmarket.
And there's more sophisticated competitors aswell.
Oh, totally.
Yeah.
Brett and David, this has been a masterclass onSBIC funds.
If a manager is considering adding SBA fundinginto their fund, what's the best resource for
(33:31):
him or her to go to to find out more?
Www.sbia.org, smallbusinessinvestorallianceOrg.
You know, we're the trade association thatstarted that way.
We're both GPs and LPs.
So if you have LPs that are looking to investin these, we do a lot of matchmaking and help
them find the funds that match their criteria.
(33:52):
As well as, you know, for funds that arethinking about forming an SBIC fund, whether it
be a buyout fund, a mezz fund, whateverstructure they want to be, there's a lot of
information on that website and we can alsotalk to them and help them get them pointed in
the right direction.
David, any parting words?
Thanks for having us on.
We really appreciate It's a topic that might bea little bit dry, but we love it and are always
(34:14):
happy to talk about it.
We were joking that it's a special type ofperson that finds us very exciting, and
thankfully, our audience is that person.
So thank you for jumping on, and I look forwardto sitting down in person soon.
Thank you, David.
Thanks for listening to my conversation.
If you enjoyed this episode, please share witha friend.
This helps us grow.
Also provides the very best feedback when wereview the episode's analytics.
(34:36):
Thank you for your support.
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