Elijah Brewer, III

Hesna Genay

Paula R. Worthington

William E. Jackson, III

English

Research Papers in Economics

ESSAYS ON ISSUES THE FEDERAL RESERVE BANK JANUARY 1997
OF CHICAGO NUMBER 113
Chicago Fed Letter
Issues in funding the
activities of small firms
through SBICs
One of the most fundamental questions
in finance is how to fund firms’ invest-
ment projects.  Some firms finance in-
vestment projects by using equity, while
others borrow from investors and/or
financial intermediaries.  Because debt
and equity contracts offer different
payoffs and rights to investors, how a
firm finances its projects is primarily
determined by the characteristics of
the firm and its projects.
Debtholders are more likely to suffer
losses if firms engage in risky activi-
ties.  To reduce potential losses, debt-
holders can require collateral or place
restrictive covenants on the loans
they make.  However, such control
mechanisms can be cumbersome and
inflexible for some firms, particularly
for those that want to pursue innova-
tive investment opportunities with un-
certain outcomes.  Equity contracts,
on the other hand, offer managers
more flexibility over the use of funds.
In return, investors gain oversight
and control rights to get involved in
the day-to-day management of firms,
along with the potential of earning
upside returns on their investment.
In competitive capital markets, the
effects of conflicts of interest are re-
flected in security prices.  Therefore,
firms, as well as investors, have an in-
terest in designing securities that mit-
igate these conflicts of interest.
This Chicago Fed Letter discusses how
different financial instruments may
mitigate conflicts of interest between
firms and investors.  Control issues re-
lating to financing decisions may be
especially important for small firms.
Because small firms are more likely to
fail than large firms and because they
may not have an established track
record or collateral to protect investors
from losses associated with bankruptcy,
developing control mechanisms is
likely to be particularly important in
financing these firms.  Accordingly,
we examine the activities of small busi-
ness investment companies (SBICs),
which are financial intermediaries
chartered and regulated by the U.S.
Small Business Administration to
fund the activities of small business-
es.  Unlike commercial banks, which
are essentially restricted to making
debt investments, SBICs provide both
debt and equity funds to small busi-
nesses.  Hence, SBICs are free to
choose the appropriate mixture of
claims on a given firm and, more
generally, in their own portfolios.
Banking organizations, however, are
allowed to own and operate invest-
ment companies; hence, they can
make equity investments indirectly
by establishing SBIC units.
Examining the investment choices of
SBICs offers insight into the factors
influencing optimal security choice.
In our research (Brewer, Genay,
Jackson, and Worthington, 1996), we
have found that the type of financing
provided by an SBIC varies with the
type of project planned by the recipi-
ent small firm.1  We have also found
significant differences between the
choices and performance of bank-
owned and nonbank-owned SBICs in
the 1980s and 1990s.  We explore
these issues below.
Factors governing security design
Financial intermediaries, such as
commercial banks, SBICs, and con-
ventional venture capital firms, are in
the business of funding the projects
of commercial enterprises.  However,
different financial intermediaries use
different types of financial instru-
ments.  Venture capitalists typically
finance business activities with equi-
ty, while commercial banks use debt.
SBICs, which are a hybrid, use both
debt and equity.  What governs these
choices?  Surely regulatory consider-
ations are important (e.g., prohibi-
tions on commercial bank equity
holdings), but our focus here is on
the role of contracting costs.2  What
mixture of claims minimizes the con-
flicts of interest that naturally arise
between managers and owners on
the one hand, and owners and lend-
ers on the other hand?3
Firms’ projects drive the security
design of investors
Finance theory suggests that security
choice depends on factors that influ-
ence the severity of these two conflicts
of interest.  In particular, the type of
securities used to fund firms’ projects
is influenced by the tangibility of firms’
assets, the degree of management dis-
cretion over the use of funds, and the
extent to which managers can be easi-
ly monitored by investors.  Tangible
assets like equipment, buildings, and
land can be used as collateral in debt
contracts, thus providing some mini-
mum protection in the event of
default.  High levels of tangible assets,
or other assets that can be liquidated,
tend to increase the amount of protec-
tion afforded to debtholders.   Thus,
projects that generate or require in-
vestments in tangible assets are likely
to be financed with debt.  On the
other hand, if the firm is undertak-
ing a project with few tangible assets
associated with it, the firm is likely to
obtain equity financing.
Projects involving substantial manage-
ment discretion over the use of funds
are those for which debt finance
would be expensive: The greater the
amount of management discretion,
the greater the opportunity to shiftPanel A:  Intended use of funds, by type
Share of
Debt Nondebt Total total $
(% of total $) (% of total $) ($ millions)
Operating capital 23.0% 77.0% $1,449.6 56.8%
Transaction-oriented 49.2 50.8 392.9 15.4
Relationship-oriented 10.7 89.3 711.5 27.8
Panel B:  Intended use of proceeds, as reported
Share of
Debt Nondebt Total total $
(% of total $) (% of total $) ($ millions)
Operating capital 23.0% 77.0% $1,449.6 56.8%
Plant modernization 73.7 26.3 17.8 0.7
Acquisition of existing business 11.7 88.3 602.2 23.6
Consolidation of debts 40.7 59.3 248.4 9.7
New building or plant construction 80.2 19.8 31.7 1.2
Acquisition of machinery/equipment 39.3 60.7 65.7 2.6
Land acquisition 94.9 5.1 29.2 1.1
Marketing activities 2.1 97.9 27.1 1.1
Research and development 2.0 98.0 76.3 3.0
Other 56.8 43.2 5.9 0.2
Total financings
(in millions, inflation-adjusted) $602.8 $1,951.3 $2,554.1
Notes:  Sample consists of all transactions over the 1983–92 period for which complete data are
available.  Dollar figures deflated by the Consumer Price Index for all urban consumers; 1982–
84=100.   Nondebt financings include equity, debt with equity features, and combinations of equity
and debt with equity features.  Transaction-oriented uses include plant modernization, consolidation
of debts, new building or plant construction, acquisition of machinery/equipment, and land
acquisition.  Relationship-oriented uses include acquisition of existing business, marketing activities,
research and development, and other.
Source:  Authors’ calculations from data provided by the U.S. Small Business Administration.
1.  Intended use of funds and security choice, 1983–92
funds to riskier projects, increasing
the likelihood of default and, there-
by, raising the cost of issuing debt.
Thus, projects that allow greater
management discretion will tend to
be financed with equity.  Similarly,
projects that are difficult to monitor
for asset substitution are likely to be
financed with equity.
Type of securities held by SBICs and
intended use of funds
To the extent that the type of project
undertaken by the recipient firm is a
key factor in determining the securi-
ty choice of investors, we would expect
to find that equity is used to finance
risky activities that generate few tan-
gible assets, are difficult to monitor,
and allow managers a great deal of
discretion over the disbursement of
funds.  Our research shows that the
investment activities of SBICs are
consistent with this expectation.
Figure 1 presents the relationship be-
tween the intended use of funds and
SBICs’ investment activities.  The
most important category for intended
use of funds is operating capital,
which accounted for around 57% of
dollar investments.  Other important
categories are acquisition of existing
businesses, debt consolidation, acqui-
sition of machinery, and research
and development (R&D).  For each
project, figure 1 also shows the per-
centage of funds provided in the form
of debt rather than nondebt.4  Panel
A of figure 1 groups the uses of
funds into three categories, operat-
ing capital, transaction-oriented
uses, and relationship-oriented
uses.5  Transaction-oriented uses in-
clude plant modernization, new
building or plant construction, debt
consolidation, machinery acquisition,
and land acquisition.  Relationship-
oriented uses include the acquisition
of an existing business, marketing ac-
tivities, and R&D.  This grouping re-
flects our a priori judgement that
relationship-oriented projects offer
greater scope for management dis-
cretion as to how the funds are used
than do transaction-oriented projects,
which are likely to require less moni-
toring and are less subject to asset
substitution problems for lenders.
Furthermore, transaction-oriented
uses may involve the purchase of as-
sets which have some liquidation value
in the case of borrower default.  In
panel A, the differences between cate-
gories stand out clearly.  Funding for
relationship-oriented uses is likely to
be nondebt.  Between 1983 and 1992,
89.3% of all dollars invested in firms
planning relationship-oriented
projects took the form of nondebt se-
curities.  In contrast, funding for trans-
action-oriented uses is less likely to
be nondebt; only 50.8% of funds pro-
vided for transaction-oriented projects
were through nondebt instruments.
As can be seen in panel B of figure 1,
these relationships hold using the
more disaggregated data on intended
use of funds.
Bank-owned SBICs are
equity investors
The SBIC program provides banking
organizations with an opportunity to
make investments not otherwise per-
mitted as commercial bank activities.
Consequently, by establishing an SBIC
unit, banks reveal their preference
for making equity investments.  Such
investments are likely to complement
the loans made by banks’ credit de-
partments and provide an opportuni-
ty for diversification.  Bank-owned
SBICs invested nearly 90% of their
funds through nondebt contracts
over the 1983–92 period; in contrast,
nonbank-owned SBICs invested less
than 70% of their dollars through such
contracts over the same period.  Thus,
bank-owned SBICs were more involved
with equity finance of small businesses
than other SBICs.  Further, as figure 2
shows, a substantial fraction (44.3%)
of bank-owned SBICs’ investmentMichael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research;
Douglas Evanoff, Assistant Vice President, financial
studies; Charles Evans, Assistant Vice President,
macroeconomic policy research; Daniel Sullivan,
Assistant Vice President, microeconomic policy research;
William Testa, Assistant Vice President, regional
programs;  Anne Weaver, Manager, administration;
Helen O’D. Koshy, Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago.  The views expressed are
the authors’ and are not necessarily those of
the Federal Reserve Bank of Chicago or the
Federal Reserve System.  Articles may be
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ISSN 0895-0164
Bank- Nonbank-
 owned SBICs owned SBICs All SBICs
(---------------------$ million)---------------------)
Operating
capital $409.2 $1,040.4 $1,449.6
Transaction-
oriented 78.0 314.9 392.9
Relationship-
oriented 387.0 324.5 711.5
Relationship-
oriented as %
of total financings 44.3% 19.3% 27.8%
Note: Dollar figures are inflation-adjusted.
Source: Authors’ calculations from data provided by the U.S.
Small Business Administration.
2. Intended use of funds and SBIC type, 1983–92
3.  Age of small business and SBIC type, 1983–92
Bank- Nonbank-
owned SBICs owned SBICs
(----------% of  $ financings----------)
< 1 year 23.9% 17.3%
1 to 5 years 42.0 44.3
5 to 10 years 16.8 18.0
Over 10 years 17.3 20.4
Total financings
(in millions,
inflation-adjusted) $874.2 $1,679.9
Note:  Sample consists of all transactions over the 1983–92
period for which complete data are available.
Source: Authors’ calculations from data provided by the
U.S. Small Business Administration.
dollars went to firms intending to un-
dertake relationship-oriented projects.
Thus, banking organizations were
taking advantage of the SBA’s small
business investment company pro-
gram to pursue an extensive strategy
of equity investments in projects that
are costly to finance using debt and,
hence, are not otherwise likely to be
funded at the commercial bank level.
Finally, we note that bank-owned
SBICs tend to finance somewhat
younger firms than nonbank-owned
SBICs, which is also consistent with
contracting theory.  The mean age
of firms funded by bank-owned
SBICs from 1983 to 1992 was 5.6
years, compared with 6.4 years for
nonbank-owned SBICs.  Young firms,
with presumably little reputational
capital, may find raising debt costly
as investors demand large premiums
to counter the risks of asset substitution
and bankruptcy.  Young-
er firms may also have
more growth potential
than older ones and,
therefore, face a higher
cost of foregone oppor-
tunities from restricting
management discretion.
Moreover, activities of
firms with high growth
potential tend to gener-
ate small or negative cash
flow in the short run,
even though the long-
term profit opportuni-
ties of these activities are
relatively high.   As a re-
sult, when firms finance
growth opportunities with borrowed
funds, they may have a difficult time
servicing their debt payment.  The
fact that bank-owned SBICs, which
tend to specialize in nondebt invest-
ments, invest in younger firms sug-
gests that the contracting cost of debt
is significant for these firms (figure 3).
Conclusion
Carefully designed securities can min-
imize conflicts of interests between a
firm’s shareholders, creditors, and
managers, and can improve the avail-
ability of funds.   In this Chicago Fed
Letter, we have discussed how SBA-
chartered and regulated financial
intermediaries fund the activities of
small businesses.  SBICs tend to use
equity contracts to finance the activi-
ties of firms that initially generate rela-
tively few tangible assets, such as
R&D.  While such activ-
ities are also likely to
have very little cash flow
in the short run, their
future growth opportu-
nities might be high.
Bank-owned SBICs
tend to pursue a strate-
gy of extensive equity
investments, specializ-
ing in funding younger
firms and projects that
generate few tangible
assets.  The propensity
of bank-owned SBICs
to pursue equity-type
investments when the
opportunity arises may
offer a glimpse of the markets that
might be served by banking organi-
zations in the absence of existing
regulations.
—Elijah Brewer III, Hesna Genay,
William E. Jackson III, and
Paula R. Worthington
1Elijah Brewer III, Hesna Genay, William E.
Jackson III, and Paula R. Worthington, “How are
small firms financed?  Evidence from small
business investment companies,” Economic Perspec-
tives, Federal Reserve Bank of Chicago, Vol. 20,
No. 6, November/December 1996, pp. 2–17.
2Regulations may also be important for how
SBICs fund small businesses.  SBICs are eligible
to receive government funding up to three
times their private capital.  SBICs also face
some restrictions on their investments.  The
results of our previous research (Brewer,
Genay, Jackson, and Worthington, 1996)
indicate that SBICs receiving subsidies are
more likely to make debt investments.
3For a detailed discussion of contracting costs
and optimal security design, see Brewer, Genay,
Jackson, and Worthington (1996).
4Nondebt securities include straight equity,
debt with equity features, and a combination of
the two securities.
5This type of separation is suggested by Leonard
Nakamura, “Recent research in commercial
banking: Information and lending,” Financial
Markets, Institutions, and Instruments, Vol. 2, No.
5, 1993, pp. 73–88.40
50
60
70
80
Purchasing managers’ surveys (production index)
Midwest
U.S.
Motor vehicle production
(millions, seasonally adj. annual rate)
Oct. Month ago Year ago
Cars 5.5 6.5 5.7
5.3 5.4 5.4 Light trucks
1993 1995 1996
Manufacturing output indexes
(1987=100)
Oct. Month ago Year ago
CFMMI 129.0 129.6 125.9
124.4 129.5 128.9 IP
Purchasing managers’ surveys:
net % reporting production growth
Nov. Month ago Year ago
MW 60.2 63.6 52.5
46.1 56.6 58.6 U.S.
1994
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Tracking Midwest manufacturing activity
Sources: The Chicago Fed Midwest Manufacturing
Index (CFMMI) is a composite index of 16 industries,
based on monthly hours worked and kilowatt hours.
IP represents the Federal Reserve Board’s industri-
al production index for the U.S. manufacturing
sector.  Autos and light trucks are measured in an-
nualized units, using seasonal adjustments devel-
oped by the Board.  The purchasing managers’
survey data for the Midwest are weighted averages
of the seasonally adjusted production components
from the Chicago, Detroit, and Milwaukee Purchas-
ing Managers’ Association surveys, with assistance
from Bishop Associates, Comerica, and the Uni-
versity of Wisconsin–Milwaukee.
While the national purchasing managers’ index suggested an acceleration in
November, the composite Midwest index declined over three points from the
previous month.  Still, the Midwest was above the nation in November, suggest-
ing that Midwest manufacturing remains stronger than nationwide.
Midwest manufacturing activity began to show the effects of the General
Motors strike in October.  Car and light truck production declined by 1 million
units.  The Chicago Fed Midwest Manufacturing Index dropped nearly 0.4%
from September.  Nevertheless, the decline in Midwest output was less than
that experienced nationwide.  To the extent that strike-related disruptions
spilled over into November, total output in the region could experience an-
other month of decline.

Issues in funding the activities of small firms through SBICs

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Issues in funding the activities of small firms through SBICs

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Research Papers in Economics