SBA Issues New Guidelines on Investor Side Letters and Withdrawal Provisions for SBIC Funds

October 27, 2010

The Investment Division of the U.S. Small Business Administration (SBA) has issued new SBIC Licensing Guidelines in SBA Technote 15 for use in drafting, negotiating, and amending the limited partnership agreement (LPA) for prospective and licensed SBIC Funds.

The LPA of an SBIC Fund must now contain terms that apply to all of a fund’s investors; impose restrictions on a fund’s or general partner’s activities; require a fund to engage in or refrain a fund from engaging in particular activities; require managers to make best or reasonable efforts to achieve a particular result; or may be construed to provide preferential treatment to or adversely affect certain investors.

SBA strongly encourages SBIC applicants and current licensees to avoid the use of side letters. When a side letter is necessary, the following guidelines shall apply:

  • The LPA of the SBIC Fund must include a provision that specifically authorizes the fund and the general partner to enter into side letters, and sets forth any conditions under which the fund or general partner may do so. The provision must state that all side letters require SBA’s prior written approval.
  • An applicant must submit drafts of all contemplated and executed side letters with its license application, or to its assigned SBA licensing analyst as soon as possible, if the side letter was negotiated after filing a license application. A licensed SBIC Fund that is still fundraising and requires a side letter must submit the side letter to its analyst along with an amendment to its LPA authorizing the fund and general partner to enter into side letters, if the LPA does not already include such a provision.
  • SBA will not approve a side letter containing a “Most Favored Nation” clause which automatically extends to a limited partner any more favorable rights and benefits than established by another investor’s side letter or similar agreement. SBA will allow a limited partner to require (1) disclosure of other side letters, and (2) the ability to veto the extension of more favorable rights and benefits to other investors.

The LPA must contain certain mandatory provisions permitting a limited partner to withdraw from a partnership, including withdrawal rights for certain types of limited partners, such as tax-exempt organizations and employee benefits plans. Other provisions permitting a limited partner to withdraw from a partnership are optional including certain withdrawal rights for banks and bank holding companies. In each case, the right to withdraw must be supported by an acceptable opinion of counsel.

  • SBA will also consider the following in deciding whether to permit a limited partner to withdraw, if the partnership or general partner violates a written policy adopted by the limited partner: whether the limited partner’s policy promotes best practices and ethical behavior in management; whether the policy has been widely adopted by a significant important class of institutional investors; and whether the policy is compatible with the laws, regulations, and policies governing the SBIC Program.
  • The guidelines also impose certain restrictions to the capital committed by an investor that has a withdrawal right based on a partnership’s or general partner’s violation of written policy including all of the following:
    • Unfunded commitments subject to the withdrawal right will not be considered Regulatory Capital.
    • SBA may allow the SBIC Fund to include the investor’s entire commitment (except assumed leverage on investor’s unfunded commitment) in the management fee base, if SBA determines that the full amount of the investor’s commitment is likely to be collectible.
    • If investor also retains the right to a refund of management fees in the event of a violation, the LPA must provide that: (A) the general partner or management company will pay the refund; (B) the general partner or management company must refund to the SBIC Fund the management fees paid by the SBIC Fund based on the investor’s unfunded commitment; and (C) the failure of the general partner or management company to pay these refunds may result in personal liability for the payments.
  • Conditions whereby a prospective investor in an SBIC Fund requires the SBIC Fund to engage in or refrain from certain activities should be set forth in the LPA including but not limited to any of the following:
    • SBIC Fund must maintain an office in a specified location.
    • SBIC Fund must make a certain percentage of its investments within a specified region.
    • SBIC Fund must not invest in any business involved in alcohol or tobacco.

SBA, however, will not approve a special withdrawal right for a particular limited partner based on the SBIC Fund’s failure to fulfill such requirements. SBA will also not approve a provision that allows a limited partner to opt out of funding a particular investment.

The Private Equity practice at McGuireWoods LLP is dedicated to keeping clients advised of new legislative and business developments as they occur. If you have any questions regarding these issues, please feel free to contact your primary attorney at McGuireWoods or the authors.

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