The Small Business Administration (SBA) adopted revisions to its regulations, loosening its prohibition on small business investment companies (SBICs) investing in passive businesses. Under the revised regulations an SBIC can now structure its investments through a second passive holding company instead of being limited to a single passive holding company. While the use of an additional holding company in the investment structure will better enable SBICs to compete with non-SBIC investors in venture capital and private equity deals where multiple layers of passive holding companies are often used, the additional flexibility will be particularly helpful for mezzanine investments, in which SBICs and other investors have little influence over the investment structure and multiple levels of holding companies are often employed.
The General Rule
An SBIC is prohibited from investing in a “passive business.”1 A business is passive if (i) it is not engaged in regular and continuous business operations, (ii) its employees are not carrying on the majority of day-to-day operations, and the company does not provide effective control and supervision on a day-to-day basis over persons employed under contract, or (iii) it passes substantially all of the proceeds from an investment through to another entity.2
An exception to the prohibition on investing in a passive business had been permitted where an SBIC invested in an entity that in turn passed the proceeds through to one or more subsidiaries, each of which was engaged in regular and continuous business operations with active employees that carried on or supervised its day-to-day business operations. To qualify as a “subsidiary,” the parent entity must hold 50% or more of the outstanding voting securities of a company. To qualify for the exception, the company in which the SBIC invested has to directly own 50% or more of the outstanding voting securities of the subsidiaries.
The Revisions to the Rule and Their Implications
The new revisions, adopted late last year, added an additional holding company layer so that the company in which the SBIC invests (Holdco Parent) can pass the investment proceeds to a subsidiary that is a passive business (Holdco Subsidiary), which in turn passes the proceeds to its subsidiary, which engages in regular business operations (Opco). In this case Holdco Parent must indirectly own 50% or more of the outstanding voting securities of Opco by directly owning outstanding voting securities of Holdco Subsidiary, and Holdco Subsidiary must directly own outstanding voting securities in Opco.3 The new revisions permit a variety of ownership percentages at the passive business levels, provided the overall 50% ownership test is met. For example, Holdco Parent could own 70% of the voting securities of Holdco Subsidiary if Holdco Subsidiary owned 90% of the voting securities of Opco.
As a result of the revision, an SBIC can now (i) finance a passive business to take advantage of the favorable tax treatment under Internal Revenue Code Section 338(h)(10), (ii) establish a “blocker” corporation between an SBIC and its investment in an Opco to protect an SBIC’s foreign investors from the taxation imposed if that income is considered to be “effectively connected to a U.S. trade or business” (including if the blocker invested in a passive holding company that in turn invested in an Opco), (iii) use a blocker corporation to shield tax-exempt investors from receiving unrelated business taxable income (UBTI) from an investment in a flow-through entity, with the first flow-through entity being a passive business, and (iv) in the case of an SBIC that either is a business development company (BDC) licensed under the Investment Company Act of 1940 or is owned by a parent BDC, create a blocker corporation that invests in a pass-through entity that in turn invests in an Opco, without jeopardizing the BDC’s qualification as a regulated investment company under the Internal Revenue Code.
Analysis and Suggestion
While this added flexibility is certainly helpful, many investment structures employ more than two layers of passive entities. In the past, the SBA noted that the 50% ownership requirement ensures “a significant relationship between the financed passive business and the active business which ultimately receives the proceeds.”4 This is true even where there are more than two layers of passive entities. In rejecting extending the change beyond two layers of passive companies, the SBA reasoned that (i) it lacked access to the books and records of the passive companies, (ii) fees and expenses could be charged at each passive level, thereby diverting money from the actual investment and resulting returns, and (iii) additional layers of passive entities would create greater opportunity for disproportionate distributions to entities other than the SBIC.5 However, under close inspection, these explanations do not hold up. The SBA can gain access to the books and records of the passive companies through the SBIC’s investment agreement with Holdco Parent. Holdco Parent’s indirect controlling ownership interest of each additional layer of passive companies and its indirect controlling ownership in the ultimate Opco can ensure the necessary access to the books and records and ensure that no “leakage” occurs. The SBA could obtain additional assurance in this regard by tweaking the existing regulations. However, the SBA shows no interest in doing so because of the additional resources it would require to monitor multiple levels of passive companies.
In the meantime, SBICs can now employ an additional layer of passive entities and should, where possible, carefully review with the venture capital and private equity sponsors whether their structural objectives can be achieved with only two layers of passive companies.