DOGE, an SBA(7)a killer?

SBA 7a loans weren’t meant to subsidize lower middle market private equity. They weren’t meant to serve as a 75% backstop on buyout loans that were too risky for other lenders to underwrite. They weren’t meant to put risk-willing entrepreneurs-through-acquisition in a position where they could face personal bankruptcy.

The SBA loan program was meant to provide expansion capital

The SBA loan program was meant to provide expansion capital for small business owners. The capital required to build that new facility, open up that new location, buy that new piece of equipment, and spur job creation. Good intentions.

But finance guys found a way to use the SBA7a instrument as a cheap source of acquisition financing. So a substantial portion of SBA loans today are used to fund relatively high-risk, very highly levered buyouts of small, often fragile business that trade at low valuations (3-5x EBITDA).

SBA default rates

Data shows that only a small percentage of SBA loans default; 3.69% in 2024 to be exact. However, I would assume the buyout loans are over-represented in the default bucket. So, what is the default rate there? Is it 5% or 15%? We don’t really know.

Why would the buyout loans over-represented? Because there is asymmetric risk. A business owner taking a loan to build a new facility has full knowledge of his business, a strong personal balance sheet (at least compared to a 29yo post-MBA searcher), and moderate levels of debt. A searcher, on the contrary, will maximize leverage, often up to 90% LTV, to optimize equity projections, and they are outsiders to the business until after they’ve inked the ominous personal guarantee (they don’t know whether there are any skeletons in the closet).

15-30% of deals end up in dire straits.

If the default rate among searchers is 5% or 15%, the amount of loans that at some point end up in distress or covenant territory is probably several times higher. It isn't unrealistic to assume that 15-30% of deals end up in dire straits. Just my back-of-the-envelope math.

Personal guarantees = a net negative

I find that most searchers who call me are already sold on the concept of SBA leverage. I had a close call with a loan many years ago, so I principally take the position of being a devil’s advocate when they reach out to me. There are plenty of voices encouraging them to lever up to their necks with personal guarantees on companies they have never been on the inside of. So I will tell them why they should consider otherwise. I hope I’ve saved a few people along the way.

If 15-30% of searchers experience stress related to a personal guarantee, it is my opinion that the aggregate upside isn’t worth it. If 100 searchers take such loans, and 15-30 of them end up in dire straits, with some portion of them actually ending up in personal bankruptcy, then I don’t care how well off the ones at the top make out. On aggregate it isn’t worth it. These are usually resourceful, smart people who don’t need to take a PG-sized risk to become successful.

SBA, meet DOGE

Anyway, back to the top of my article. The SBA loans weren’t actually meant to subsidize lower middle market private equity. Taxpayers probably wouldn’t like to learn that they funded MBA’s M&A quests.

It's like raising a $5m PE fund and owning the full upside.

“It’s like raising a $5m PE fund and owning the full upside,” says one person in my network. Yeah, no way taxpayers would like that.

Maybe DOGE will address this.

DOGE aims to slash $1 trillion of federal expenses. What would happen if DOGE removes the SBA 7a loan subsidies?

It would dramatically alter the self-funded search landscape.

The impact on searchers, lenders, and sellers

Let’s walk through the three main constituents: the searchers, the lenders, and the sellers.

The searchers would experience that financing was effectively more expensive. They would not be able to underwrite/finance the worst deals, which wouldn’t be a bad thing. The good deals would still be financeable, but they’d have to give up more of the economics. It would still be worthwhile to pursue the good deals. The upside would still be worth it. Searchers would also become more creative with financing. The deal structure in SBA-oriented deals is highly prescriptive today because there is so much red tape that one has to comply with. More creative financing is a good thing; creativity equals innovation equals value creation. So new ways of financing would be new ways to create value for the various stakeholders in the cap table. As an example, I’m invested in a deal in Europe, where they don’t have SBA financing (yes, imagine that, deals actually happen without SBA too!). The searcher in that case didn’t raise any senior debt and no common equity, but instead found inspiration in the venture world and raised a unitranche layer of convertible debt, where as an investor you’re senior in the cap table (lowest risk), you get a nice interest payment as current income (some cash, some compounding), and then the principal converts into a percentage of the company ownership in the future contingent on milestones. Win-win for both the searcher and the investors. No PG, no conventional debt, complete alignment, current income, fair division of upside.

The lenders would still play a role. They have built a skillset around diligencing SMB loans. They have built pipelines for such deal flow. There is no reason they should cease. But they would have to increase their pricing (higher rates, shorter maturities) and/or raise their underwriting threshold (i.e., the bar for approving a deal). The latter is probably difficult to accomplish in practice since they probably already think all their loans are winners, and there isn’t a black-and-white rank that tells them which, say, 20% of loans they shouldn’t do if taxpayers don’t bail out 75% of the principal in a loss. So pricing would be the more realistic adjustment avenue. And you would then see some convergence in pricing towards where SBICs, mezz, and private credit exist today, which is 200-400 bps higher. You’d probably also see more five-year amortizations, versus the ten-year which applies today, because it is less risky to underwrite nearer term. The higher pricing would, as discussed earlier, force searchers to improve the quality of the deals they bring to the table, so this is positive.

Lastly, sellers would be impacted a great deal. Sellers of mediocre businesses would perhaps not be able to sell at all. They would have to discount significantly or facilitate an ESOP instead. They’d figure it out, but there wouldn’t be an army on BizBuySell suitors. All business owners would probably have to accept a lower valuation and/or more structure. Why? Because the financing is more expensive, so to make the economics work the buyer would need a better entry point.

SBA: a value creator?

Astute observers might argue that lower valuations would generate lower tax proceeds and thus lower revenue for the very same government that funds the high valuations. This is above my pay grade. I believe markets would figure it out, and we would have a world without PG victims and without (unknowing) taxpayer acrimony.

Some readers might argue that the SBA isn’t actually losing money on this program because the fees more than offset the defaults. I don’t know if that’s true. I especially don’t know if that’s true in the searcher category (where I am guessing that default rates are higher). And even if the SBA is marginally profitable (which I highly doubt), then private lenders would probably be more efficient anyway.

Incumbents benefit from change

Regulatory changes tend to favor the incumbents who are skilled and resourceful. Just like Big Tech lobbies for changes/regs as it increases the complexity and barriers of entry, a change in the lower middle market ecosystem would favor those who are already networked and experienced as they can best navigate disruption.