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From Private Sector, A Challenger to SBA


November 7, 2001
Alan Kline,Thomson Financial

For the past 48 years, banks seeking guarantees on small-business loans have had one option: the U.S. Small Business Administration.

But that suddenly changed this year when a small California start-up, in partnership with Kemper Insurance Cos. of Chicago, started selling its own guarantee product to banks and other small-business lenders.

Business-Backers Management Corp. of Solana Beach, near San Diego, began positioning itself in January as a "private-sector alternative" to the SBA. Its goal is not to steal business from the SBA's popular 7a program, said its president, Larry A. Prosi, but to capture the share of the market that is "unserved."

"The SBA does $9 billion to $10 billion a year in its 7a program, and the demand is far greater than that -- perhaps as much as $15 billion, $20 billion, or $25 billion," said Mr. Prosi, a former commercial lender at several San Diego-area banks.

Though Business-Backers has made only a handful of deals, it appears to be getting its product on the market at the right time. President Bush -- an opponent of corporate subsidies -- has proposed cutting the SBA's 2002 budget by 40% and specifically eliminating 7a subsidies so that the loan guarantees would be entirely self-funded by premiums.

Modeled after the 7a program, Business-Backers' "collateral value protection insurance" guarantees up to 75% of a small-business loan, to a maximum of $500,000. (Most 7a loans are guaranteed up to 75%, with a maximum of $1 million.) Kemper, through its KEMPES Inc. subsidiary, writes a policy to cover a lender's losses if a borrower defaults. For that protection, a lender pays an average policy premium of 3%. The similarities to the 7a program are not coincidental, said Business-Backers chief executive officer Steven J. Appel.

He explained that any new guarantee product must mirror one offered by the SBA if it is to catch on and, until the SBA revised its policies a few years ago, the private sector had little incentive to compete.

The SBA once guaranteed up to 90% of a small-business loan, so lenders were only on the hook for 10% if a borrower defaulted. The result: Banks were less careful with the underwriting, which led to high default rates. But the SBA has been gradually lowering the guarantee levels since the mid-1990s. Now lenders are employing stricter underwriting guidelines, which has led to fewer defaults.

"As the SBA has become more like a business in the last five to seven years, it has created more of an opportunity for the private sector to come into the picture," Mr. Prosi said. "Someone could have done this five years ago, but they wouldn't have made any money at it."

Of course, profits are still a ways off for Business-Backers, too. Though some 30 banks have agreed in principle to work with it, including $50 billion-asset LaSalle National Bank in Chicago and $70 billion-asset PNC in Pittsburgh, only four are using its loan guarantees. The SBA, by comparison, guaranteed nearly 44,000 of its 7a loans last year.

Indeed, Mr. Appel and Mr. Prosi can attest that building an alternative to the venerable SBA was no easy feat. The two have been at it for five years, working to find investors, compile loan-loss data, and develop the business plan.

In 1999, Business-Backers' first insurance partner, Reliance Group Holdings of New York, ran into financial troubles and backed out of its commitment -- a week before the product's scheduled rollout. In late 2000 its deal with a second insurer, ACA Financial Guaranty Corp., also of New York, was terminated after Business-Backers concluded that ACA didn't have enough name recognition to attract lenders.

And amid that turmoil, Business-Backers' co-founder and progenitor, California lawyer Morton Rible, died.

"We've had a number of stops and starts," said Mr. Appel, a former consultant with Arthur Andersen LLP who, like Mr. Prosi, joined the company when it was founded in 1996.

Bill Mecklenburg, senior vice president at KEMPES, in Scottsdale,
Ariz., said his company was sold on the partnership after viewing Business-Backers' loan-loss data. Using a database of SBA transactions, Business-Backers was able to determine which industries are riskiest to lend to, and as a result, opted to steer clear of loans involving crop financing, start-up businesses, or single-location eateries.

"They've made it so there is a high degree of predictability" with the loans KEMPES insures, Mr. Mecklenburg said.

He added that Business-Backers is under fewer restrictions than the SBA. For example, the SBA is prohibited from guaranteeing loans that refinance existing debt. It also cannot back loans for a minority owner in a business to buy out a majority owner. Business-Backers, on the other hand, is eagerly pursuing such deals.

"These are needs in the small-business marketplace that the SBA wasn't fulfilling," Mr. Mecklenburg said.

Thomas J. Doherty, senior vice president for business banking at LaSalle, agreed. Though the bank remains an active SBA lender, it signed its deal with Business-Backers in May mainly so it could use its guarantees on refinancing deals.

"It's just one more thing we can offer to our customers," he said.

For now, Business-Backers is primarily targeting 7a participants. Mr. Appel said the best way to get the program off the ground is to work with lenders who are already comfortable using loan guarantees. "When you go to someone who isn't using the product at all, you're asking them to change their culture internally and to use a new product," he said. "Those are two pretty big hurdles for banks to clear."

But the company is courting other lenders as well. Mr. Appel pointed out that only 4% of commercial banks are SBA preferred lenders, which means that 96% either do not work with the SBA or do so for only a handful of deals a year.

One institution sold on Business-Backers' guarantees is $1 billion-asset State Financial Bank in Milwaukee. An active small-business lender, State Financial rarely seeks 7a guarantees from the SBA, "because the approval process can take anywhere from three to six weeks," said president John Beckwith. It felt that Business-Backers "would be potentially easier to work with and that the turnaround would be quicker."

He was not disappointed. Business-Backers approved the bank's application for a loan guarantee in two days.

Business-Backers is getting the word out mainly through its 10-person sales team, which has a combined 125 years of banking experience. (The only employees who are not former bankers are Mr. Appel and senior vice president Michael S. Hearne, a former director of finance at the SBA.)

The company is also marketing to community banks through bankers'
banks; in April it set up a booth at the annual convention of the National Association of Government Guaranteed Lenders.

Nevertheless, Business-Backers has other hurdles to clear before it can
declare itself a legitimate competitor to the SBA.

For example, SBA loans are actively sold on the secondary market, and at the moment no such market exists for Business-Backers' loans. Also, because SBA loans are backed by the "full faith and credit" of the U.S. government, banks' capital requirements against those loans are lower.

"No private enterprise could ever compete with that," Mr. Prosi said.

One banker voiced concern about how regulators would perceive loans guaranteed by an entity other than the SBA. Bob Ostertag, senior vice president at $750 million-asset Colorado Business Bank in Denver, said some national banks might be skittish about partnering with Business-Backers, because the Office of the Comptroller of the Currency has not commented on how it might treat these loans during examinations. "It would be nice if the OCC blessed this," he said.

Others downplayed such fears. Richard Fulkerson, Colorado's banking commissioner, said that though regulators cannot "endorse" a product, he would not have any supervisory objections to loans guaranteed by Business-Backers. "We're open to any new product that would enhance the creditworthiness and asset quality of banks," he said.

LaSalle's Mr. Doherty added that the Kemper name should be enough to satisfy most regulators.

"It's not a difficult program to understand," he said. "You have to take into consideration the insurance company that's backing this and the quality you're dealing with."

Source: Copyright 2001 Thomson Financial. All Rights Reserved.

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