Historically, SME debt financing has almost no representation in the fixed income allocations of pension funds. There is a reason. Most of it consists of very modest, short-term loans that may suit the deposit-taking financial institution, but not necessarily the more cautious and cost-sensitive institutional investor.
Some American market analysts have argued that pension funds possess a natural affinity for private debt placements beginning at around $10 million (US $) and involving medium-sized borrowers. Recently, the Federal Reserve System estimated the volume of such debt issues to be about two-thirds of that in the public corporate bond market and such debt outstanding to stand at more than half of total bank loans. While life insurance companies have been responsible for over 80 percent of this activity in the past, their supply role has diminished, precipitating a "credit crunch" in the American middle market in the early 1990s. The Federal Reserve noted that pension funds were in the best position to fill the gap.
A few state-based pension funds, such as the $54 billion (US$) State of Wisconsin Investment Board (SWIB), have done so. In 1998, SWIB led all other American pension funds in asset allocations to private debt placements, followed closely by Retirement Systems of Alabama. One aspect of SWIB's program is a $300 million direct lending mechanism developed over several decades through an in-house account management unit of skilled credit analysis and monitoring personnel. SWIB generally makes fixed-rate, intermediate and long-term loans to established, medium- sized firms in manufacturing, retail and service industries in the state. Loan sizes average $10 million, but may be as low as $3 million. The balance of SWIB's nearly $3 billion in debt financing is conducted through various other means, including sale-and-leaseback arrangements, asset-based financing and non-residential mortgages.
SWIB puts an additional $300 million into 130 Wisconsin banks and thrifts through purchases of certificates of deposit (CDs). Under this model, lending institutions can acquire from the pension fund a maximum of $10 million for periods of months and up to three years. By way of these fully-insured CDs, SWIB indirectly capitalizes loans that will, in some instances, be extended to local small business, while leaving management-intensive creditor tasks to specialists. CD purchases are practiced by pension funds in some other states, such as Pennsylvania, in some cases with the qualification that lender criteria be explicitly linked to SME borrowers.
Subordinated debt is one of the primary financial instruments deployed by the $127 million (US $) Texas Growth Fund (TGF), capitalized in two pools by three public sector pension plans, including the Teacher Retirement System of Texas. With a preference for co-investment situations, the TGF targets state-based, medium-sized enterprises in deals ranging from $2-6 million in size. The mid-1998 portfolio, valued at $67 million, is comprised of thirty investee firms, mostly situated in traditional manufacturing industries. TGF got its start in 1988 with statutory endorsement by the Texas government.
Sources: US Federal Reserve System, The Economics of the Private Placement Market, 1993; Texas Growth Fund, Brochures, 1998; SWIB, Brochures, 1998; CLMPC interviews
Mezzanine financing is vital for many reasons. Sometimes, it serves as the step following a growth- oriented firm's venture phase and expedites, or substitutes for, public offering. As debt, it may appeal to middle market clients preferring not to dilute existing ownership. It is based on contracts and covenants similar to those of term loans, but that are more flexibly customized to borrower specifications. Subordinated debt can be an adjunct to a financing solution or operate in purer form. As the latter, it is an adaptable and cost- effective alternative to equity.