The Case for Investing in SBICs

River City Bank (RCB) has been one of California’s premier financial institutions since 1973. Although its roots are in consumer banking, over the years, RCB has evolved into a boutique commercial bank. Today, it caters to successful mid-size commercial and real estate companies across California and the Western United States that have revenues of between $10 million and $250 million. With $3.5 billion in deposits and $4 billion in assets under management, RCB has grown by five fold since 2008 and now ranks among the top 5 percent of banks in the country in terms of asset size.

We recently sat down with RCB’s President and CEO, Steve Fleming, to ask about the bank’s investment strategy and how Small Business Investment Companies (SBICs) fit into it.

How would you describe RCB’s investment strategy and asset allocation? Is that typical for banks of your size?

Like all banks, we’re heavily regulated. In our case that’s by both the FDIC and the state of California. That restricts the types of investments we can make because, for the most part, regulators only allow us to invest in highly conservative asset classes like US treasuries, government agencies, mortgage-backed securities, and investment-grade corporate and municipal bonds. While banks of our size may differ in terms of their allocations to those types of assets, their portfolios all look fairly similar because they’re all designed to minimize credit risk and maximize liquidity.

As you noted, those are pretty conservative asset classes. What, if anything, can you do to potentially improve returns?

In addition to the investments I mentioned, there’s a carve out that allows banks to allocate a small portion of their investment portfolio to alternative investments via SBICs. For us, it’s been a great way to gain exposure to private equity and venture capital as limited partners in a few funds.

Is it common for banks to invest in SBICs?

Yes, absolutely. I don’t know the exact numbers, but I’d guess that about half of banks do. Certainly the larger more sophisticated ones either already are or should be. Given the benefits, it’s a pretty compelling value proposition.

And what are those benefits?

The most compelling benefit is that they have the potential to generate a higher return than we can get from the other more conservative asset classes we’re allowed to invest in. Having exposure to venture capital and private equity also helps to further diversify our portfolio, which is always desirable. And, it’s a way to earn credit towards our obligations under the Community Reinvestment Act (CRA).

‍Are there any other benefits?

Another nice benefit is the opportunity to provide banking services to some of the SBIC portfolio companies. We’ve developed a fair number of new commercial banking relationships thanks to those referrals. It’s not why we invest, but it’s certainly a perk.

Do you have any advice about how to select an SBIC and how other bank executives should approach their boards about it?

Anytime you’re considering a new potential investment, you have to look at whether it has the likelihood of creating value for your shareholders via an attractive risk-adjusted return. Do your homework and understand exactly what risks you are taking so that you can convey all of that to your board. Make sure that you can absorb a loss of principal because, while not probable, it is a possible outcome. Also, recognize that you are making a long term investment which is relatively illiquid.

I think it’s also important to take your time to find the right general partner - not all venture capital and private equity funds are created equally. You’ll want to understand the types of companies they’ll be investing in, where those companies are located, and what their track record looks like. You should also ask about the potential new client opportunities that will get referred to you and what other bank investors are saying about working with them.