Investing in Qualified Opportunity Funds (QOFs)

SBIA Comment Letter to:
U.S. Department of the Treasury
Internal Revenue Service
July 1, 2019

Investing in Qualified Opportunity Funds (QOFs)

On behalf of its membership, the Small Business Investor Alliance (“SBIA”) is pleased to submit comments in response to the second round of proposed rulemaking under new Section 1400Z-2 of the Internal Revenue Code regarding qualified opportunity funds (“QOFs”).1 The SBIA is the national organization that represents small business private equity funds and their investors, including Small Business Investment Companies (“SBICs”) and banks that invest in them.

The statutory purpose underpinning the proposed QOF regulations is to encourage sustained economic growth and investment in designated distressed communities (“Opportunity Zones” or “OZs”) by providing federal tax benefits to taxpayers who invest new capital in businesses (“qualified opportunity zone business” or “QOZB”) located within those OZs through a QOF.

SBIA’s members are a natural constituency for the OZ program because they are privately-owned and managed investment funds that invest exclusively in domestic small business. Market uptake among this group in the OZ program during its first year of operation, however, has not been as robust compared to QOFs formed for real estate investments. SBIA believes this is more likely a function of the regulatory structure and operational focus for QOFs that trends toward real estate opportunities.

Rather than crafting complex and targeted recommendations to amend the regulatory structure for QOFs, SBIA instead offers a straight-forward suggestion. Leverage the U.S. Small Business Administration’s (SBA) long-standing SBIC program, created explicitly for small business investing, to complement QOFs and deliver on the legislative purpose for the OZ program to infuse capital investment in small businesses located in underserved areas.

If the goal of Opportunity Zones is to bring prosperity and economic opportunity to parts of America that lack both, then there is no better example of the type of investments that the QOFs seek to make than the mission-driven, job-creating small business investments made by SBIC funds.
SBIA presents the following framework for consideration.

SBIC Background

The 60-year-old SBIC program is a market-driven platform that serves an important public purpose of facilitating private investment into domestic small businesses.2 Congress declared generally in authorizing legislation that the SBIC program would “stimulate and supplement the flow of private equity capital and long-term loan funds which small business concerns need for the sound financing of their business operations” while also stimulating the national economy and job growth.3

Halfway through the 2019 federal fiscal year, the SBIC program included more than 300 licensed funds, representing approximately $30 billion in small business investment capital.4 Companies that in their early stages received SBIC investments and have subsequently grown into icons of American industry include Federal Express, Apple, Intel, and Callaway Golf. Many more small businesses backed by SBICs have grown from “mom-and-pop” shops into robust, sustainable mid-sized businesses that bring prosperity and employment to communities across the country.

SBICs are privately-owned and managed investment funds that invest exclusively in domestic small business. SBICs invest private capital enhanced by access to an SBA-backed credit facility using the Federal Home Loan Bank system. This permits individual SBICs to multiply paid-in capital up to three-times or $175 million, whichever is less, while the maximum leverage for an SBIC family of funds is currently $350 million. This public-private partnership structure where private capital leads and the SBA-leverage follows provides SBICs a deeper capital pool from which to make equity and debt investments in qualifying small businesses.
These investments are in real companies with real staying power and real growth potential.

SBICs, structured as corporations, limited partnerships, or limited liability companies, provide long-term loans, debt-equity investments, and management assistance to small businesses across a range of sectors, geographic locations, and stages of growth. Some SBICs specialize in an industry sector while others invest more broadly. There are various forms of SBICs:

  • Leveraged SBICs increase the amount of capital available for domestic small business investing by accessing the SBIC credit facility. The leverage is at the fund level.
  • Non-leveraged SBICs typically include bank-owned SBIC funds or SBIC funds that primarily have banks as their limited partners. These SBIC funds do not seek or receive SBA leverage.

A recent independent study prepared for the Library of Congress found that SBIC-backed small businesses created almost three million new jobs and supported an additional 6.5 million jobs over the 20-year period of their study.5 Every one of those jobs created by each of those small businesses was a gain to the communities where they are located and to the broader regions from where they drew employees and to whom they provided goods and services.

Those documented SBIC results are exactly the types of benefits envisioned by Congress in its OZ program.

A Proposed Framework for Opportunity SBICs

Since its inception, the SBIC program has included various classes of SBICs including early-stage, energy, impact investment and low-and moderate income (“LMI”). An LMI Zone is a low and moderate-income geographic area that meets one of several federal definitions for targeted underserved areas because of economic or employment challenges. By the end of the first quarter of 2019, approximately 20 percent of SBIC investments were in small businesses located in LMI areas.6

SBIA invites the White House Opportunity and Revitalization Council (“WH Council”) to recommend that the SBA amend its existing regulations and include designated Opportunity Zones within the definition of an “LMI Zone” eligible for SBICs to make investments of debt and equity capital.7

Upon such designation, interested fund managers including current SBIC licensees could structure investment strategies and begin the licensing process to stand up this new class: Opportunity SBICs (“OSBICs”).

This action aligns with the implementation plan for the WH Council because that plan calls for the integration of OZs “into existing federal programs.”8 It also allows the OZ initiative to expand capital access more rapidly to QOZBs by leveraging the proven infrastructure of an existing federal program to evaluate, qualify, and monitor OSBICs and their investment strategies.

i. Structuring Funds
  • Funds would apply for designation under the existing SBIC licensing process, with OSBIC designation available to new and current funds either fully or as a component of a traditional SBIC.
  • OSBICs would decide whether to operate with or without federal leverage. Levered funds could include both debt-focused and equity-focused funds. For levered funds, however, SBA generally will not approve strategies that restrict investments in small businesses to a single state or other limited geographic area because this can increase risk and limit a fund’s flexibility to achieve satisfactory fund performance.9 The “substantially all” test found in draft OZ regulations that permits up to 30 percent of the tangible property of a trade or business to be located outside a designated OZ may require modification because OSBICs would need to comply with this prohibition against geographic limits on investments. This is an important material distinction between investment strategies in real estate versus small businesses.10
  • Unlevered funds could include both bank-owned and traditional fund structures with multiple limited partners. SBIA encourages federal bank regulators, subject to prior negotiations, to extend additional CRA credit to a bank-owned fund that stands up an OSBIC to incent participation beyond any presumptive credit earned for SBIC investments generally.
  • OSBICs, like any leveraged SBICs, must be able to use debt as part of their OZ investment strategy because debt capital is often cheaper and safer than equity which may be lost if an investment fails. The net benefits from expanding financing authority for QOFs including OSBICs to make loans to QOZBs and use debt instruments like warrants, which if treated as exercised and therefore considered an eligible equity investment, could help accelerate OZ success stories.
  • The proposed regulations are silent about the express use of debt as a QOF investment strategy, but they distinguish between debt and equity investments by taxpayers who, as investors, seek to qualify for favorable capital gains treatment. The proposed regulations stipulate that a taxpayer’s investment into a QOF must be an equity interest and not a debt instrument within the meaning of 26 I.R.C. 1275(a)(1).11 This distinction is further supported because “Congress tied [favorable capital gains treatment] to the longevity of an investor’s stake in a QOF, not (emphasis added) to a QOF’s stake in any specific portfolio investment,” which, we argue by inference, means the QOF’s underlying financial strategy should be decoupled from any prohibition against investors using debt to qualify for favorable capital gains treatment.12
ii. Investment Criteria
  • OSBICs, like all SBICs, may invest using debt, equity, or debt with equity features.
  • SBICs must invest in “small businesses” defined either as (i) those with less than $19.5 million in tangible net worth and average net income for the preceding two years of less than $6.5 million, or (ii) those qualifying as “small” under SBA’s NAICS Industry Code standards tied to annual sales or number of employees.
  • SBICs may invest in businesses located in the United States or its territories but may not invest in those businesses with more than 49 percent of their employees located outside the U.S. or its territories. SBICs may hold an ownership stake in a small business for the fund’s duration but may only control the business for up to seven years, or longer subject to SBA approval. SBICs may not invest more than 10 percent of its total fund in any single small business.
  • SBICs may not invest in project finance, passive businesses, real estate, financial intermediaries, or foreign companies. Additionally, SBA may prohibit SBIC investment in small businesses deemed against the public interest.
  • Equity-focused OSBIC funds would be able to tap the discounted (or “deferred interest”) debenture structure used for LMI investments. Those debentures are issued at a discount to face value for ten or five-year terms. No interest is due on the first five years of debentures. For example, if the interest rate is four percent on a 10-year debenture, the SBIC would receive $80,000 in proceeds for issuing a $100,000 debenture, with interest payable semi-annually after the end of the fifth year. The $20,000 is available to cover payments during the initial investment period in a qualifying QOZB because those businesses may not yet be profitable.
iii. Potential Tax Benefits to Investors
  • SBIA acknowledges that extending the current capital gains tax benefit under the OZ program to OSBICs investors poses budget scoring questions that SBIA is unable to answer at present.
  • Like QOF investments, only OSBIC investments made within an OZ would qualify for any federal tax benefits.
  • Budget scoring uncertainties, however, should not delay the proposed regulatory designation because the benefits of the current SBIC program would extend to licensed OSBICs. The primary benefit is access to low-cost capital through the $4 billion in annual authorized federal leverage.
  • Going forward subject to federal budget scoring analysis, the extension of tax incentives to OSBIC investors could include the current OZ capital gains tax treatment, or extending to them the current partial federal exclusion on capital gains from certain qualifying small business stocks held for more than five years (“Small Business Stock Gains Exclusion”).13
  • Separate from any leverage commitment to OSBICs under the current $4 billion annual authorization ceiling, SBIA recommends caps on individual private capital commitments into OSBICs to limit potential annual lost federal revenue because of subsequent preferred tax treatment.


SBIA appreciates the opportunity to present these comments. We also applaud the tremendous work of the Economic Innovation Group’s Opportunity Zones Coalition that has submitted comprehensive recommendations to help improve the OZ program.

SBIA looks forward to collaborating with the Department and all stakeholders to update applicable regulations for the OZ program to ensure America’s small businesses and the communities served have access to the capital they need.

About the Small Business Investor Alliance (SBIA)

The Small Business Investor Alliance (SBIA) is the premier organization of lower middle market private equity funds and investors. SBIA works on behalf of its members as a tireless advocate for policies that promote competitive markets and robust domestic investment for growing small businesses. SBIA has been playing a pivotal role in promoting the growth and vitality of the private equity industry for over 50 years. For more information, visit or call (202) 628-5055.

1 26 U.S.C. 1400Z-2 (2017).
2 The U.S. Department of Agriculture operates a similar program for rural economic development. The Rural Business Investment Company (“RBIC”) Program is a developmental venture capital program for the purpose of promoting economic development and the creation of wealth and job opportunities in non-metropolitan areas and among residents living in those areas. Like the SBA, the USDA selects and licenses RBIC applicants that will agree to address the unmet equity capital needs of small enterprises primarily located in rural areas. 7 U.S.C. 1989 and 2009cc et seq. (2017).
3 Small Business Investment Act of 1958, Pub. L. 85-699 (Aug. 21, 1958). 15 U.S.C. 661.
4 SBIC Program Overview, U.S. Small Business Administration (March 31, 2019).
5 Paglia and Robinson, Measuring the Role of the SBIC Program in Small Business Job Creation, Report for the Library of Congress, at 4 (January 2017) <>.
6 SBIC Program Overview at 2, U.S. Small Business Administration (March 31, 2019). (The percentage share jumps to 25 percent when including SBIC investments in women, minority, or veteran-owned small businesses.)
7 13 C.F.R. 107.50
8 Implementation Plan for the White House Opportunity and Revitalization Council at 11 (April 2019).
9 SBA, SOP 1004-01 Processing Applications for SBIC Licenses at 41 (Aug. 6, 2014).
10 Prop. Treas. Reg. §1.1400Z-2(d)-1(d)(3).
11 83 Fed R. 54280 (“C. Investments in a QOF”) (Oct. 29, 2018).
12 84 Fed. R. 18660 (“B. QOF Reinvestment Rule”) (May 1, 2019).
13 26 U.S.C. §1202. Another potential incentive for evaluation may be to exclude from an investor’s income the interest earned on the debt portion of an OSBIC’s portfolio earnings because like municipal and qualified private activity bonds these investments, too, serve a public purpose. 26 U.S.C. §103.


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