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Part III: Opportunities and Industry Response

In response to the increasingly challenging environment CDLFs and CDVCs face in raising subsidized capital, they have turned toward finding ways to reduce their ongoing reliance on such capital by becoming more sustainable. For many organizations, sustainability is associated with growing their size. While some small CDLFs and CDVCs can survive because of ongoing local subsidies, overall it is difficult to cover operating expenses with a small capital base. To grow their size, CDLFs and CDVCs are exploring new sources of subsidized capital, such as state-level initiatives. They also are identifying ways to access new sources of capital – pension funds and individual investors – that historically have not been significant for community development finance. Finally, CDLFs and CDVCs are rethinking the way they do business and repositioning themselves to become more sustainable by cutting costs and by finding ways to utilize market-rate capital and access traditional capital markets to fund operations.

State and Local Governments

Although economic conditions in the states are uneven, they generally offer a more receptive policy environment than the current federal level. Community organizations also have a track record of successfully lobbying for state-level CDFI Funds, CRAs, and tax credits designed to encourage community economic development. The power of state-level initiatives is best illustrated by California, where public- sector activity over the last decade encouraged creation of innovative sources of capital to fund community development:

• Insurance industry-funded Community Organized Investment Network (COIN), which both certifies and funds state-level CDFIs.

• Twenty percent tax credit for qualified deposits of $50,000 or more in CDFIs.

• Double bottom line: Investing in California's Emerging Markets initiative, launched in 2000 by State Treasurer Philip Angelides "to direct investment capital – through state programs and the State's pension and investment funds – to spur economic growth in those California communities left behind during the economic expansion of the past decade” (Angelides 2001,2). The initiative led two of California's largest public pension funds, the California Public Employees' Retirement System (CalPERS) and the California State Teachers' Retirement System (CalSTRS), to make substantial investments in real estate and businesses located in the state's poorest communities.

Pension Funds

Historically, most pension-fund assets have been conservatively invested in fixed income, public equities, and real estate. In the last few decades, pension funds have expanded to include "alternative” investments such as venture capital. Pension funds now account for over 50 percent of all venture capital (National Venture Capital Association 2006).

Some pension funds also have incorporated economically targeted investments (ETIs) into their portfolios, which have both financial and social objectives. To date, most of the pension-fund ETI investments have been in fixed income and real estate. The real estate focus has created an opportunity for some CDLFs to access this capital if they can provide the scale and rate of return that pension funds require.

Pension funds generally have been reluctant to make private-equity ETI investments because of the greater risk involved. Only a few of the most innovative pension funds have expanded their ETI investments to include private equity, including several investments into CDVC funds. While pension investments in CDVCs are still the exception, they are likely to increase if the CDVC funds can demonstrate an appropriate risk-adjusted rate of return and an ability to absorb larger investments.

Individual Investors

Individuals have been a source of capital for community development finance from the field's beginnings. At present, community development banks and credit unions rely on individual investments for approximately three-quarters of their capital (CDFI Data Project 2007). Much of this capital is in the form of government-insured certificates of deposit (Phillips 2006). For nondepository CDFIs, however, socially responsible investors make up a fairly small percentage of all capital sources. In 2005, for example, CDLFs received only 3 percent of their investment capital from individuals (CDFI Data Project 2007). Although there is anecdotal evidence that some CDVC funds recently have been able to attract larger investments from individuals, they accounted for only 6 percent of all CDVC investments as of 2000, the last year for which these data are available for the entire industry.

Individuals can invest in specific CDFIs directly via an equity investment in a CDVC or a loan to a CDLF. Individuals also can invest in CDFIs via intermediaries, such as the Calvert Foundation, which aggregate the capital and provide due diligence on different CDFIs. Some CDFI trade associations also serve as investment intermediaries for both large and small individual investors. The Community Development Venture Capital Alliance (CDVCA), for example, has a fund that accepts individual loans of as little as $10,000 for a period of ten years.

CDLFs and CDVCs face a number of challenges in attracting individual investors, including an inability to offer insured deposits, a diversity of difficult-to- explain products, and investor perception that community investments are higher risk. Nevertheless, a growing number of CDLFs and CDVCs are trying to access this potential source of investment capital.

Accessing Market-Rate Capital: Securitization and Structured Financings

Given the decreasing availability of subsidized capital, energy is being focused on market-rate capital and the traditional capital markets. Two possibilities that have proven effective for CDLFs are the use of structured financings and securitization. Structured financings enable certain assets with more or less predictable cash flows to be isolated from the originator and used to mitigate risks and thus secure a credit (Hew 2006). Securitization consists of aggregating loans with similar characteristics and selling them to investors.

Selling loans to free up capital is not a new concept for CDLFs. Historically, however, they have sold their loans to a limited group of socially motivated investors. Despite their historically low loss rates, CDLFs have had to discount these loans in order to overcome the perception that they are lower performing than conventional loans.

To make their loans a viable option for the much larger number of institutional investors, CDLFs had to demonstrate to such investors that their loans performed comparably to those made by conventional financial institutions and to offer a product that was at a scale of $50 million and above, which is the size necessary to make a public placement cost efficient (Dunlap, Okagaki, and Seidman 2006). The solution was to combine loans from multiple organizations and to have them rated by a Wall Street rating agency, making the investment attractive to mutual funds, insurance companies, and pension funds.

A number of loan pools were created between 1999 and 2006, demonstrating that the traditional capital markets can bring new investors. There still are obstacles, however, to making this an ongoing source of capital for CDLFs. These barriers include a lack of standardization in loan-performance data, documentation, and underwriting procedures; a lack of infrastructure to support these transactions; a lack of models for forecasting future borrower demand for community development loans; a lack of capacity among some community development lenders; and the belief on the part of many lenders that loans wifi be discounted in the securitization process (Stanton 2003; GAO 2003). A number of initiatives are under way to overcome the remaining barriers and make securitization a viable, ongoing way for CDLFs to access market-rate capital.

Repositioning and Rethinking

In addition to identifying innovative ways to attract capital to make growth possible, CDLFs and CDVCs are rethinking their business models in order to become more sustainable and less reliant on subsidized capital. Toward that end, many of them have undertaken strategic planning processes to determine how to reach this objective (Dunlap, Okagaki, and Seidman 2006). For CDLFs, the resulting innovations included the following:

• Forming partnerships, networks, and mergers to increase impact and cut costs.

• Identifying and focusing on the most lucrative and socially meaningful activities, while outsourcing others, such as loan processing and back-office operations, in order to cut expenses.

• Increasing their levels of off-balance-sheet transactions in which CDLFs invest funds for other organizations in exchange for origination and servicing fees.

• Diversifying their base of borrowers and mix of products.

CDVCs also are considering alternatives to enable them to access new sources of capital. However, the industry is divided on how to proceed. Many current and potential investors associate CDVCs with smaller capitalization levels, tightly drawn geographic target areas, small deals, and low financial returns. Those CDVC funds that have moved away from this model want to reframe the industry to change perceptions and make it possible to raise more capital. They point to other socially oriented venture capital that CDVCs could incorporate – minority- and female-focused funds or funds that invest in clean technology. While having both social and financial objectives, these venture funds market themselves as able to deliver competitive financial returns and have attracted billions of dollars from traditional investors.

Other CDVC managers advocate that the industry include funds that make double bottom line equity investments in real estate, such as the Urban America and Genesis funds, which have raised hundreds of millions of dollars. Others suggest that CDVCs reposition themselves to fill the void of equity investments of under $5 million in geographies not served by traditional venture capital, arguing this could become attractive as the number of SBIC funds making equity investments shrinks in response to the elimination of SBA leverage for participating security SBICs. While individual funds have pursued these ideas, the industry has yet to embrace them.

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