I: CDLF and CDVC Structures and Current Activities
Community Development Loan Funds
CDLFs lend capital to businesses, for-profit and nonprofit real estate and housing developers, nonprofit organizations looking for facility or operating capital, and increasingly individuals looking for financing to purchase or rehab homes. Most organizations and people financed by CDLFs are not able to obtain capital from more traditional sources or cannot obtain it on terms they can afford.
As of2005, there were about five hundred CDLFs in the United States, with more than $3.5 billion in assets. CDLFs financed more than $2.6 billion of activities that year, with more than $2.3 billion in additional financings outstanding. These figures are somewhat misleading, however, as a few large organizations accounted for most of this activity. The five largest CDLFs, for example, accounted for 52 percent of total loan fund capital and 58 percent of all direct financing outstanding. The top twenty CDLFs held 77 percent of all capital and were responsible for 79 percent of all financing outstanding. Most CDLFs are small, with median capital of $8.9 million as of 2005 (CDFI Data Project 2007).
The CDLF model emerged from a variety of origins, including efforts in the late 1960s and 1970s, by a few community development corporations and a group of revolving loan funds, to make loans to businesses to promote economic development (Grossman, Levere, and Marcoux 1998; Rubin 1998). In addition to business lending, many of the early CDLFs focused on financing construction of low-income housing in response to the lack of alternative sources of capital.
Although housing and business loans still make up the bulk of CDLF financing, accounting for 66 percent and 17 percent of all CDLF dollars outstanding, many CDLFs have diversified their offerings, providing operating and facility construction loans to nonprofits – including charter schools, childcare centers, healthcare facilities, social services agencies, and arts organizations (CDFI Data Project 2007). As with their business and housing finance activities, CDLFs began providing capital to nonprofits because more traditional capital sources viewed the nonprofits' revenue streams as too unpredictable to make them good credit risks. The newest area of CDLF activity is home loans to individuals. As of2005, twenty-two CDLFs reported providing housing loans directly to individuals, a growing trend (CDFI Data Project 2007).
CDLFs, which are legally nonprofits, rely on loans and grants to capitalize their activities. Loans, mostly below market rate, accounted for 68 percent of all CDLF capital under management as of 2005. They were provided by banks and thrifts (49.6 percent); foundations (16.3 percent); federal (9.5 percent), state, and local (4.6 percent) governments; religious institutions (6.4 percent); nondepository financial institutions such as pension funds (4.0 percent); individual investors (2.9 percent); national intermediaries such as Opportunity Finance Network (2.5 percent); and corporations (2.5 percent). CDLFs relend loans and grants at market or near-mar- ket rates, using the spread – or difference – to help finance their operations. Most
CDLFs also must find ongoing subsidies to pay for technical assistance (TA) they provide to borrowers, high-cost predevelopment and microloans, and other aspects of their operations that the spread on lending does not cover.
CDLFs lend independently and in conjunction with conventional lenders. When lending in partnership with more conventional institutions, CDLFs generally take a subordinate position, absorbing most or all of the risk. Because most CDLF loans are riskier than those made by banks, and at times unsecured, CDLFs also provide extensive pre- and postinvestment TA to their portfolio companies. TA is used both to help potential borrowers qualify for capital and to assist them with various aspects of operations after they have received that capital. TA includes help with writing business plans, creating marketing strategies, and developing financial systems.
An aspect of CDLF activity that has received little attention is the role they play in demonstrating financial viability of low-income communities to traditional financial institutions. In the area of small business lending, for example, both through successful solo lending and by taking the higher risk portions of joint deals, CDLFs have encouraged banks to lend to small business customers located in low-income markets, a group banks previously had rejected (Rubin and Stankiewicz 2001).
In the area of multifamily housing, CDLFs have helped bring banks into multifamily projects and demonstrated that such deals could be successfully and profitably underwritten. CDLFs also have helped banks understand how to lend within those communities. Banks now consider lending to multifamily development projects reasonably safe because of the underlying physical collateral; presence of subordinate, risk-alleviating financing such as CDLF loans, Low-Income Housing Tax Credit equity, and public loans; and extensive organizational and project-based counseling and TA that the CDLFs provide to the borrowers (Zielenbach 2006). As a result, conventional financial institutions have become much more involved in projects that previously were financed primarily or exclusively by CDLFs. Construction and permanent financing now comes frequently from banks and less often from CDLFs. In certain markets, CDLFs and their bank supporters compete for the same multifamily loans.
As banks have moved into markets once served entirely by CDLFs, the latter have had to take on increasingly risky investments (Rubin and Stankiewicz 2001). In real estate finance, for example, as conventional lenders have become more willing to take on more of a project's financing costs, CDLFs have often been pushed further into making early-stage, higher-risk loans. This heightened risk position, coupled with a lower interest rate spread associated with higher interest rates, has caused many multifamily CDLF lenders to revisit their loan pricing so as to make it closer to market cost. CDLFs are less willing and able to offer deeply discounted monies and more willing to provide market-rate financing, particularly if their dollars are effectively the only ones available for seed/gap capital (Zielenbach 2006).
Community Development Venture Capital Funds
CDVC providers make investments of equity and near-equity in small businesses. An equity investment consists of cash a company receives in exchange for partial ownership of that company in the form of preferred or common stock. A nearequity investment consists of a loan with special features – warrants, royalties, or participation payments – which enable the lender to participate in the upside if the company receiving the capital is successful. Both equity and near-equity are forms of patient capital, giving young firms funds needed in early years without requiring immediate repayment of those funds, as is the case with most loans.
The earliest CDVC providers were Title VII community development corporations, which, in the early 1970s, began making equity investments in businesses as part of their economic development work. Other CDVC funds were begun by individual states, intending to stimulate business growth in low-income areas, and by CDLFs, which expanded into equity provision to meet needs of their debt clients (Rubin 2001).
There were more than sixty CDVC providers either active or in formation as of the end of 2006, with about $1 billion under management (Rubin 2007). This is a substantive increase from the six providers with less than $100 million under management that existed just a decade earlier (Rubin 2001). This dramatic growth reflects the overall growth of CDFIs during this time, due in large part to the Clinton administration's active support of the industry. In the case of CDVCs, growth also reflects the overall positive perception of venture capital during the late 1990s, as traditional venture capitalists made record-breaking profits for their investors via a strong economy and an unprecedented public appetite for initial public offerings.
CDVCs differ from traditional private venture capital funds and small business investment companies (SBICs). Most importantly, unlike the majority of traditional venture capitalists and SBICs, which have an exclusively financial returns objective, CDVCs invest with both social and financial goals. Thus, they consider a company's potential for significant high-quality job creation for low-income individuals, as well as its likelihood of rapid economic growth, before making an investment. As a result of this dual bottom line, CDVCs are willing to invest in companies in numerous industries, stages of development, and locations, setting them apart from traditional venture capitalists, which tend to specialize by industry and stage and to invest almost exclusively in a handful of domestic technology corridors, such as California's Silicon Valley and the Boston area's Route 128.
The earliest CDVCs also differed in their legal structures. Unlike traditional venture capital funds, which are for-profit and usually structured as either limited liability companies (LLCs) or limited partnerships (LPs), the early CDVC providers utilized a multitude of nonprofit, for-profit, and hybrid legal structures. Since the late 1990s, however, CDVC providers have begun adopting the more conventional LP and LLC legal structures for their investments. This helped them raise larger funds by attracting bank investors familiar and comfortable with these traditional venture capital models.
Another major source of CDVC capital has been the federal government, through the New Markets Venture Capital (NMVC) program and the CDFI Fund. Foundations were an important early source of CDVC capital. Most foundation investments, however, have been in the form of program-related investments structured as low-interest debt versus the equity dollars that venture capital investing requires. Furthermore, foundations appear to have moved away from supporting individual CDVC funds, investing in few of the most recently capitalized CDVC funds (Rubin 2007). This trend is discussed in Part II.
Many of the CDVCs using the for-profit LP and LLC models have created nonprofit subsidiaries, enabling them to raise grant funds to offset operating expenses. CDVCs tend to have higher operating expenses because they provide portfolio companies with TA. TA is necessary because CDVC funds often have a more limited number of investment prospects, whether because of geographic restrictions or the social screens many of them impose to meet other objectives (e.g., a company's environmental or labor practices). This limited deal flow may require funds to invest in companies with less experienced management and then work with them to increase their levels of knowledge and market readiness (Rubin 2001).
Like traditional venture capitalists, CDVC providers must exit their investments in order to make a profit and free up capital for new investments. In general, they tend to hold their investments for a longer time than do traditional venture capitalists, tying up valuable capital and management time and decreasing their financial returns. The longer holding times reflect both the greater difficulty of exiting from the types of companies in which CDVCs invest and the unwillingness of many CDVC managers to force an exit that would be detrimental to a company's overall survival or to the survival of any jobs the company could have created. This longer holding time, combined with the industry's relative youth, has meant that most CDVC funds are still holding the bulk of their investments.
-  The total number of CDLFs is an estimate provided by the Opportunity Finance Network. This chapter is focused on a subset of CDLFs for whom microloans – of $35,000 or less – constituted less than 50 percent of their financing activities.