Community Development Financial Institutions – Opportunities for Managers of Loan Funds and Venture Capital Funds

Community Development Financial Institution (CDFI) certification is awarded to “community-based organizations that seek to expand economic opportunity in low-income communities and provide financial products and services to individuals and businesses often underserved by traditional financial institutions.”¹ The CDFI Fund, which oversees the certification process, provides technical and financial assistance to empower qualified organizations that are providing disadvantaged communities with financial products and services. Particularly, as the focus of this OnPoint, the CDFI Fund provides a variety of unique benefits to privately-managed loan funds and venture capital funds seeking to assist communities that historically have lacked access to traditional financial services. These benefits may be appealing to banks, bank holding companies and other financial service providers that can serve as investors in these for-profit CDFI-eligible investment funds. The program has garnered recent attention in the wake of COVID-19 with participation by a number of large firms.

Overview of CDFI Program

The CDFI Fund was formed as an agency of the Department of the Treasury in 1994 to oversee the CDFI certification program. Once certified, CDFIs are qualified to apply for technical and financial assistance awards (i.e. grants and low-cost credit), as well as operational support and training through the CDFI Fund’s Capacity Building Initiative. CDFI certification is based upon whether the CDFI entity: has a primary mission of promoting community development; primarily serves one or more target markets; and maintains accountability to the defined target market(s). Government benefits and incentives are available for traditional lenders to invest in CDFIs, which, in turn, support communities that traditionally have been overlooked by financial services providers. It has been reported that a 2018 survey conducted by the Opportunity Finance Network estimated that “58% of the clients served by its roughly 300 [CDFI] members are people of color, 85% are low-income and 48% are women.”² Certification ProcessCDFI certification is a designation conferred by the CDFI Fund. Obtaining CDFI certification is a formal acknowledgement by the CDFI Fund that a financial institution meets certain community-development finance criteria. To be eligible for CDFI certification, an organization must be a legal entity and:

• Have a primary mission of promoting community development;
• Be a financing entity (i.e., an entity whose predominant business activity is the provision, in arms-length transactions, of financial products and/or services);
• Serve one or more target markets;³
• Provide development services in conjunction with its financing activities;
• Maintain accountability to a defined market (typically through representation on its governing board and/or advisory board(s)); and
• Be a non-governmental entity (other than a Tribal government) at the time of application.

An entity seeking to be certified must submit a CDFI Certification Application through the CDFI Fund’s Awards Management Information System (AMIS).⁴ In addition to financial records and extensive information to demonstrate that the applicant satisfies the CDFI criteria, applicants must provide general information about the applicant and its affiliates. There is no formation deadline; the program is always accepting applications, and there is no application fee. CDFIs also submit program disbursement requests through the AMIS. Once formed, CDFIs are required to confirm they meet ongoing certification requirements on an annual basis, as well as report their yearly lending and investment activity to the CDFI Fund.

CDFI Loan and Venture Capital Funds

Although there are four general types of CDFIs (banks and thrifts, credit unions, loan funds, and venture capital funds), the CDFI-certified loan fund and venture capital fund designations are best suited for social impact funds seeking to benefit both from: investor interests in supporting CDFIs; and the technical assistance and long-term capital available through the CDFI Fund. Importantly, for-profit funds are eligible to be certified under either of these categories. CDFI loan funds tend to focus on non-profit housing and business developers in urban and rural lower-income communities. CDFI venture capital funds provide equity and debt-with-equity to small and medium-sized businesses, often minority owned, in distressed communities that hold the promise of rapid growth and financial returns.

The vast majority of CDFI funds are structured as loan funds. According to the CDFI Fund’s website, as of August 14, 2020, there were 1,135 CDFIs. As of that date, loan funds (predominately not-for-profit) comprised 49% of all CDFIs, while there were only 16 CDFI venture capital funds, comprising about 1% of all CDFIs.⁵ There are four main types of CDFI loan funds, each of which is defined by the type of client served (i.e., microenterprise, small business, affordable housing, community service organizations); however, many CDFI loan funds serve more than one type of client in a single institution.

CDFI loan funds can lend: independently; with non-profit partners; or in partnership with both traditional and CDFI banks. CDFI loan funds also may take a subordinate position when lending in partnership with traditional banks. Traditional banks that invest in CDFI loan funds can benefit from the opportunity to participate in loans that otherwise may not meet their underwriting requirements. As permitted by law and regulation, banks can provide capital to CDFI loan funds through: conventional loans; equity-equivalent investments (subordinated debt instruments with features such as rolling terms and limited right-to-accelerate payments that enable them to function in a manner similar to equity); and grants.

Banks also can structure loans to provide financing in conjunction with a CDFI loan fund. For example, a bank can make a loan that is senior to CDFI subordinated debt. Such financing structures may reduce costs and increase access to credit for bank borrowers that fit the CDFI lending parameters. Even without subordination, the bank can co-lend and limit its exposure to the risk of a larger loan, while the customer benefits from additional financing. Banks can participate in the loans originated by the CDFI loan funds and buy seasoned CDFI loans.

Although not typical, if a CDFI loan fund were structured as a for-profit vehicle, a broader range of investors conceivably could provide capital to the CDFI loan fund. Due to recent changes to the Volcker Rule’s treatment of “covered funds,” banks and bank holding companies also can make equity investments in a CDFI loan fund.

Recent Investor Interest

Congress has earmarked billions of dollars for CDFIs to issue Paycheck Protection Program loans in response to the COVID-19 coronavirus pandemic. Nevertheless, the program is relatively small. According to a publication released by the CDFI Fund, as of May 2020 certified CDFIs had only approximately $160 billion in assets.⁶ While demand for CDFI Fund grants and support historically has exceeded Congressional appropriations, the private sector has helped to fill this shortfall. Recently, CDFIs have seen a surge in investments from traditional lenders (i.e., banks) and corporations that are seeking to finance CDFIs as part of their corporate sustainability initiatives. Bank regulators give Community Reinvestment Act (CRA) credit to banks for a loan or investment that “has as its primary purpose community development,” and investments in CDFI entities can satisfy these CRA requirements. This creates a powerful incentive for banks to invest in funds with a CDFI designation.Below are a number of observations with respect to the CDFI structure/regime that may particularly appeal to banks as potential investors, with a focus on the bank regulatory implications for banks and bank holding companies participating in CDFIs.

Community Reinvestment Act of 1977

The CRA is intended to encourage banks to help meet the credit needs of the local communities in which they are chartered, consistent with the banks’ safe and sound operations, by requiring federal banking regulatory agencies to examine the banks’ records of meeting the credit needs of their entire community, including low- and moderate-income neighborhoods. Banks and bank holding companies that receive low CRA ratings from bank regulators may be limited in their ability to make acquisitions or engage in new activities. A bank’s CRA rating is based upon the bank regulator’s assessment of the bank’s performance in meeting the needs of the bank’s community, which is determined in part based upon the regulator’s evaluation of the bank’s community development lending, investment and service activities. Banks may demonstrate their commitment to community development activities: through investments (grants, equity or debt) in CDFIs; by purchasing loans from CDFIs; or by lending alongside CDFIs.

Volcker Rule

Banks and bank holding companies generally are prohibited by Section 13 of the Bank Holding Company Act (Volcker Rule) from investing in “covered funds,” which are defined broadly to include any fund that relies on section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 to avoid investment company status and regulation. Most loan funds rely on one of these 1940 Act sections to avoid investment company regulation. Notably, the Volcker Rule provides an exception for investments in “public welfare funds,” whose business is to make investments designed to promote the public welfare; this expressly includes (as most recently amended in June 2020, effective October 1, 2020) investments that qualify under the CRA. This most recent amendment to the public welfare fund exclusion was adopted in order to eliminate any uncertainty about the ability of banks to invest in community development funds. The most recent Volcker Rule amendments also establish express exclusions from the definition of covered fund for private credit funds and qualifying venture capital funds.

Regulatory Capital Requirements

Banks and bank holding companies are subject to risk-based regulatory capital requirements. Although equity investments can be subject to relatively high risk weights for purposes of the regulatory capital requirements, an equity exposure that qualifies as a community development investment will be subject to a 100% risk weight; this is the same risk weight as is applicable to loans for AAA-rated corporate borrowers. Equity exposures to investment funds generally will be subject to a look-through approach based upon the risk weights of the assets held by the investment fund. However, if the investment fund qualifies as a community development exposure, the risk weight would be equal to the adjusted carrying value of the investment by the bank or bank holding company.

Conclusion

CDFI loan funds and venture capital funds are options worth considering by fund managers in order to attract new capital in pursuit of community-driven investment opportunities. Renewed government support, as well as growing interest from the private sector, make this an excellent time for innovative private funds, which are interested in acting as a catalyst for investments in underserved communities, to seek CDFI certification.

Footnotes

1. CDFI Certification Fact Sheet
2. WSJ, Renewed Focus on Race Triggers Surge of Interest in Community-Based Lenders (Aug. 18, 2020).
3. Target markets can be defined by either “Investment Areas” or “Targeted Populations.” Investment Areas: have a poverty rate greater than 20% (as defined by the Census Bureau or the applicable state), have median family income (MFI) at 80% or below specific MFI benchmarks or an unemployment rate 1.5 times the national average, have significant unmet needs for financial products and services; or are wholly located within an empowerment zone or enterprise community (as designated under section 1391 of the Internal Revenue Code). Target Populations are defined as: African-American; Hispanic; Native American; Native Alaskan, residing in Alaska; Native Hawaiian, residing in Hawaii, Other Pacific Islander, residing in Other Pacific Islands; or Low Income Targeted Populations. For a specified geographic unit, this last category includes individuals whose family income, adjusted for family size, is: for metropolitan areas, 80% of the area median family income; and for non-metropolitan areas, the greater of 80% of the area median family income, or 80% of the statewide non-metropolitan area median family income.
4. CDFI Certification Application Supplemental Guidance and Tips (Dec. 2018).
5. The CDFI Fund’s website provides a list of certified CDFIs.
6. Proposed CDFI Certification Application: Quick Reference (May 2020).