This interview is part of Next Up: CDFI Leaders Thinking Ahead and Acting Now, an 8-part series exploring the Community Development Financial Institution industry.
Tim Ferguson: There is a perception that CDFIs have become too bank-like to fulfill their mission to provide capital and resources to underserved communities. Do you agree?
Adam Zimmerman: Well that depends. How are you defining “bank-like?”
TF: I’m talking about CDFIs having relatively tight credit boxes, their processes, and the ways they think about risk all being really reflective of the institutions funding them.
AZ: I would define bank-like as having a defined set of underwriting standards, collateral requirements, and obviously an aversion to losses. You know, I’ll take a step back and say that there’s a group of organizations across the country – loan funds – that have balance sheets that are $100M to $500M or so, and it seems that the $500M size is about the top (I’m not considering New Markets). As far as I can tell, most of the organizations of that size are largely real estate based lenders; whether that be housing, community facilities, or otherwise. And I would expect the approaches of those organizations to be more bank-like, because they’re driven largely by what the underlying value of the real estate is. So they’re making those kind of underwriting decisions.
We are not in that group. We are largely a business lender, and in any given year 25% of our new production will be in consumer lending. Both of those products are largely uncollateralized or under-collateralized. So the kind of lending we’re doing is very much what, years ago, they used to call character based lending. I remember a video on the Cascadia Revolving Fund, in which they called it “whites of their eyes lending.” It’s character-based, with forward looking pro formas, and involves taking our experience from working with thousands of businesses, considering a business owner or entrepreneur’s zest for success and positivity, and their personal expectation that they’ll blow the doors off. We bring a more conservative look to that, but “conservative” compared to an ambitious business owner — compared to a bank, we’re far outside the pale of the risk they’ll take. Both in terms of the projections that we’re willing to underwrite, as well as the collateral we have available, that we’ll take and still get a loan done.
We’re not bank-like at all, in my opinion. And I’ve never worked in a bank, so there you go.
In terms of our HR and recruitment especially over the last couple years, we have specifically implemented tactics that pull us away from getting people out of traditional banking institutions, because the work that we do takes a special kind of approach, particularly on the commercial lending side. People who come out of banking can read the numbers, they can spread financials, they can make assessments of financial strength, and the good ones can make assessments of character. But they often do not have the ability to think outside of a particular transaction in terms of impact, in terms of how that transaction and the next five they’ll do will bolster the resilience and the health of the community they work in. Being able to do both takes a special kind of individual.
We’ve been moving toward advertising for a position called Regional Strategist, rather than Commercial Lender. And so far, we’ve had pretty good luck attracting people who have business experience, but also have a broader view of community development. We’ve had a lot of misses over the years hiring folks out of traditional financial institutions, and it’s just gotten too frustrating. So we’re trying a new way, and we’ll see how it goes.
TF: Of your capital deployment, what proportion is going to small business enterprises?
AZ: Well we lump together commercial lending (which includes nonprofit borrowers) – so without numbers in front of me, I think we’re close to roughly $39M in new commercial loans in 2017; about $35M of that will be for what you would characterize as small business; and about $10M in consumer loans. So, roughly $50M total in closed loans in 2017.
TF: That’s quite extraordinary. It’s interesting that you’re hiring a hybrid type person. In some ways it’s going back to how relationship bankers used to work.
AZ: Exactly; and they’re sort of a dying breed. You know, we work in a special geography – it’s our place. And that’s another conversation: local versus national. But here in Oregon and Washington, community banks are nearly non-existent and going that way quickly. The local industry knowledge and relationships that characterized, even 15 years ago, a $300M bank in Southwest Oregon with 10 or so branches – those people are gone. Or if they’ve been retained through a series of mergers and acquisitions, they’re now operating within a much tighter credit box, and they just don’t have the latitude that they used to.
TF: So when you’re looking at a particular loan or potential borrower, how do you evaluate them? Clearly it’s more than what their financials say.
AZ: Well, as with most things, the answer is complex. So, we have very few “do nots” within our credit policy in general. We’re also the first to tell a potential borrower who has a treasury and maybe an existing lending relationship to make sure they have that conversation, presumably with some sort of depository.
Let’s see if I can put this succinctly. We think about this in two ways: one is that we are a nonbank lender that provides small business credit to businesses across Oregon and Washington. We do that based on loan amounts in increasingly efficient ways. So if your loan amount is under $100,000 we have one way of dealing with that, and then as the loan size increases, there is more risk and complexity.
We call the small loans Small Business Loans; and then we have Capital Plus Loans, which are from $250,000 up to a couple million dollars. Those require additional coaching, more careful underwriting in many cases, and may take a couple rounds of back and forth with the business over the business cycle to get them where they need to be, and to get the information we need to do the deal. And then we talk about Catalytic Deals, which is short hand for our much larger deals, which are those involving us as a leverage lender, or a New Markets lender. So that’s how we classify our loans in our new five year plan.
The second thing I would say is that “we do small business loans.” Again, we have only a few “do nots” but we do have “will nots.” That said, our strategy is to go deep in the places where we have a footprint. We’re looking to help the communities we’re in to advance their community resilience, their economic development goals, and their environmental goals. First we’re selecting where we want to help, and then we’re making small business loans, and nonprofit community facilities loans, and we’re trying to align those with the strategy we’ve put out there. And this approach is new for us; this is in our new 5 year plan. Our hope is that in 36 months we’re able to look at a section of our portfolio focused on a place like the Olympic Peninsula in Washington, and of, say, $10M in commercial lending, to be able to see that $7M of that that is closely associated with the strategy and impacts we sought to influence.
TF: So essentially, you’re looking at specific communities, doing some form of assessment of what the capital or other gaps are, and then working over a 3-5 year period to lend on a consistent basis to small enterprises or nonprofits community facilities in that particular area.
AZ: That is correct, with one amendment: it’s not just capital gaps, that’s the given for us. It is more about where the community is trying to go with its economy, with its social service structure, with its conservation and environmental goals, and doing our best to align our investments with opportunities that move those things forward.
It’s more of a collaborative process. For years we’ve been more reactive, which is typical of people who invest. We’re the last people to be invited to the table, because we’re “just the money guys.” But that shouldn’t be the case, and that has not been the case when we’ve had the deepest impact. We have greater impact when we’ve been at the table early to advise partners on how capital can help them move a project or community goal forward. We need to keep early engagement front and center for us, because our goal is not to be a reactive source of creative capital, but a partner in community development.
TF: So are the communities reaching out to you initially, or are you proactive with them?
TF: And when you’re evaluating whether or not you want to work in a community, what are the key elements that you look for within the community itself? Are you looking for agents of change?
AZ: Yes. We have eight places within our two-state region that we have chosen to go deep into. As part of our new strategic plan, we’re in the process of developing more specific “sub strategies” for those places, which will help us identify the efforts that we will be most effective in supporting.
In choosing those places one of the things we look for is leadership. This is especially true in some of the more rural places, where many communities are still reacting to things that have been done to them, rather than taking stock of where they are and figuring out how to move forward in creative ways. And often that moving forward requires generational change in leadership, so we’re looking for that condition.
In the Northwest we’re looking for representation from underappreciated or underrepresented groups. In some of these places those are tribal voices, immigrant voices, and so on. So, places that have those elements of engagement and leadership look good to us.
And then we’re looking for opportunities for small business. We tend to look away from communities that can’t get along with each other and have a strange small business climate, i.e. communities that are still highly dependent on a couple major employers. Instead, we look more to communities that are diversified or diversifying and seeking new economic foundations, primarily out west after they’ve lost natural resource jobs.
TF: You’ve mentioned your new strategic plan several times. What are some of the other key components? One particular question I have is: in the plan, what are you thinking of in terms of the allocation that will be made to those communities where you’re deep in place? How much of your activity will be focused on them, as opposed to the other lending you do?
AZ: It’s all focused on place. For commercial lending we have two primary sales approaches. The first is place based, where we have feet on the ground in eight places, backed up by a strategy of what we think we can do and where we think we can help in those places; and an opportunity for those individuals on the ground to source transactions. And like I said, the better we are at sourcing transactions, the more overlap there will be between the kinds of community impact we want to support and loans we are originating. That said, we have a network two states wide, so people will always find us, and we will do those loans. But I want most of our transactions to be dense around the places we have said we’re going to work.
And then the second approach, and this is something we haven’t done before, is that we are rolling out sector focus for our work in particular areas that are important in our regions. For example, right now one of our focus areas is clean energy investment. Now, this type of lending is something we’ve been doing for a long time: $50 to 60 million over our history. But we have never approached it with a fine pointed strategy. We’re also doing the same with food and agriculture. Again, we have a long history of investments in farms, processors, and retail/wholesale but we’ve never said “we do this,” nor have we pursued some of the tools to help us do that, like guarantees. And then we’re working on a community facilities strategy in the same way, which is more of a real estate focused approach, but trying to figure out how to put capital into the places where we have feet on the ground to support community facilities.
In our vision, there’s a Venn diagram overlap between our places and our sectors, but they won’t overlap perfectly. We’ll have deals that are important to our sectors; for example we’d invest in someone who makes equipment for solar installation, which could be anywhere in Oregon or Washington, and we’d be very happy about that deal. But I’d be even happier if they happen to be in a place like Spokane, where we have a place-based strategy.
TF: What do you say to funders when they ask what your impact is? How do you describe it?
AZ: In the interview summary, you guys used the word “sufficient” in your question about impact. I’m curious about the word “sufficient” in the context of this question.
TF: Some CDFIs are pursuing aggressive, more bank-like lending strategies – the 7A program is case in point. If you dig down and look at the underlying transactions, I’m guessing a lot of them are not that close to mission.
AZ: I think that’s true. I would say a couple things. I think it’s clear from what I’ve said so far that we’re very much about aligning our investments with the impacts and outcomes that we believe are relevant to the places we work and the sectors we care about. So after careful assessment and knowledge of OR and WA, we’re operating from a foundation of knowing what the places and sectors we care about need. Then we consider what impacts speak loudly to the policy makers and others, and then working backwards from there. So over our entire history, we have collected a rich set of impact metrics, which I call outputs. These are the things we count when we close a loan, and they include traditional things like jobs and wages; as well as things like whether or not we’ve leveraged local real estate ownership, whether or not the transaction results in reduced greenhouse gas emissions, whether or not the jobs are living wage jobs, and so on. We have a whole slew of outputs that we count, or at least look to count every time we close a transaction.
Those are great, and for years we’ve been more or less a leader in aligning our community development lending with measurable mission outputs. Now I don’t think we’re falling behind, but we’re looking to revise how we do it. Let me give you an example: an example of an impact that we would seek to align with is reduced fossil fuel consumption in Oregon and Washington. Now, can a $200 million loan fund attribute that to our work? Not really; but we can work backward from there by talking about outcomes. In this scenario, some of the outcomes we would look at are: Are we finding emerging companies and entrepreneurs that are working in clean technology and capitalizing them? Are we creating ecosystems of businesses that can feed off each other? Again, can we attribute that directly to our work? Not necessarily; but we can make the argument that a stronger ecosystem of clean-tech businesses is good, and we are financing some of those. And then of course we can look at the outputs of the original transactions: this hypothetical lighting company is saving a lot of energy, and we’ll count that and report it out. So we think about this a lot, and attribution is hard. There’s one level of collecting metrics, and another level of making a reasonable argument for attribution.
Years ago we participated in a “triple bottom line collaboration” with ten other CDFIs, which we led along with CEI. We developed and all agreed on a set of metrics, and we developed a proxy portfolio of deals from ten groups. We were able to show, in terms of individual metrics, what those deals were accomplishing. It was a cool process: someone would bring a deal forward and present it like they would to a credit committee, and would explain the metrics it would hit (e.g. jobs, energy, reusing materials, redeveloping real estate). Then we would have a conversation around if it passed a “smell test.” It wasn’t a scientific conversation, just a discussion around whether or not it would move the needle on certain issues. It was a fun practice for that group, and I learned a lot from it.
TF: So when I look at your institutional funders, a lot of them fall into the CRA lender category. Is that a fair categorization?
AZ: Yes, I would say about half of our debt is bank debt.
TF: And the other half?
AZ: Roughly 25% is foundation debt. We also have USDA Intermediary Relending Program (“IRP”) money. So the other half is some combination of foundation and government.
TF: And when they talk to you about your impact, do you get the sense that they care?
AZ: The banks? No, not really. Our challenge with bank debt is that we operate with some amount of trepidation around rising rates. I’ve heard from one of our national bank partners that their Community Lending department has been rolled into Commercial Lending, so now their masters are people who don’t understand what institutions like ours are trying to do. And that creates a tighter credit box for the community development lenders within that bank, and that’s a problem.
TF: Because you’re concerned that the flow of capital will be reduced?
AZ: I don’t think it will reduce actually. I think capital is seeking a place to go, but at a different price and risk point than is appropriate for the work we’re doing.
TF: So how are you thinking about other sources of funding? I’m thinking particularly of so-called impact investors.
AZ: We’re wrapping up our first private placement offering issuance. It was a $20 million offering, and it’s about 75% subscribed. When we started it, we were shooting for it to create roughly 20% of our balance sheet, and a larger percentage of our debt through the PPO. And we’ve done that, though it’s taken longer than we thought it would.
There’s more opportunity there. That money is generally priced better as a whole than institutional debt that we’re able to access right now. And it’s pretty sticky. So even if we have family office with a $250,000 investment in us for a year, they tend to be rolling it over, which is good. So that’s one thing, and we’ve got momentum there.
And then, we have to figure out how to do fund management. Because we believe our demand for our capital will grow faster than our balance sheet will grow. So we have to manage other people’s money, and that will come from the impact investment space.
The tricky part with this is that I don’t intend for us to chase the impact that other investors want. We can’t get pulled down rabbit holes when someone shows up with a million dollars and says “I really want you to invest in X.” We’ll certainly do those deals, but as soon as we put boxes around little piles of money, our lives get really complicated, and that level of complication isn’t worth it. What we have to do is effectively sell our 5-year vision and our place-based and sector-based strategies to the investors that are buying those things. We want to attract the people who are aligned with us, not people who want us to align with them, because it will pull us in too many directions.
TF: What we’re seeing in impact investing in general is a large-place based component – people are interested in investing in places they know. Are you seeing that trend within your 8 places? Are there specific funders interested in supporting you in those markets?
AZ: In the urban markets, absolutely; there are investors who have place based interest, namely community foundations. We actually have a meeting with one community foundation today; they have an endowment/Donor Advised Fund that they’re rolling out; they have a $1 million investment in us and are looking at making an additional $2 million investment from their new fund. Their investment in us will be flagship investment; they’ll spend a lot of time talking about it, in large part because of the way we’ve operated. They’re mostly interested in the rural component of what we do. So yes, there is interest and we’re seeing it. I couldn’t tell you what I think it’ll look like in a couple of years in terms of the components of our debt, but our expectation is that the portion of our debt that is sourced from CRA institutions as a percentage will decline.
TF: So from how you describe it, I imagine you would answer the question ‘have CDFIs been doing impact investing all along’ with a resounding yes”
AZ: Absolutely. The annoying thing in the market right now, is that to me it seems that there are a lot of potential investors that are showing up to this impact investing party, which is great, and a lot of them that are still drinking the “kool aid” that they can have both near-market rate returns and impact. And my belief is that there are some anecdotal stories about that, but if you look at the need across the board, you can’t have all the return you want and all the impact you want. I don’t believe that’s something that is true.
TF: And when you think about the capital you have to offer, is it solely debt? Do you think about equity as well? For entrepreneurs, particularly those of color or in poorer communities, debt is often not something they’re comfortable with. How are you thinking about the continuum of capital?
AZ: There are a number of small angel and seed funds that are pretty diverse in terms of their geography, and somewhat diverse in terms of their desired customer type, i.e. focused on entrepreneurs of color, or female entrepreneurs, etc. We have made some small investments in some of those funds or those companies, but we do not present ourselves as equity investor. This is primarily because many of those investments are going to technology companies, where the potential for return continues to be the highest, or at least is perceived as the highest. But in our experience those companies don’t move the needle with regard to sticky, long-term living wage employment. They’re wealth generating opportunities for a relatively small group, which often turns around and sells. And there’s nothing wrong with that, but it doesn’t fit our skill set particularly well in terms of our human resources and what we’re good at; we’re better at helping companies structure operating capital so they can follow a growth curve, not structuring an equity investment to make them more appealing for a purchase. Could we go out and acquire that talent? Of course. We also don’t necessarily have the right matching capital for that either. We could pivot and do that, but it would compromise our ability to borrow debt because it would compromise our equity stack, and I’m not quite ready to do that.
So, we’re watching. It’s the hot new thing among economic development professionals to have a seed fund in your community, but my expectation is that when the economy turns again, I think a number of these funds will just die unfortunately.
I serve on a State Board here in Oregon, and my vision for small business opportunities continues to be that we need a more streamlined portal for businesses that are seeking capital. Businesses waste a lot of time chasing money and not knowing where to look. If the State could do anything, they should provide a better understanding of the capital infrastructure, so that businesses could get where they need to go faster, even if the answer they get when they get there is that they’re not ready yet.
TF: Is the state receptive to that?
AZ: Oh sure, but getting a State’s bureaucracy to be responsive to a market need is another story. It’s not on any one individual; it’s like trying to turn the Titanic.
TF: If you weren’t CDFI, what would you call yourself?
AZ: I would call us a community development institution with a lending function. We lead with impact, engagements, and strategy, and we use capital to try to move that forward.
TF: Craft3 is interesting because you combine urban and rural, as opposed to being just one or the other, which is quite unique. As you think about the execution of your new strategy, what are the things you worry most about in terms of successfully executing on the new plan?
AZ: On the commercial lending side, I worry most about having the right mix of deal size and risk. Our average loan size this year will be about $300,000. We’ll have a series of transactions that are between $1-3 million, and then a cluster between $250-1 million. Right now one of our challenges on the portfolio side is that we have a handful of large deals where when any one of them gets a cold, it makes the whole risk management structure feel a little quivery. We don’t want to be in that position. What we really want is for the bulk of our transactions to be within the sweet spot of $750-1.5 million. Growing that in terms of the number of transactions will make our outstanding loan structure more resilient. Finding that mix of transactions within the strategic overlay I described is what I’m most excited about, but it’s also what I’m most worried about. We’re essentially trying to narrow our pipeline and deepen it at the same time, while also creating a more resilient set of loans outstanding.
The other thing is having enough capital. You know, in the right economic climate we’ll be successful adding loans to our books. But at some point, our ability to leverage and raise more debt will become constrained. That’s why we have to think about fund management and aligning that with our vision, and not chasing somebody else’s vision. I fear being pulled in too many directions, which would make us much harder to manage.
TF: You mentioned earlier that you were looking for different type of person, distinct from a traditional lender. Is talent a concern or challenge for you? Or do you find a good pool of people who are interested in doing well and doing good?
AZ: Here’s what I do know: we have the most talented team right now that we’ve ever had. We’re reaching a new level in terms of the cohesion of that team in their ability, and it’s largely a generational shift. We seem to be attracting interest – people want to come work for us, and they stalk us to some extent. And I think, although I don’t know yet, that we may have a solution to balance between the on-the-ground relationship and pipeline development work, and the solid number crunching work, in terms of how we structure internally. We need to be able to do both, but historically we feared that if we turned over to a “hunter/skinner” model, we would end up with sales people. The type of talent we’re attracting is coming for so much more than that – they’re coming to be a part of something. We have a great culture; we have a strong commitment to maintaining a team with shared cultural values that works well together. So yeah, I think we’ll keep attracting people. Right now wage inflation is sort of a pain in the butt, especially in Seattle and Portland markets- everybody wants more money. But we seem to be able to retain people, even though they could earn 15% more somewhere else.
TF: Is there anything else you’d like to add?
AZ: You had a question in the interview summary about whether the industry is keeping up or falling behind. I challenge how relevant “the market” is. Our job is to operate; it’s not about keeping up with the market, it’s about whether you’re operating on the “margins” or on the “edges.” The margin is comprised of the people who have a capital need that could be served by a depository or a fin tech lender, but either shouldn’t be because those are predatory products, or can’t be because the box is too tight. And we’re on the margin, so we can do that deal for them; we can see our way to underwrite it.
The edge is where no one is working: it’s new, it’s risky, it’s emerging. We’re innovating to try to serve that need. And if the margins are along the side of the ribbon, then the edge is the end of the ribbon where it frays. If we do our job right at those edges, we’ll eventually get pushed out, because more conservative institutions will start to fill that need. And that’s what should happen.
TF: And then you move to the next edge?
AZ: Right. And our biggest need is for philanthropy to see and embrace that model. We need investment for some period of time to prove those “edge” theories; it’s like an equity investment in a company. We’re pursuing that right now with our new 5-year plan, and a couple of foundations are helping us to invest in that innovation. For me it’s a lovely situation, because it’s not a traditional grant supported model, it’s an equity investment model. We’re trying to prove an opportunity. That links back to human resources too, because it’s exciting, and it attracts people who want to do cool stuff. If we can do more cool stuff in a couple years, that will keep people engaged. To me, that’s the most powerful attraction for Craft3.