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?
Frank Altman: No. I do think that CDFIs have become more risk averse than they were earlier in the evolution of CDFIs. They’ve become more risk averse in part because they are heavily relying on bank loans and investment to capitalize their balance sheets. That being said, they still take more risks than banks. But do they take enough risk? Probably not.
When you say “bank like” –you’re talking about the credit box. I think there are other aspects where CDFIs have become more bank-like in the sense of creating policies and procedures that you would see in a well-run financial institution. In that respect, that’s a good thing. But in terms of the credit box, no.
TF: Do you think that there’s any trend or discussion towards that changing?
FA: I think the only way it will change is if CDFIs have enough strength in their balance sheet that they can take risk without running afoul of what their banks and other investors are looking for. Net asset ratio is a key indicator that everyone looks at – it’s very hard to take risk and sustain losses, all while keeping your net asset ratio at a level where it needs to be. So that’s one issue.
The second is CDFIs’ pricing. CDFIs don’t price for the risk that they’re taking. There’s a view – which is held by almost everybody – that CDFIs have to be lending at below-market rates. And I think that causes a further inability to take on greater risk than they’re taking on now.
Third, you have to look at asset classes they’re lending in. A lot of CDFIs started off in the housing field, and multi-family affordable housing lending is very low risk. For those organizations, there’s a cookie cutter approach. The same goes for some other asset classes in the nonprofit world, and so forth. When you do business lending, lending to startups, or lending to very low wealth individuals, there’s a lot of risk and lenders need to have the capacity to bear those risks.
TF: There’s been a lot of talk about small business lending in general among CDFIs in last 5 years. Do you think that’s core to the activities of many CDFIs, beyond a handful like CRF, NDC and a few others?
FA: The CDFIs that are focused on small business lending are micro lenders; there are quite a few groups that make microloans. The difference in the risk of a microloan versus a business loan is that business loans are large enough that you have to rely on the capacity of the business itself to repay you; whereas microloans are closer to consumer loans, where the loan may be small enough that the borrower can still repay it if the business fails. That’s the big difference in how people look at the risk difference between micro and true business lending.
Micro lenders tend to charge higher interest rates. They are taking on higher risk, they’re shorter-term transactions, and there’s a smaller principle at risk. They’re underwriting against it more like a personal loan than a business loan.
TF: People in general would probably agree. The bulk of financing activities in the CDFI industry are around housing.
FA: It’s certainly a large percent, if you take New Markets Tax Credits (“NMTC”) out of the mix. NMTCs have brought CDFIS into a different area. They’re still primarily doing real estate loans with New Markets.
TF: One of the original intentions of NMTCs was to be 50/50 small business and real estate, but I think it’s probably closer to 90-95 real estate.
FA: There actually were four uses for New Markets in the legislation. Only one is being used now, and that’s loans to operating business or real estate projects. You could also buy loans under NMTC – the Community Development Entity (“CDE”) could lend to or invest in another CDE, and the CDFI Fund required some allocatees to do this for a while but then stopped.
What’s left is what people are doing now – real estate secured loans; including real estate in terms of buildings, and real estate-secured loans for a facility or where a business resides. The real estate component has become the new way it’s done because real estate doesn’t move- investors are comfortable that the business will remain in the low income community for the 7-year compliance period. And that’s too bad. I’ve suggested for many years that they change the NMTC recapture provisions, which apply to all credits received over the entire 7-year compliance period, and instead make them more like the Low Income Housing Tax Credit (“LIHTC”) provisions, which do not reach back to the beginning of the tax credit period. This change would create a much broader array of types of things that could be financed through the credit. But such a change requires legislation, so who knows where it will end up?
TF: I want to go back to the small business piece, which I know is important to CRF. I’ve heard consistently from CDFI leaders that though they may have a high credit bar, that allows them to be self-sustaining and serve their borrowers; so therefore it’s worth it. Others would say that’s not enough – that you’re not having enough of an impact unless you can loan to borrowers with a credit score under 600, or a loan to value of greater than 80%, etc. Who do you think is right? What are the implications of this?
FA: I think that when a balance sheet is leveraged, which for most CDFIs it is, banks love to lend to you, and they get a lot of credit for that. If you can raise debt capital, if you have reasonable ratios, it’s pretty much there. But the problem is: if the balance sheet isn’t strong enough, you really can’t take on higher risk or under-collateralized borrowers without putting the financial health of the organization at risk. Where is that line? I’m not sure.
We did a lot of what I would call “gap lending” – lending that was subordinate to banks, and we got creamed when the market crashed. And now we’re not doing that anymore; or we’re doing it on a very limited basis. And the marketplace doesn’t want it either. To go into capital markets with a bunch of real estate secured second-liens without some other guarantees is pretty much impossible. I always feel like it’s an amputation of what we were able to do before. Now, we did lose money in that terrible time, but in the grand scheme we were doing those types of loans for years with very limited defaults and very limited write-offs (less than 1%) up until the crash.
So, were we mispriced for the risk? Yes. Did we take on too much risk? Until that pre-crash period, no one thought they were taking on too much risk. Everybody was doing this kind of stuff. So I think there’s been a pull-back, in a lot of sense related to the financial soundness of the CDFIs. If we had a net asset ratio of 30, we would be doing a lot more risky loans, but it’s very hard to get to that. Even with the new plan we put together with Next Street, we only approach a true net asset ratio that gets above 20 – and we rely heavily on Equity Equivalent Investments (EQ2s) as part of our capital structure. And they are very important, but in the end they are not true equity.
And we’ve tried to manage risk by doing the SBA lending, which helps us get access to capital markets at scale, but then SBA puts limitations the types of lending we can do which makes it difficult to lend in a way we’d like to.
TF: And that’s again primarily around the credit box?
FA: Yes, and all of the eligibility requirements.
TF: You mentioned the patient capital fund. I think that’s a really interesting prospective innovation. Can you talk about what the catalyst for this was, and what your vision is? Why do you think it’s an important type of capital to have available within CRF?
FA: I’ll actually go back to some of the graphics you guys provided for us on the capital needs of different stages of business: at the beginning your real need is risk capital, equity-like capital, convertible debt, things that most CDFIs are not comfortable with.
Let’s go back to the gap loans I was talking about earlier, which are real estate-secured, and second lien behind a bank – very much structured like the 504 SBA program is. That second lien is an equity gap filler for the transaction. And that’s an important tool to have in the toolbox. With patient capital, we’re trying to be a bit more flexible – we’re still using debt but taking some of the risk to the borrower out of the transaction by allowing it to be structured as interest-only for a period of time, or having a percent of revenue or percent of sales as trigger for pain. So if there’s a cash flow issue threatening it, we can be patient while the business ramps up its sales and revenue. Those are features we think are important. But it’s still debt. What the industry really needs is to bring equity to these businesses. This is a big one people haven’t been able to solve.
TF: Do you think there is a solution?
FA: I think there’s a potential solution that is totally different from what we’re doing as an industry—and that’s crowd funding.
We’ve been looking at it for a while and haven’t been able to crack it. It requires a lot of R&D effort. I’m hopeful that ImpactUs could be the place where crowd funding occurs in the industry, but I’m not sure they’re taking off.
A few years ago there was a Federal Reserve symposium in DC around crowd funding and it was mind- boggling to me how much money is being raised by crowd funding– more than private foundations give, more than charitable dollars being raised.
My daughter raised about $50K for her company when she was getting started – through IndieGoGo. I was not really aware of how crowd funding worked at that time, and I was nervous that she would end up in jail! So she received $50K in “gifts,” and contributors got swag in return. I have a nice backpack with the company logo that I got in return for making a contribution.
Think about low wealth borrowers, or borrowers that rely on home equity, which got stripped off many of their balance sheets during the crash…so they don’t have equity but they have a great idea. If they can tell their story, they can raise the money through the public. And I’m not talking about buying shares- although that’s possible with crowd funding as well. I’m talking about a basic level of supporting a business that will have an impact in low income neighborhoods. This has been in the back of my mind for a while, but I haven’t figured out how to get into it. Maybe that’s next for us.
TF: You’re talking about something different from investment notes, right? For example, CIP recently did a private placement product, LIIF just posted their own notes on the ImpactUs platform, and of course the Calvert notes that have been around a long time. So, something different than that?
FA: Yes, that’s debt that comes off of a CDFI’s balance sheet, not equity going into the borrower that the CDFI is lending to. They’re both important tools.
TF: You’ve raised something really interesting, which is thinking about alternative sources of funding. To some extent I imagine you could call it a form of impact investing, right?
FA: Well, what I’m talking about is the most basic level: people making gifts, not investments. There’s a couple of other things that are going on – this is kind of moving toward the social enterprise side of the world, or people positioning their companies as social ventures. Having a B Corp wrapper is helpful. There are people out there that just give these companies money. The second thing that they do is they sponsor prizes. Unfortunately, almost all of this is going on outside of CDFI world by and large.
CDFIs have not been particularly relevant to these startup organizations. I believe that’s because of two things: the first is how we CDFIs raise money for our institutions; we raise it for the institution, not for the borrower. That’s a big distinction. And second, that we are really lenders; we think all problems can be solved with some sort of debt instrument, and that’s not working. What’s happening is the social venture world is coming up with different ways to raise capital for businesses.
I’d say that CDFIs are mostly on the periphery of all of this. So my daughter’s company was founded and formed as a class project at NYU; they had to come up with an idea for a social enterprise. So, she and two other women came up with an idea to use technology to dramatically improve attendance at public schools. Then they competed for a prize at Penn, and won $50K, which gave them working capital. Then they won a prize at NYU and got a lot of institutional support from the University. Then they hooked up with the Blue Ridge Foundation, which was incubating these kinds of efforts, primarily using convertible debt. And they brought in some high net worth investors. The point is, it’s a completely different path that they took. There are a whole lot of companies doing this. And there’s not a single CDFI involved. The original capital came in through people who liked the idea and just wrote them a check.
What I’m talking about is that the biggest problem we have in business lending in low income communities is the lack of borrower equity. It’s very hard to raise equity. People in low-income communities don’t have sufficient resources, they don’t have equity in a home, they don’t have a rich uncle, their friends and family are likely to be low to moderate income. So how do they raise the money? We have to find ways to provide equity at the front end of this process; or the equity that is constraining growth on the existing business. And that’s what we’re trying to do in a surrogate way with patient capital. But, because it’s still debt, it only has a limited ability to really be impactful. It’s a necessary product and we’re excited about it.
TF: CRF has a reputation of having strong technology capabilities. Is there a role for crowd funding within your capital access framework, or whatever platform ends up being developed?
FA: We’ve had a couple of discussions with lawyers specializing in this. As a small business, you can raise up to $1M on the internet through crowd funding without having changes in the securities laws. So there’s true investments, and then there’s this what I would call ‘raising gifts.’ Honestly, I don’t know enough about it. But what I will say is that I think it’s a different animal than the capital access framework. It might be another component. And there are existing platforms like Indigogo and Fundrise, so I don’t know that we would need to build a platform. It’s more around building awareness of business need.
The other issue, which I have not investigated enough, is this: if we’re helping a business raise money so that they can borrow from us, does that represent a conflict, or is it self-dealing? There’s a fair amount of investigation that needs to be done.
TF: It’s a really interesting idea, and your daughter is an interesting example. Since she was at NYU, she had good access. Part of challenge we have in the communities we’re talking about is that they don’t necessarily know what’s out there. And one big benefit of CDFIs is that they’re so strong “in place.” So, figuring this out in a way that can help create that access is important. Do you agree?
FA: Absolutely. We got on this topic by talking about our patient capital product. We’re in pilot mode right now, and we have to take some risk, but we have bunch of, basically, bankers who are trying to manage the risk. We need to try different iterations and hopefully come up with something that works.
TF: Do you see other sources of CDFI funding, banks and government, going forward?
FA: I think the high net worth individual impact philanthropy is an interesting place to pursue. We’ve obviously talked about this in the past, and maybe “impact investing” isn’t the impact we’re thinking about…but we need to be looking more broadly into those areas.
It’s interesting, I’ve been going to the Skoll World Forum for the last several years; a lot of social ventures attend. Impact investors really want to put their money in Africa, etc., but I don’t see a lot of people excited about funding CDFIs in the US. They would rather fund a micro-lender in Bangladesh. There are a lot of really cool entities raising impact money, but I don’t know…I think we have to position ourselves differently as an industry. Take the note, for example. Notes are the most tangible impact investing opportunity in the CDFI world today, and they have a role to play. But they have a limited role- they’re a limited source of funds.
TF: Some of the things you’ve touched on lead to my next question: is the CDFI industry keeping up, leading, or falling behind the market?
FA: I think it is keeping up. I think the CDFI industry is not market-driven, it’s funder-driven, and it is driven largely by the CDFI Fund, which I think is a problem. This is something I’ve always been wary of, but we ended up doing it ourselves.
TF: How could that change? Or how might it change?
FA: Well it could change pretty quickly if the CDFI Fund goes away!
The last big innovation of the CDFI world was NMTCs. The CDFI Guarantee was an innovation, but it’s really another federal rule-driven program. New Markets is a market-driven program because you’re out there selling tax credits which have a market price, and there’s a lot of demand.
But I’d say that CDFIs will not be keeping up with the market if the market changes. They’re keeping up with primarily federal and some foundation trends. And it’s really hard, because the CDFI Fund gives out $150M a year in grants, and no one else is doing that. Of course people are going to go for that money.
TF: Talk a little bit more about technology and your view of the importance of the industry trying to collaborate on that front.
FA: There been a recognition – at least among a number of leading CDFIs – that we need to become much more efficient because the financial world (whether that’s fintech or big banks) is being absolutely turned inside out by information technology. If we think that we’re going to be able to be highly impactful by making bespoke loans across a table with someone, we’re going to be pushed to the side of relevancy. That’s my concern. That’s why we’ve been spending all this time trying to build a tech platform that will bring borrowers to CDFIs in a different way. There’s a lot of excitement around these platforms, whether ours or AEOs, or another. But we’ll see how many people want to actually sign up.
“If we think that we’re going to be able to be highly impactful by making bespoke loans across a table with someone, we’re going to be pushed to the side of relevancy.”
TF: What is it about the industry that makes CDFIs hesitant to sign up? Why do you think that is?
FA: If you’re a nonprofit, Microsoft gives you a huge break on the license cost – so, people expect that break, I guess.
I also think there’s a certain amount of competitiveness in the industry, so CDFIs ask ‘why would I depend on someone else?’ And CRF is guilty of this too sometimes. It’s a mind shift, a shift to understanding what it means to be in a network versus a hierarchy. And I look at rule driven federal programs – they have the effect of making people into delivery mechanisms for federal objectives. That may not be a bad thing, but it tends to stifle some creativity.
Take SBA loan programs, which we’re in. It has a 500-page Standard Operation Procedure guide that is basically the rules for the program, and you basically underwrite to the rules. In the SBA world they say “you underwrite to the guarantee;” in other words, some say you should be less concerned about underwriting the business, and be more concerned about making sure the guarantee won’t be voided when you have a repair. That’s a rule driven program; and it doesn’t make you a very creative lender.
To the extent that the CDFI continues to have more regulatory responsibility, people have to make sure they’re running the organization to be compliant with rules on an annual basis. And all those things make you less creative or less able to respond to market changes from year to year. They used to look at this certification periodically– maybe every 5 years or more, and now it’s annual. What happens is, you start getting into this delivery system, as opposed to a market-driven system or a network system where the entities are responding to different signals in the marketplace.
TF: Do you feel the CDFI industry is meeting the demands and needs of the people they’re trying to serve?
FA: My wife, when she was alive, would see how hard we work and would say “you work as hard as anyone on Wall Street, but you’re dealing with the crumbs.” And that just doesn’t seem like the right thing. And, I kind of agree, though it was a rough thing to hear from a loved one. AEO did a study a couple of years ago about the potential market and how much was served by CDFIs, and it’s something like 2% of the potential market out there. I think this is impactful on a micro level, but it’s not enough capital to change things in a meaningful way. NMTC is getting there, it’s in the billions. The theory of change is that if you get jobs into low income communities, business growth will have an impact on residents of that community. This has been difficult to measure as well.
Basically, we don’t put nearly enough capital on the street. With some exceptions, capital coming into the industry – grant capital from foundations – is largely going toward keeping the lights on in organizations. This is sucking up dollars that could be on the street. I want to see organizations become more self-sufficient, or even profitable, because then they can do more lending. This is what we’re trying to do with our effort to build our technology platform. “Sufficient impact” to me is not being at the level of the financial crumbs of the financial marketplace.
TF: There’s a consistent theme in our conversation that traditional funders – like the banks or the Treasury – really curtail what CDFIs are able to do, both in terms of the amount of money and how it should be deployed.
FA: As an industry, we think we have more flexibility because we’re not regulated financial institutions, but there are still some handcuffs that come from the regulated institutions. I don’t think they’re punitive, they’re just part of the system and we’ve become used to it.
TF: If you weren’t a CDFI, what would you call yourself and why?
FA: Well we weren’t actually a CDFI until 2009.
I would call us a social venture or a social impact venture. When we started CRF the term CDFI wasn’t around. The idea of a social venture was still very much in infancy, though there was a group headquartered here in MN that had a lot of leadership from the Founder of Control Data, Bill Norris. They came up with the idea that you could be an investor but also have a social mission for the investment. And I think that’s led some organizations in that direction. So I’d go with social venture.
TF: When you think about CRF overall, what else are you changing in terms of how you’re operating? I’ve heard a lot about funding side, what about the other aspects of business?
FA: Well as you know, we’re looking to build enough scale in business lending that it becomes a profit center for the organization that can make us a self-sufficient and profitable nonprofit overall, and offset the costs of R&D and innovation, at least in the immediate term. So we’re very focused on improving internal operations, and growing the scale of the business.
We still have to focus heavily on fundraising, but it’s to fund the innovation, which is a loss leader, or to grow our balance sheet so we can do more. And we’re having some success with that. We’re looking very hard at how to engage individual contributors in a way we haven’t done before. We have an experienced “high net worth” fundraiser now on our staff who is chomping at the bit to help us in those efforts. So, that’s a change that we’re making. But the philanthropic capital we’re trying to raise is aimed at growing our lending capacity, not keeping the lights on. That’s something I’m very excited about.
TF: In terms of investments and things that will help to ensure your success, how important is the talent component?
FA: Oh very important. The philosophy that we’ve had at CRF is that we want to be a place where anyone involved in finance would say this is a ‘career enhancing’ move not ‘career limiting’ move. This means if you want to be able to get the best people, you have to give them the tools and the remuneration that would be helpful in growing their own career. From the very beginning of CRF, the idea was that we’re not a “bake sale non-profit;” we’re going to have sophisticated people and systems, and infrastructure that allows the organization to grow and function, and to attract and retain talented people. I think over the years we’ve done that. We’ve had some great people come from major financial institutions and other enterprises, and they’ve brought skills in asset securitization and structuring, and credit and lending; these are important ingredients to the success of the organization.
We are focusing, moving forward, on Diversity and Inclusion – trying to increase all forms of diversity in our staffing and talent pool, vendors and customers. That’s going to be very exciting over next 4-5 years as we bring on additional people and perspectives.
TF: Do you have any final thoughts?
FA: One thing. My earlier discussion was about crowd funding for businesses, but CDFIs can crowd fund as well. That’s something we should draw our attention to. The federal dollar spigot will close at some point, or at least not grow. We have to find a way of diversifying our funding. I would say that, if I had to do it over again, I would establish CRF as a for-profit entity, not a nonprofit. But at the time no one was talking about for-profit social ventures. The biggest problem we all have is raising equity. The only two ways of doing that in a nonprofit – getting a grant or earning it—both of those are very slow. Even growing capital at 5% a year just doesn’t do enough. I’d like to think about other limited profit structures. There’s been a lot of thinking about that, there just isn’t much of this in the CDFI world. Part of the strategic plan for CRF is to maintain some for-profit affiliates that can raise money by selling its shares. And we’ll see how that goes.