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?
Luz Urrutia: I view CDFIs as the key participants in the financial services ecosystem that provide real affordable capital to underserved communities. In doing that, they really have to manage the risk and pricing equations. I believe that, since a CDFI’s mission is what drives them to provide affordable capital when other lenders are not, they are the ones that are helping lower the “price risk curve” within the different segments in which they choose to serve.
I do see in a way why that might be a perception. When you look at how CDFIs acquire customers, how they define their credit boxes, how their loans perform, the number of transactions they complete, and the scale of their business…there appears to be a conflict between their mission and the execution. I look at some of what we do, and there are products that we offer today that can also be offered by a bank; or we could partner closely with banks in offering these products. But from a CDFI perspective, I believe that banks are more focused on their asset quality, and if they’re going to serve this underserved market then they’re partnering with CDFIs to take on the loans they can’t underwrite due to the risk and pricing requirements.
In my opinion, some CDFIs are becoming an extension of banks within certain customer segments. CDFI’s can also acquire customers at potentially lower costs, and are not as focused on asset quality and asset classes, which is a big distinction between banks and CDFIs. In addition, many more CDFIs are focused on microloans, which banks are not doing.
TF: So one of the products Opportunity Fund offers might be a good example of this, which is the product you offer to the trucking industry. When I first learned of this, I was struck by who is able to take advantage of it and what it means from a jobs perspective. Could you explain a bit about what that is and why it’s really important?
LU: The reason why this business line is so attractive is because it offers a triple-bottom line impact. On one hand it’s a sustainable line of business for Opportunity Fund. On another hand it’s a mission based business; the businesses are generally single owner operated, so the loan provides for them and their families in a meaningful way, and creates economic independence and opportunity. And in a third way, it’s good for the environment, because truckers are improving emissions by redoing engines of these trucks. So when you look for perfect triple bottom line impact, trucking is a type of lending where not many others compare.
TF: And the State provides a guarantee, correct?
LU: Absolutely, that makes it very attractive. The CalCap Program, a loan loss reserve, represents a big competitive advantage for lenders. Unfortunately, not enough institutions take advantage of it. This is a program that if offered in other states, it could potentially promote access to responsible capital for small businesses as it would allow more lenders to lend within segments that are riskier and where many banks cannot participate.
TF: And then the rate of return is also very attractive, right?
LU: Absolutely, we’ve talked about this. At Opportunity Fund we want to focus on business segments that are both financially sustainable and have strong mission alignment. Our intention is to ensure that we have a business model where all programs, products, and services we offer can deliver sustainability and strongly align with our mission. Trucking brings both, as well as supporting environmentally safe lending.
TF: From the financial perspective, Opportunity Fund offers loans to these owners that would be much more expensive if they had to obtain them elsewhere, right?
LU: Yes, and in some cases, access is also an issue, in addition to pricing. The question is if they would even be able to access similar loans at all. While the “secondary” source of repayment is the asset, some of these borrowers don’t have credit or have a thin file. This, coupled with additional requirements that traditional institutions have for lending money, make many of these loans ineligible for most banks. An in situations where the borrowers could access a loan, the pricing would be significantly higher, which in turn would have detrimental impact on the borrower’s ability to cover the debt payments.
TF: One of the things you mentioned in response to my first question was that some elements of the CDFI industry are a natural extension of the banks themselves. With that in mind, I want to talk more about Opportunity Fund’s decision to partner with LendingClub. I’m curious what the rationale was there, and whether you see that extending to other partnerships in the future.
LU: I think this brings us back to my original comment about how CDFIs are better positioned to provide affordable pricing even when the credit quality of the borrower is not within the parameters of other lenders. The model we hope to prove is twofold. The first goal is to become the “second chance” look for loans that LendingClub isn’t prepared to approve. These are good loans that fit within a broader credit box. The goal here is that we can help, over time, to lower the rate risk curve in the segment of customers that we’re serving. We’re building the loan volume and will continue to prove that this could be one outcome.
The second piece is scalability: how scalable and sustainable can this model be while managing loss rates? A benefit to acquiring customers online is to improve efficiencies in the lending value chain, primarily because part of the benefit would be a very efficient value chain where there is not as much interaction with a borrower. We aim for a more digital relationship. Our interaction with LendingClub customers is more hands-on than the relationship LendingClub traditionally has with their customers; at the same time it is clearly less hands-on than the relationships we have with customers we market to directly. So what we want to prove out is our ability to create efficiencies in that value chain and have a healthy portfolio with manageable losses, all at a lower cost.
TF: It’s been roughly two years since you announced the partnership with LendingClub. What is your impression over the past six months since you were appointed CEO?
LU: I was so impressed. One of the first things I learned is that Opportunity Fund is one of these incredibly innovative and opportunistic CDFIs. CDFIs are generally viewed as more conservative in many respects, so for Opportunity Fund to partner with an organization like LendingClub, and for them to have an interest in partnering with us, is a big statement to both institutions. It was a perfect match. LendingClub had an interest in serving this segment and didn’t want to say “No” to some customers. They recognized that Opportunity Fund could be their second look and we would also provide responsible and affordable capital. In the process, we’re hoping to be able to prove that we can lower the price/risk curve.
I’m pleased with the volume and the response. I’m obviously learning more every day, and trying to better understand what other customer segments we could attract through the LendingClub distribution channel. Our expectations are that we will be able to grow our partnership while maintaining the projected losses in the portfolio.
Also, one of most important things is that we build a platform that is able to interface with a marketplace lender of the size of LendingClub, and to do so in a relatively short period of time.
TF: And it’s an exclusive relationship, correct?
LU: Correct, we are their only partner for second look.
TF: So it really is innovative within the industry.
LU: Very much so. Then the question is whether it can be replicated with other marketplace lenders, and how would that work. Like I said, we’re still learning a lot. We know that it’s working for the partners, but we always need to look at how it’s working for customers. It’s not enough to know that they’re getting the loan. We have to ensure that the process was easy and they were able to obtain an affordable loan. Recently, we conducted customer surveys and we were very pleased with the learnings. More to come on that front.
TF: In our preamble you mentioned that you’re new to CDFIs specifically. You clearly understand lending into underserved communities, but your previous experience doing so was with a for-profit. What are your impressions as to what the major differences are, and do they help or hinder the activities of CDFIs?
LU: So there are CDFIs that are for-profit, and then ones that are nonprofits, like us. Being a nonprofit gives us a huge advantage; it gives us low cost of capital, and allows us to access contributions to build capacity to deploy the loan dollars. That’s our most significant competitive advantage.
When I look at it from my experience in the for-profit world, I evaluate the “end to end” customer journey – the value chain from customer acquisition, to loan underwriting and processing, servicing, and collections. We are able to provide affordable loans, mainly because of our low-cost capital. Opportunity Fund has done an excellent job at several points of that value chain in terms of the operational aspects: our one-to-one sales process, the application process, the credit decisioning, being able to underwrite small businesses that others can’t, servicing the loans and funding them at significantly lower rates. The challenge, and this is where scale comes in, are the customer acquisition strategies. That’s where being a nonprofit impacts us, because we don’t have the funding required to acquire customers at scale and through multiple acquisition channels.
However, this is where LendingClub and other distribution partnerships will be very valuable as a scalable means of acquiring new customers. We are in the very preliminary stages of evaluating what model would allow us to acquire customers that others may not be willing to lend to and do it in a cost-effective way, using partnerships, enhanced data analytics, and technology.
The other key component is loan capital; almost 100% of our funding is from lines of credit from banks that are lending to us for CRA purposes. This is an excellent source of funding, but as we grow we need to think strategically about our capital structure. Having access to other sources of capital to scale our lending will be critical so that we can continue to help the borrowers we most care about and have the impact we desire.
I believe that the ability to acquire customers and access low-cost capital will be important elements for CDFIs especially in the nonprofit space, and even for some for-profit CDFIs, to maximize their opportunity and their impact.
TF: So something like LendingClub is an example of using a partner as a customer acquisition?
LU: Absolutely. Opportunity Fund employs different strategies for customer acquisition. In addition to boots on the ground, we also have relationships with community partners, mostly non-profits that provide ancillary services to small business borrowers and need a partner to provide capital. These partnerships refer micro-borrowers to us. We also work with brokers, dealerships, and mobile food truck manufacturers. LendingClub gives us access to another segment of underserved customers through the online channel. In addition, we are very excited about the partnerships with AEO and CRF and seeing how we can help scale lending to more underserved small businesses. Our objective is to find ways to provide as much responsible and affordable capital through additional distribution channels where those lenders are not prepared to underwrite those loans – we can be the first look, second look or even the third look. In addition to originating the loans and to give us more lending capacity within our balance sheet, we are also in a position to sell those loans to institutions that are seeking earning assets. In some cases, these institutions could refer the customers, and in other cases they are just acquiring the loans that we originate.
TF: So, as an example, you could take a pool of the trucking loans and sell them to a bank or another investor interested in the yield of that sort of portfolio?
LU: Yes, and that’s what we do today. We do loan sales to a number of institutions; they all love the trucking portfolio for the reasons we’ve talked about. And we will continue to expand our bank partnerships so that we can have greater leverage in our balance sheet and continue to provide more loans. Over time our capacity and ability to grow using our own balance sheet will be limited. That’s the challenge for most non-profit CDFIs – their ability to raise sufficient capital. That’s why we continuously have to seek new sources of capital as we scale our lending business.
TF: You mentioned earlier the inherent conflict between mission and execution in terms of the credit box. Can you say more about that?
LU: Yes, that’s where we have a healthy tension. When we talk about credit box, we’re referring to both risk and pricing considerations. Because we’re a mission driven organization first, we’re providing pricing that, in many cases, is below market. That’s how we’ve structured our business model. However, in order to lend at the lower rates, we must access sufficient low-cost capital to fund the portfolio as well as raise enough in contributions to build the capacity to deploy the loan capital.
I’m confident that we’ve built a credit box that allows customers that don’t have access to responsible and affordable capital to get access through Opportunity Fund. However, as we expand our distribution channels and geographies, it will be critical for us to access additional data sources, make better use of data analytics and technology to continuously enhance our credit model, and approve more customers while ensuring that we are maintaining our mission and acceptable loan losses.
TF: I want to ask you more about the data piece. I know that you’ve been deeply involved with the Center for Financial Services Innovation, and in terms of consumer finance, the whole finance world is being thought about differently. I haven’t yet seen that translate to the small business sector – do you agree with that? When you talk about data sources, do you think about apps, approaches, etc. from consumer finance being utilized in the small business financing world?
LU: I totally agree. The evolution that consumer finance has had for “invisible populations” or populations that don’t have as much access is significantly ahead of what the small business marketplace is able to access. When you evaluate the lower part of the pyramid – meaning the micro borrowers – they behave very much like consumers and there’s an opportunity to access alternative data sources, such as bank account data, phone records, rental payment history, etc. There’s also the ability to look at payables of the business and how they’re paying their bills. A lot of borrowers use their own personal accounts and credit and mix their personal and business accounts, so we have the ability to understand those transactions and the impact on their cash flow. These data points can be very helpful to make decisions about the credit-worthiness of a borrower, which in essence translates to their business.
TF: My impression is that funding for CDFIs has come mainly from CRA lenders and the Treasury. Assuming you agree, do you feel that they drive a lot of what the determinants are within credit box?
LU: Absolutely. That’s a great question, because the lenders are looking for a certain level of performance and losses; they’re not necessarily looking at what algorithms go into your credit box. What they’re looking for is the output: who are we serving; what are the margins and how is your portfolio performing? As you get into non-traditional ways of underwriting borrowers, there is certainly an increased element of risk – real or perceived – that many lenders (i.e. banks) aren’t ready to take on yet.
Because it’s so new, the proof will be in the pudding. Who are the lenders that are using these alternative data sources; how are they accessing it; how are they using data analytics and technology to better underwrite these portfolios; what is the outcome and performance? Another key element is what are the volumes? There is a level of investment required to integrate with alternative data sources and hire talent that understands how to build data models and implement technology to serve this segment of the population. Most CDFIs don’t have the volumes to justify the investments.
It will take time for lenders to be comfortable with that model. But there is no question that the small business environment has not reached the level of sophistication and evolved in the same ways as the access to data that the consumer finance world has.
TF: Absolutely. That could be a game changer. It means we could extend capital to much boarder group of enterprises, as well as individuals.
LU: Absolutely, and when I look at the data sources that we accessed in my previous companies in order to underwrite a consumer, I can extrapolate 30-40% of those sources for business underwriting, primarily in the micro borrower segment.
TF: That’s a good segue. What do you see as the future of funding for CDFIs? When you think about next 3-5 years, what are you thinking about as possible alternatives to banks and Government?
LU: As CEO it’s my role to plan for the worst and expect the best. One of those areas is looking at what the world would look like for us if we did not have access to some of the subsidies we currently have access to today, such as funding from the CDFI Fund and low-cost capital provided by banks through their CRA lines. We also get Program Related Investments (PRIs) from institutions for loan funding. In addition, we raise philanthropy from multiple sources – corporations, foundations and individuals – to build capacity that allows us to deploy the loan capital.
There are also larger institutions that are placing bets on organizations to encourage innovation, collaboration, and technology solutions. I’m thinking of things like JPMorgan’s PRO Neighborhoods, or the Wells Fargo Diverse Community Capital Program. I think there are going to be additional sources of funding from institutions that will go beyond the traditional CRA investments. This may happen more as the federal funding may be at risk. And some of these institutions are going to do it because it’s the right thing to do; some will do it for reputational purposes, because they think it’s a good way to put money to work, or test different models for distribution and client acquisition.
I do think that a lot of these philanthropic funders are increasingly more focused on impact per $1 and ROI. As a result, it is our responsibility to develop market/customer solutions that can create impact through scale and are sustainable over time. My hope is that there will also be funders that will be willing to invest in the micro borrower segments, even though the opportunities for scaling and sustainability are very limited.
I also believe that growing institutions like Opportunity Fund will have to access reliable and larger pools of funds to support the growth, such as securitization and Impact Investment Notes, to name a few.
TF: That’s interesting. You’ve given us a different perspective on some of the activities of these large banks, which are outside of their straight CRA activities.
LU: And I think there’s going to be more development on that front.
TF: I think you’re probably right. Some may be forced, because of acquisition. If you look at mergers and acquisitions within the national banks or the bigger regional banks, they’re often required to have some form of community benefits strategy, which can be in the billions of dollars. So they’re going to have to think differently about exactly what you’re talking about – they’re not going to be moving a million dollars here and a million dollars there; they’re talking about much larger dollar amounts.
LU: Yes, this is where securitization could be an excellent tool, which I know is being addressed by the Aspen Institute, and others. In order to have a system-wide securitization facility there need to be standards across customer underwriting, processing, servicing, and collections. This standardization is going to take some time to develop. Given that CDFIs are all focused on economic mobility and serving a segment that traditional lenders don’t serve, my expectation is that there would be a way to create a pilot and test some standards around the credit value chain, have a large enough portfolio that can attract investors to securitize it. I think this will be a longer-term solution.
TF: One of the things the west coast is really well known for is the impact investing movement. For example, everybody has talking about the TPG Rise Fund, which closed $2B dollars last year. What do you think about this movement and what do you see as the opportunity or implications for CDFIs in general, and for Opportunity Fund in particular?
LU: You’re talking about things like impact investing bonds and social investment?
TF: Yes. People are saying investors are looking for more than just financial return; they’re looking for social impact as well.
LU: I agree wholeheartedly with you. Many CDFIs can fund their organizations with lines from banks, internally generated cash flow, and philanthropy – the latter in the case of non-profits. In our field, we are seeing a growing interest to invest in impact investment instruments that provide both a smaller financial return and a social return. Impact investors are willing to forego market returns as long as the investment is intended to support social programs and projects.
I also think that recent changes related to tax reform may impact the way some impact investors and philanthropists think about their investments. Giving investors the opportunity to invest in things that have two components – social impact and a financial return – will be important. To one audience you might talk about the financial returns and why they’re good compared to other investments; and for another audience it’s going to be about the impact their dollars are having on the overall economic opportunities in the communities they’re investing in.
I believe that having options for investments, whether bonds or notes, is going to grow in importance over time.
TF: I think it’s going to be really interesting to see if mainstream capital really moves. For example, we can go back to your idea of the creation of some sort of fund that has a securitized product within it. Because that by definition should provide much higher returns.
LU: That would be ideal, because that type of funding will have a significant impact on lenders by allowing them access to greater pools of funds. Once again, the challenge will be how to get different organizations to sign up for consistency in their underwriting and servicing, and making sure that those guidelines are followed. It’s a long shot, but a tremendous opportunity here.
TF: I’m hearing that, from your perspective, you feel there’s quite a lot of innovation going on. Do you agree, or do you think the CDFI industry is falling behind?
LU: Again I’m talking from my experience, which is with few CDFIs. I honestly have not been in the broader CDFI market. My sense is that, in general, CDFIs have largely fallen behind the market. I think the market has seen recent innovations in how to acquire customers, how to underwrite and how to access capital, as examples.
For example, most recently we’ve seen the creation of new asset classes in student loan refinancings, and unsecured prime consumer loans, but none of these innovations have happened in the CDFI space. I’m not sure CDFIs are as focused on innovation, other than some of the creative partnerships that some have formed with fin-tech lenders.
I believe Opportunity Fund has been on the leading edge with its partnership with LendingClub. I think there are other CDFIs that are looking to partner with fin-tech lenders as well, but overall I wouldn’t say that CDFIs are innovating and keeping up with industry pace. Of course I’m speaking of the ones I know, which is a very small group.
TF: That’s a really interesting way to think about it. I think organizations like Opportunity Fund know that if they’re going to continue to grow, they’re going to have to change things, and innovation is one of them. I hope that’s something the market can achieve. I don’t think there’s any group of enterprises, at least in the US, who have the knowledge of the place-based opportunities that CDFIs have. So, if you weren’t a CDFI, what would you call yourself and why?
LU: How about a mission based sustainable lender? I think this idea that those two can’t coexist under the same roof is false. We’ve talked about the ability to measure where we invest our resources and time relative to both financial sustainability and mission, and I think there’s an opportunity to look at the programs, services, and products against both of those components. So we can very clearly articulate the reasoning behind why we choose to do things that are financially sustainable with lower mission alignment, and why we choose to do things that are higher mission but offer lower financial sustainability, provided that the sum of the portfolio ends up positive, and business can continue to invest in itself and create even more impact. So “mission” and “sustainable” ought to be occurring in the same sentence. Some people make the argument that if you’re financially sustainable you’re not servicing your mission, and vice versa, and I’m not sold on that yet.
TF: When you actually look at it, there are not that many CDFIs that are sustainable in the way you’re talking about, which is basically where your income covers your expenses.
LU: Correct. But I want to say this: when I look at our Statement of Activity or P&L, we can’t as a mission driven organization only look at our earned revenue. We have to look at our earned revenue plus our impact and social value because that’s the essence of who we are. And the sum of those two needs to cover both our operating expenses and our cost of capital. It’s not just about generating earned revenue. Social impact and value are equally as important and, together, they deliver our results and support who we are.
TF: So we’ve talked about funding, deployment of capital, impact, and the economics of the business. When you think about what it’s going to take to be successful over the next 5 years, what are you most focused on and investing in?
LU: I think we’re very focused on defining who we want to be as our customers grow and their needs evolve and as our competition and the market landscape changes. There is a continuum of different products and services that our small business borrowers need, spanning transaction and liquidity management, debt and equity. We need to be able to acquire more customers through more distribution channels and continue to do it more effectively and efficiently. We also need to look at the entire value chain for lending and identify aspects where we can reduce friction and improve efficiency. Last but not least, we need to continuously identify new sources of predictable and reliable low-cost funding.
As we look at our business, we also need to understand what are the growth enablers, evaluate where we are and how do we get where we need to go. That includes looking at our human talent; credit and risk management tools; data analytics; and technology.
In addition, we also need to be focused and disciplined when evaluating the opportunities we pursue. Knowing when and being willing to say no to many things, and focusing on the areas that drive more impact and scale, such as serving more customers through more distribution channels and partnership, with the right products and technology solutions, having a credit box that allows us to say yes to more customers and using data analytics to continuously evaluate our business and drive improved performance.
TF: When you’re looking for people, do you find that there’s an interest from people outside of the nonprofit world that want to be at the intersection of ‘doing well’ and ‘doing good’?
LU: Absolutely. Some of the resumes we’re seeing are coming from very successful people in the for-profit world, whom some would say would never come to a non-profit organization. It’s not for everybody, but there are people who have been successful in their careers, who are willing to say that financial compensation isn’t necessarily their only driver at this point; they want to do good, have impact, and create goodness and richness in society. It’s no different than an investor investing in impact notes; there’s a willingness to take less return in exchange for doing some good. I think there are a lot of folks out there looking at an organization like Opportunity Fund and hearing our story and seeing where we’re going. A lot of other CDFIs have this opportunity as well.
One of the things I’m finding out is that because we’re a nonprofit, or because we think our compensation levels can’t compete, especially in Silicon Valley, we just don’t go after those candidates. So I think we have to do a better job in telling our story: who we are, what we do and where we’re going. We need to market ourselves better to potential employees. We’re a great place to work, especially given the times we are living through right now; there are a lot of people that want to step forward and make a difference and positively impact the lives of those who are less fortunate.
TF: That’s definitely true. Thank you so much for your time, Luz.