Impact Voices | January 12, 2021

Community lenders can lead the COVID recovery for small businesses – with an infusion of common equity

Laurie Spengler and George Surgeon
Guest Author

Laurie Spengler

Guest Author

George Surgeon

During Bill Clinton’s campaign for the presidency, he shared his vision of a federal government initiative that would provide $1 billion in financial support to create 100 community development banks and one-thousand microloan funds.

In the face of Congressional headwinds, by the time the community development financial institution, or CDFI, legislation became a reality in 1994, the four-year appropriation for the new CDFI Fund was knocked down to $382 million. So who would have imagined that only 26 years later, Congress would authorize and President Trump would sign into law a $12 billion emergency appropriation to capitalize CDFIs and minority-owned depository institutions, or MDIs? 

The appropriation, part of the Consolidated Appropriations Act, 2021, directs $3 billion in emergency funding to the CDFI Fund in addition to the Fund’s annual appropriation of $279 million for FY 2021. It also creates a $9 billion Emergency Capital Investment Program (ECIP) to fund capital investments in MDIs, CDFI banks, and CDFI credit unions. 

The entire $12 billion is intended to increase the availability of credit for consumers, small businesses, and nonprofit organizations that provide direct benefits to low-and moderate-income communities, low-income and underserved individuals, and minorities impacted by the COVID-19 pandemic. ECIP captures many of the key provisions of the Jobs and Neighborhood Investment Act (JNIA) spearheaded by Sen. Mark Warner of Virginia that achieved broad bipartisan support in the Senate.

For impact investors, this unprecedented appropriation provides a unique opportunity to invest in MDIs and CDFIs. By vastly increasing the capitalization of CDFIs and MDIs, the appropriation offers the possibility of a strong capital cushion to lower the risk for impact investors to invest in CDFIs and MDIs.

Good intentions

The $3 billion appropriation for the CDFI Fund is nothing short of a triumph. It surpasses by far any previous appropriation and dwarfs the largest appropriation for the CDFI Fund during the Great Recession years, which totalled $227 million in FY 2011.

Since CDFIs leverage their equity capital on average by around $4 in loans to target markets for each $1 in equity, the emergency appropriation should result in an increase of $12 billion in lending. Impact investors can act as multipliers by providing debt capital to leverage these funds. And this multiplier potential does not consider the hundreds of millions in grants made to CDFIs in 2020 by Mackenzie Scott and major financial institutions.

ECIP is similarly extraordinary. As Saurabh Narain, CEO of National Community Investment Fund, one of the earliest and most consistent equity investors in MDIs and CDFI banks, noted, “this injection of capital into minority depositories and CDFIs is probably one of the most significant injections of capital ever.”

Importantly, by limiting ECIP investments to minority-owned and CDFI depository institutions, Congress recognized the unique ability of these financial institutions to reach those “at the bottom of the pyramid” and those most impacted by the pandemic.

Terms of investment matter

As impactful as ECIP may be, it could have been so much more. ECIP unfortunately may fall short of accomplishing its primary mission of increasing lending in disinvested urban and rural communities.

ECIP specifies that the Treasury Department’s capital investments be in the form of 10-year limited life preferred stock (or subordinated debt) with a maximum 2% coupon. This parallels the structure of Community Development Capital Initiative (CDCI) investments for CDFI banks and credit unions under TARP and those made by the Small Business Loan Fund (SBLF) in 2010 and 2011. 

In addition, no payment is required during the first 24 months after closing, and a downward adjustment of the coupon to 1.25% and even 0.5% is available to financial institutions that significantly increase lending to low- and moderate-income borrowers and underserved communities. As with CDCI, an investee can negotiate repurchase of its ECIP investment based on its fair market value. Unlike either SBLF or CDCI, there is a clear preference for small financial institutions and a possibility that ECIP investments may be given or sold for a de minimis amount to a mission-aligned nonprofit CDFI affiliate of the investee.

The problem lies in the form of investment. Limited life preferred stock – while counting as regulatory tier one capital – is not real equity capital. As we noted in our earlier ImpactAlpha op-ed, what MDIs and CDFI depository institutions need is pure, common equity, not debt or limited life preferred stock. While ECIP investments may be valuable to better position some MDIs and CDFI banks for the future, the infusion is likely to be used to refinance existing capital and not necessarily increase lending in the near-term, especially not to higher risk consumers and small businesses.

Another drawback is that, while ECIP investments will be significantly less costly for CDFIs and MDIs than limited life preferred stock in the private marketplace, they will be costly compared to other sources of funding. The average cost of funds for FDIC-insured institutions reached .3 % in September, the lowest level on record since the FDIC has tracked such rates, according to its Quarterly Banking Profile. ECIP’s 2% coupon is even more costly given that it is paid in after tax dollars.

Further, due to ECIP’s bullet maturity in ten years, it will be incumbent on well managed financial institutions to create sinking funds from future earnings to repay the ECIP investment at maturity. This is simply good balance sheet management. However, the unanticipated consequence is that it will limit the extent to which ECIP investments can fund loan growth. Enhancing lending activity in communities of need, which is the clear and welcomed purpose of the legislation, runs the risk of falling short of expectations.

Finally, key aspects of the ECIP investments are not defined in the legislation. In particular, the legislation calls for the Treasury to place restrictions on executive compensation, share buybacks, and dividend payments on ECIP investees. While all admirable and appropriate points in principle, unless Treasury’s regulations are carefully constructed, these restrictions could discourage the strongest institutions from taking down ECIP funding. For those that do, the restrictions will encourage early repayment. A modest yet consistent dividend payout can be an influential tool for CDFIs to demonstrate robust performance to hesitant investors.  

We trust that Treasury will make ECIP restrictions reasonable and not simply impose the CDCI TARP restrictions that resulted in many recipients curtailing growth and lending to repay CDCI investments. The CDCI restrictions also scared off private sector investors looking to invest in CDFI banks but who needed current returns and liquidity to justify investing. (To track these developments, follow leading voices such as Fran Seegull of the US Impact Investing Alliance @franseegull, and Beth Bafford of Calvert Impact Capital @calvertimpcap.)

Aligning intention and delivery to ensure ECIP is indeed epic

In conclusion, it is difficult to envision significant demand for ECIP capital investments as introduced by the legislation. Recall that in the dark days of the Great Recession, CDFI depository institutions only took down $570.1 million in CDCI funding, and just 332 institutions took down $4.0 billion in SBLF funding, even though SBLF was authorized for up to $30 billion.

During the PPP rollout we witnessed how small businesses – especially minority-owned businesses – turned to MDIs and CDFI depository institutions when they could not even get a hearing from conventional lenders. These same businesses and low-income consumers will look to these institutions with increasing urgency during our nation’s recovery from the pandemic. MDIs and CDFI depository institutions do not need a bail-out to address these needs; however, they do need a significant infusion of common equity capital to strengthen their balance sheets in order to dramatically increase lending during the recovery as anticipated by the ECIP legislation. The ECIP investment instrument is a fine first start, but unless the ECIP investment conditions are modified, the heralded good intentions of the legislation are likely to remain just that – good intentions without the desired impact.

We encourage Treasury to ensure that the legislative intent is translated into a program that truly benefits underserved low-and moderate-income communities and consumers – especially minority consumers and small businesses. We encourage impact investors to join Treasury in this effort by increasing their investment in MDIs and CDFI depository institutions – especially common equity investments. The time is now.

Laurie J. Spengler is CEO of Courageous Capital Advisors, LLC. George P. Surgeon is CEO, GSJ Advisors, Inc.