This article is part of “Investing in Racial Equity,” an ImpactAlpha series in partnership with Living Cities that explores how foundations and financial institutions can deploy capital to close racial wealth gaps and create opportunities in America’s cities.
ImpactAlpha, June 20 – If we really want to re-invigorate the American economy and grow jobs, we need to understand why America’s fastest-growing populations, people of color, aren’t starting and growing companies. We must build comprehensive solutions that transform how capital is deployed, companies grow, and jobs are created by people of color.
Living Cities has been an impact investor for eleven years through the Catalyst Family of Funds. We manage about $80 million of institutional capital and have invested in more than 30 different funds and financial institutions. At $37 million, our Blended Catalyst Fund is one of the largest explicitly race focused funds in the market.
Asking the right questions to guide investments in closing racial wealth gaps
Our organization is focused on harnessing this experience, our available loan funds, long standing relationships, and reach to show that there is another, better way to deploy capital and grow jobs. We call this focus ‘capital for the new majority’.
What does capital for the new majority look like? We have been aggressively building a portfolio that has our capital land in places that we care about, puts people of color in decision-making positions, and begins to challenge definitions of creditworthiness and other norms, including the idea that the system as it exists now is how it has to be.
Market failures
America has a crisis that much of philanthropy and the social sector writ large isn’t registering. Our job creation machine, largely built after World War II, is broken. It turns out that it is really hard to get un- and under-employed people into good jobs—even if they are trained for them—if those jobs don’t exist.
For the past 40 years, the entities that create 90% of all new jobs—start-up companies less than five years old—have been on a steady downward trajectory. A recent Economic Innovation Group (EIG) report, “Dynamism in Retreat,” paints a frightening picture of this long-term decline. The data tells us that the number of start-ups fell by nearly half between 1978 and 2011, and start-up rates were lower between 2009 and 2011 than they were between 1978 and 1980 in every state and Metropolitan Statistical Area except one. If we aren’t producing new businesses, we aren’t producing jobs and opportunities for people of color and low-income Americans.
How Kellogg Foundation is interrupting racial bias in capital markets
On top of that, the people we have long relied on to create these companies and grow jobs no longer do so. In 1996, 77% of all new start-ups were founded by whites; by 2014, that percentage had dropped to 59%. And while start-ups by Latinos and Blacks rose over that period percentage-wise, they did not increase in sheer volume. The EIG report shows that if we had generated the same number of start-ups in 2014 as in 2006, only eight years earlier, we would have generated almost 1 million more jobs that year.
We must better understand why people of color, America’s fastest-growing populations, aren’t starting and growing companies. A report from The Kauffman Foundation, “Including People of Color in the Promise of Entrepreneurship,” casts a spotlight on the unique challenges faced by entrepreneurs of color when launching and growing businesses—including a lack of wealth and networks, and a history of being denied capital from traditional institutions. Nothing in that report is new, yet we haven’t even come close to solving these problems.
Our current institutions—the banks, and private equity and venture funds that provide capital, as well as the technical assistance providers that help companies grow—have a pitiful track record of serving people of color and women successfully. After controlling for education, credit score, experience, number of owners, and firm age, firms owned by people of color on average received loan amounts 35% lower than those offered to white-owned firms. The denial rate for women-owned firms—both white and of color—is twice that of white male-owned firms, according to the 2003 Survey of Small Business Finances. On the equity side, ~2% of venture capital funding went to black founders in 2016 and .0006% went to the fastest growing group of entrepreneurs, black women.
In short, the scope of our collective work to date to address these market failures has not met the scale and complexity of the challenges that we face as a nation. We must build comprehensive solutions that transform how capital is deployed, companies grow, and jobs are created by people of color. Without these solutions, we will not only fail to grow our economy in the second half of this century but fall even further behind in addressing the significant racial disparities in income and wealth that exist, therefore perpetuating a cycle of inequality and an imbalance of power, for individuals and communities of color.
‘New majority’ capital
Living Cities’ focus on ‘capital for the new majority’ is an attempt at a better way to deploy capital and grow jobs.
The foundation of our work, begun eighteen months ago, was the repurposing of our Blended Catalyst Fund to focus exclusively on closing racial income and wealth gaps. As one of the first impact investment funds dedicated to racial equity, the response to this focus has been overwhelmingly positive.
We frequently receive the question: What does that mean, and how do you do that? We intentionally invest capital in places overlooked by mainstream markets and in funds and organizations with people of color in leadership roles. We also look for alternative ways to determine creditworthiness that don’t rely on the exclusionary practices of the current system.
We are tackling the issue of disparate access to capital from multiple angles, some of which are more tactical while others are more systemic. Here are some of the things we look for in our new transactions.
Fund managers of color. First, we seek to invest through intermediaries (funds or financial institutions) that have managers and owners of color. This is because we believe these managers are less risky than the “system” assesses them to be. We also believe they make different capital allocation and operations decisions than white managers, and that those decisions are more inclusive of other people of color.
Access to capital. Second, we are seeking intermediaries that have found more inclusive ways of creating income and wealth-building opportunities for people of color through access to capital. This includes those that are offering more reasonable financial terms – e.g. lower interest rates, longer tenors – to individuals and entrepreneurs of color. It also includes intermediaries that have found alternative underwriting and diligence methodologies that promote increased inclusivity, e.g. finding a proxy for FICO scores, character-based lending. We are also seeking intermediaries that offer support that changes who is eligible for income and wealth building opportunities, e.g. technical assistance that precedes underwriting.
Ecosystem building. Lastly, we are seeking entities that, as part of their business model, are building a more robust ecosystem for people of color.
When we diligence new transactions, we are very clear about the centrality of racial equity to our mission; if that discussion makes our potential borrower or co-investors uncomfortable, we are probably not the right partners for one another. Our financing agreements are also very clear about our expectation that our borrowers will incorporate a racial equity perspective into their work, and that they will operate within communities of color. Post-close, we ask that our borrowers report against their impact metrics, disaggregated by race.
As such, there is a significant amount of opportunity, financial and programmatic, in this market but no charted path for us to follow. We are continuously asking ourselves whether what we are doing is working and asking ourselves where we need to make changes to be more effective.
Building a portfolio
This is what some of the transactions in our portfolio and pipeline look like.
One fund in our pipeline is raising $30 million to on-lend to small and growing businesses owned by people of color in the Southeast. When we were diligencing the fund, we met some of the companies in their pipeline; the fund manager describes these companies as “blue collar, cashflow” businesses, some of which had revenues that were as high as $10MM. Nevertheless, these are companies that don’t feel comfortable walking into a bank and applying for a loan – perhaps because they have been turned down or had bad experiences in the past. Instead, they prefer to work with someone that offers technical assistance, reasonable terms, and cultivates long-term relationships.
The fund is managed by a black-owned firm that employs four other people of color. The fund manager feels their cultural competencies, in working with entrepreneurs of color, are one of the things that makes them attractive to their borrowers. Interestingly, the emerging fund manager is being mentored by one of the largest minority-owned investment advisors in the country. This investment advisor has a long history of working with emerging managers and they are also an equity investor in the fund.
Apply a racial lens, and other lessons from Living Cities’ impact investments
A student lending company we explored an investment in lends to low-income, high-performing students who have been admitted to four year universities but who require financing on reasonable terms in order to complete their degrees. Many low-income students have a difficult time accessing credit on reasonable terms because they may not have guardians who can co-sign loans. Therefore, due to a lack of financing, many low-income students end up going to less competitive colleges, not going to college at all, or, in the worst of both worlds, borrow to begin college but never complete their degree.
Unlike most other lenders, who eschew lending to low-income youth, the company deliberately targets this demographic. In order to best serve their low-income borrowers, the company has created an alternative underwriting methodology that includes proxy measures for credit-worthiness, beyond income and wealth. The firm is largely led by people of color who once were low-income students themselves. Due to the demographic they are serving, they believe that most of their borrowers are people of color as well.
NewCorp, a New Orleans based community development financial institution (CDFI), is a Living Cities borrower. Our loan is part of the $1.5 million BuildNOLA Mobilization Fund, which supports lending to minority and women-owned small businesses working on public sector contracts. The businesses the fund is lending to have demonstrated the technical capacity to perform work for the city but do not have the cash-on-hand for working capital or the access to mainstream financing required to handle the unpredictable payment schedules of public sector work. By borrowing from NewCorp, these businesses are able to bid for city contracts.
The BuildNOLA Mobilization Fund operates within the context of a city which mandates that at least 35% of its contracts go to minority and women-owned businesses; this type of policy provides a fertile ecosystem for the BuildNOLA Mobilization Fund and reinforces its raison d’etre. NewCorp is a small CDFI that is led by and employs a team comprised of people of color. It is culturally well-equipped to implement the investment strategy associated with the BuildNOLA Mobilization Fund.
Racial-equity lens
At Living Cities, we are “investing for racial equity” – meaning our impact investment funds are (one of many tools) used to promote racial equity. However, there are many “right” ways to embed racial equity in investment work.
Building local startup ecosystems that work for entrepreneurs of color
The different ways to embed racial equity include a positive screen upfront for managers of color or communities of color; a requirement that a certain percentage of your investment capital benefit communities of color; a request for racially disaggregated impact metrics post-close; or questions about who is benefiting within communities.
All of these ways are necessary, will increase awareness of racial inequality, move the investment field in the right direction, and contribute to positive social change.
Ben Hecht is the CEO of Living Cities and Brinda Ganguly is the managing director of Living Cities’ Catalyst Funds.
