Community Development Financial Institutions, or CDFIs, are private financial institutions that exist to provide access to financial products and services in low-income communities where conventional banking services may be lacking. Over the past 30 years, the CDFI sector has grown into a $150 billion industry including large, sophisticated organizations that operate nationwide, as well as smaller, local institutions. We spoke recently with two industry experts to get their perspectives on the state of the CDFI industry today.
Tim Ferguson is founder and Chairman of Next Street, an advisory firm serving small businesses and nonprofits. Ferguson considered the future of the CDFI industry in a recent paper and a series of interviews with CDFI leaders, including LISC CEO Maurice Jones.
Tell us a little bit about how Next Street is thinking about the current state of the CDFI industry. What’s your perspective on where things stand and where we’ve been?
We think it’s an exciting point in time, with a lot happening. We hear from clients that the credit cycle is felt to be at the top and, if anything, is beginning to soften and that gives a lot of leadership within CDFIs some cause for concern. That’s not surprising, given that the last time we had serious dysfunction in the market was 2008-2009. Larger organizations have all had pretty significant periods of growth and are beginning to think about things like: How do they ensure they have the right infrastructure to support the level of assets they have? How do they continue to scale and grow their business? What should their attitude and position be with regard to sustainability?
There is one other thing in general, and that is a focus on ensuring they have absolutely the right talent to support the ambitions they’ve got. I think there’s a need for people who really understand the communities coupled with ability to execute from the business point of view. And that’s what makes it both intriguing, but also really difficult, because often the organizations have been more mission-focused and when you bring in people who have a different type of focus, it can be hard to marry the two.
In CDFIs: The Next Alternative Financial Institutions, you note that CDFIs are uniquely positioned to meet the growing demand for impact investing due to their intimate understanding of and relationships in many of the neighborhoods that these dollars seek to support. How does that understanding translate into tangible advantages for investors? How do CDFIs ensure that this message reaches potential investors?
That’s a really interesting question. It’s too early to say. I know what I think the potential is, but I’m not sure it’s there yet as a reality. Most of the funding for the CDFI community still comes from government and from the CRA banks. My question would be, is there an opportunity with so-called impact investors that are seeking both financial and social returns? Have CDFIs figured out how to attract, keep and make perform the money that is not from traditional sources?
A second question is how you do actually measure financial and social returns. I still hear pretty consistently that people are looking for low-cost capital from CDFIs, and not looking for capital with a cost of eight to 15 percent. CDFIs also have often relatively small investment opportunities and the question becomes whether they are able to deploy larger amounts of money than has historically been the case. Are those deals out there for investors? We don’t know the answer to that quite yet.
Finally, there is a huge difference between making a loan and investing capital in different sorts of instruments, such as a bond or equity or some hybrid, and so the question is whether or not the skills exist within the CDFI industry to do that. It comes back to talent. Potentially, CDFIs are really well-positioned because they do know the community better than almost any other entity.
Historically, the CDFI industry has managed Community Reinvestment Act funds from banks and the federal government and there’s been a lot of talk about the need to diversify the investor pool. How optimistic are you about the industry’s ability to do this?
I’m a glass-half-empty person, but in this case, I am actually optimistic that some of the CDFIs will actually figure out what they need to do and make investments in the type of people they need. For example, LISC has done this in building its 7a loans business. CEI [Coastal Enterprises, Inc] has a new fund focused on solar and green businesses and they are using very good talent out of their New Markets Tax Credit business. There are examples where people are beginning to say there is a way to think differently about this. New leadership can be a catalyst.
How do you see capital strategies differing based on CDFI size?
It will probably fall to the bigger CDFIs to figure out how to pool things and then effectively act as intermediaries for investors more broadly. I think it will happen in small numbers. There are now roughly 900 CDFIs. Like everything, the top 10 or 20 are a significant portion of the total assets, and I think that will probably continue.In that top 20, there will be organizations that significantly change and alter their strategies and others that stay the same as they are today. The ones that alter their strategies will be the ones to attract different sources of capital. We are at the very early stages of impact investing. That amounts to about $282 billion right now. The worldwide market is $100 trillion. It’s not even a blip. I think that number will grow.
You have to believe in a number of things for that to be true. For example, you need to believe there is the transfer of wealth from Boomers to Gen X and millennials, which is expected to be trillions in the next 20 years. You also have to believe the next generations are going to want and acknowledge that they need both financial and social returns, and that has huge implications for all sorts of things, for example, how we measure investment performance. There are a lot of potential barriers along the way and people who have to be persuaded that this is a shift to their business models they need to make or they will become dinosaurs, and that is hard because Wall Street has a system and it works really, really well for them.
Do you foresee any risks in pursuing new types of investors in terms of mission-alignment? How can the industry manage this challenge?
I think there are a lot of risks and I would argue that the risks can be just as clear with CRA as they are with new types of investors. For example, as banks are inherently conservative, they limit the types of loans they are prepared to make, not necessarily what the businesses in the communities we serve happen to need. Are CDFIs becoming too bank-like in their business?
Opportunity Zones are an example of new money. It’s a really interesting tax credit, but let’s be clear, it’s an IRS tax code, not a program. It’s about a tax strategy and not necessarily about the community investment per se. The money is attractive, but we should consider the longer-term implications for residents in communities where that money will be invested.
I think that the hardest thing still is for entities like CDFIs to resist chasing the money. My advice is to be very clear on what your mission is and what you’re trying to achieve. Sometimes saying no to people is the hardest thing we have to do. If you’re staring at a $10 million grant and it isn’t aligned with your mission, you should probably say no to it.
Fran Seegull is the Executive Director of the U.S. Impact Investing Alliance, an organization focused on building the national movement to use investment capital for social, economic and environment impact.
Tell us a little bit about U.S. Impact Investing Alliance and your take on the CDFI industry.
The Alliance is a field-building organization dedicated to advancing impact investing among U.S. asset owners. We work with investors and financial intermediaries that are committed to sustainable economic, social and environmental impact. The Alliance is focused on catalyzing and advancing a movement toward impact investment—one that is rooted in and inspired by decades of work by community advocates like CDFIs as well as microfinance institutions.
Who are the investors that you work with?
The Alliance works with a range of investors including foundations, donor-advised funds, pension funds, banks, high net-worth families and intermediaries. For example, the Alliance facilitates the work of the Presidents’ Council on Impact Investing, a group of 20 U.S. foundation presidents committed to deepening the practice of impact investing within their own institutions and partnering with each other to build the impact investing field.
Many in community development emphasize the uniqueness and the importance of place-based strategies in every community. How do you reconcile that perspective with the industry’s need to tell a larger, comprehensive impact story, particularly to new types of investors?
Any story of impact has to be rooted in the individual lives of those we seek to benefit. You don’t inspire investors purely with innovative financing techniques or risk-adjusted returns alone. What motivates investors, policy makers and residents is to understand how financial tools can improve their lives, strengthen their communities and give voice to their interests and priorities. There’s power in the big picture too, of course, in the $230B (GIIN) moved to impact worldwide or in the announcements of mainstream funds entering the market. But the stories that underlie those numbers are what truly matters.That is what moves investors to impact and keeps them coming back.
How do you see the CDFI industry measuring and communicating its impact in line with other groups like the Global Impact Investing Network?
As a field, we are converging on impact measurement, reporting and management standards more consistently and effectively. CDFIs need to be able to make a compelling case for the impact of their work—to investors, to policymakers and most importantly to the communities they serve. In this regard, it’s helpful to have sector-wide data, especially in working with policymakers. Groups like Opportunity Finance Network (OFN) aggregate data regionally and nationally and that can speak compellingly to various constituencies.
How feasible is it for CDFIs to compete for investment dollars from mainstream investors as they seek to diversify their portfolios? Are you seeing that socially-motivated investors are willing to accept lower returns if the social impact returns are high?
CDFIs offer unique community investment exposure that can be leveraged to attract new investors. Part of attracting more mainstream investors is communicating the financial and impact track records. The decades of experience the CDFI sector has investing in communities is a major comparative advantage, especially among those investors looking to move capital out of elite coastal areas where it’s become increasingly concentrated. Also, investors are beginning to see that to invest in distressed areas such as Opportunity Zones you need the expertise and local context that CDFIs can offer.
CDFIs and microfinance institutions both performed fairly well during the 2007-2008 financial crisis. Some investors have seen that these investments can serve as a hedge against the public markets. In a period of income inequality, uneven recovery, rising interest rates and a whipsawing public markets, CDFIs can showcase their track record of stable returns, low default rates, high community impact and potential weak correlation to the capital markets.
So, CDFIs should be able to work with a wide range of investors, from those who are motivated to accept concession in order to maximize impact all the way to traditional, market rate investors who see the opportunity in communities. The key is being able to articulate the type of investment and the type of investor that is appropriate for a given deal. And to be clear about the impact thesis. We have seen regional and national CDFIs like LISC start to tap wealth platforms and the capital markets to raise funds. And Opportunity Zones present another opportunity to attract new sources of investment capital to distressed communities.
Have you heard concerns within the community development finance community about pursuing these new investors, particularly concerns around mission drift? If so, what’s your response?
Yes, the growing importance of mainstream financial actors in impact investing while exciting for the scale of resources they bring to the table comes with legitimate concerns about maintaining the integrity of impact. This is another reason why having clear and commonly accepted standards for impact matters so much. Investors need to have trust and confidence in the products and services marketed to them as impact. Communities need to be prepared to proactively and effectively engage with investors to ensure that their priorities are reflected in investment decisions. CDFIs can be an important bridge in this work, having the trust and knowledge of the communities where they are engaged and the expertise and credibility to operate in the financial markets. We see this in full effect with the Opportunity Zones tax benefit.
Ownership and building equity among residents and business owners in the places where we work is a major theme in community development right now. Do you see investors focused on bridging wealth gaps and sustaining community ownership over time?
Increasingly, yes, but it does require a shift in mindset to think about the role of capital in a community across the life cycle of an investment, including the exit. For some, this shift is occurring naturally as part of a growing understanding that investing in the sustainability and resiliency of places can contribute to financial returns and risk mitigation. Others are arriving from a deeply seated belief that we must act radically to reorient capital if we are to have any hope of overcoming systemic threats like climate change and rising inequality.
What are you most excited about for the CDFI industry in 2019?
At a macroeconomic level, we’re about to exit a period of consistent economic growth and stability. 2019 is going to be more volatile, and yet this can be an opportunity for CDFIs. Through the financial crisis, impact investors found that their CDFI investments outperformed the market as they continued to deliver sustained and consistent returns. As investors brace for more volatility, there’s an almost paradoxical opportunity for CDFIs to step forward.
I don’t want to be glib about this – because macroeconomic volatility translates to very real, personal hardships on the micro-level and damage to the communities that CDFIs serve.
But if we can learn from the lessons of 2007 and 2008, and if CDFIs can step forward to provide a bulwark to these communities, then 2019 could be an opportunity for further growing and advancing the industry. Policymakers will also continue to support CDFIs – through tried-and-true policies like the CDFI Fund and through more experimental efforts like Opportunity Zones. 2019 will be a year to push boundaries for what CDFIs and impact investors together can achieve.