ADDRESSING FIVE MISCONCEPTIONS ABOUT IMPACT INVESTING THROUGH CDFIS

By Jennifer Oertel, CMF Impact Investing Expert in Residence

In our last blog, we summarized studies demonstrating that ESG investments (those taking into account environmental, social and governance factors) perform on par with pure financial investments and tend to perform better in a downside economy.

In this blog, we’ll dispel some misconceptions about impact investing through an “intermediary” organization such as a community development financial institution (CDFI). CDFI certification is a U.S. Department of Treasury designation given to specialized organizations that provide financial services in low-income communities and to people who lack access to traditional financing. CDFIs include regulated institutions such as community development banks and credit unions, and non-regulated institutions like loan and venture capital funds. Certified CDFIs are eligible to apply for federal funding from the U.S. government and can receive investments from private and charitable funders.

Similar to what is said about community foundations, if you’ve seen one CDFI, you’ve seen one. They differ significantly in their impact focus, the work they support and the services they offer. We at CMF have featured many local CDFIs in our work over the years, including IFF, Rende Progress Capital and Northern Initiatives.

In recent conversation with IFF, a CDFI serving the Midwest with offices in Detroit, we discussed several misconceptions CDFIs encounter related to impact investing, even beginning with the term often used to describe their role in impact investing: “intermediary.”

Misconception #1: A financial intermediary is a middleman for our money. It is better to do direct investing so we can make a higher return and borrowers can save on the rate.

The role of intermediaries, including CDFIs is a very dynamic one, offering significant value. Conducting due diligence and underwriting an investment, whether it be a loan, equity investment or a real estate investment requires a different set of skills than is prevalent in much of philanthropy. An intermediary not only analyzes things such as future cash flows and debt capacity, and recognizes legal and financial risks, but also stitches together other layers of the capital stack with other investors in order to reach the investment amount needed, thus lowering the risk of any one investor. And the work doesn’t stop there. Once a loan or investment has been approved, the closing, monitoring and servicing of the loan or investment requires significant back-office support that not all impact investors have readily available. Even large and seasoned private foundations often choose to deploy a portion of their impact investments through CDFIs and impact funds.

By way of example, an impact investor making direct investments of $500,000 into socially impactful real estate projects would be able to fund one to two deals. The investor would need to locate the deals, conduct due diligence on the potential investee(s), structure the investments and perhaps try to connect that investee with technical assistance. Not all impact investors have the skills and capacity to conduct all of these activities, and many don’t have connections with other investors who can co-fund transactions. Investing in a CDFI or an impact fund means investors get to leverage technical expertise while accessing a larger capital pool to reach even greater scale, and at the same time de-risk their investment.

Misconception #2: CDFIs compete with the local banks.

CDFIs arose to serve the very segment of the market that banks cannot serve. Structurally, as non-regulated financial institutions, CDFIs have flexibility in underwriting and portfolio management that regulated banks do not have. This flexibility allows them to serve organizations that would otherwise have no access to financing. This also allows them to participate in deals with banks in more junior positions (meaning their return of capital is subordinated to that of the banks and their return on investment may also be lower) that make possible deals that otherwise would not be funded by a bank. As organizations build credit history and strengthen their balance sheet, they may eventually grow into an organization that qualifies for bank debt. In sum, CDFIs are partners with banks in extending credit into a community and building the future pipeline of borrowers.

Misconception #3: We know there is need in the community for capital so the investable deals should be easy to find.

While it is certainly true there is no shortage of organizations in need of funding, some need a lot of technical assistance to get ready to receive an investment, as opposed to just absorbing grant funds. This capacity building can include anything from financial management and business planning to real estate construction management. We often hear that impact investors have challenges locating potential investees that are investment-ready. IFF has developed its own target market criteria which speaks to its hypotheses about what it takes to be debt-ready. IFF has also invested in nonprofit capacity building programs like the Stronger Nonprofits Initiative and Learning Spaces, increasing capacity and improving access to quality early childhood education across the city of Detroit and the Midwest. Other Michigan-focused CDFIs like Rende Progress Capital, which focuses on entrepreneurs excluded from the financial system due to racial bias, provides business technical assistance as well as wealth counseling to its clients. Clients of Northern Initiatives have 24/7 access to their online business resource with hundreds of interactive tools, templates, videos and guides. Opportunity Resource Fund is one of the few CDFIs that supports home ownership through a mortgage fund which reviews the complete financial picture of borrowers, not just their credit score. These are just a few examples of the many CDFIs working to support and improve Michigan communities and the people who live there.

CDFIs offer financial subject matter business expertise and work with funders to build an investable pipeline utilizing multiple financial tools while leveraging the respective comparative advantages of involved stakeholders.

Misconception #4: We have to choose only one CDFI for our investment.

Just as CDFIs collaborate with banks, they also collaborate with other CDFIs. According to Chris Uhl, executive director at IFF of the Eastern Region, which covers Michigan and Ohio, “A robust ecosystem is one where there are many players offering differentiated products and services.” IFF specializes in financing nonprofits whereas other CDFIs specialize in financing small businesses. “We often participate on deals together, and in many areas outside of the metro hubs, there may not be even one CDFI serving the community.” As a relatively larger player in the ecosystem, IFF’s partnership with smaller local CDFIs can also help strengthen their balance sheet and the overall local financial ecosystem. “IFF can facilitate access to liquidity and capital grants that may be out of reach for smaller organizations.”

As noted earlier, CDFIs vary significantly in impact focus and expertise. Investors should consider investing in multiple CDFIs to support the overall community development space. Community foundations and other impact funders can also use their convenor role to support coordination and collaboration, and larger CDFIs can efficiently support the growth and success of smaller CDFIs.

Misconception #5: The best way to ensure impact is to restrict the money to investor priority geographies and sectors.

CDFIs, just like community foundations, have their fingers on the pulse of what is needed in their communities, and providing unrestricted grant or investment capital that is responsive to those needs allows the experts the flexibility to be responsive. It also allows them to deploy capital more quickly instead of having to wait until investable projects can be found to fit a myriad of investor restrictions. Further, strengthening CDFIs, which are often public charities or their equivalents, can also be socially impactful while lending to a robust financial services ecosystem that puts its funds to work in and for the community.

How can you facilitate impact investments through CDFIs?

It is relatively easy to conduct due diligence into CDFIs because their business is rather transparent. Many also choose to be rated by Aeris, which reports on aspects of their work such as impact management, financial strength and performance as well as other pertinent factors. Another benefit of an ecosystem-building approach, like that which CMF and many others have been working to build, is that stakeholders in the ecosystem can leverage one another’s resources, sharing the costs of due diligence and negotiation. The more that impact investors can coordinate efforts, the more transaction costs and other barriers will be lowered.

Impact investing through a CDFI is a relatively workload-light and effective way to multiply the impact of an investor’s dollars while minimizing risk. (IFF reports that it has always returned 100% of investor dollars, plus a return on those dollars, for the entire history of its 33-year existence.) It is certainly one great tool in the impact investing toolkit.

Want to explore this topic further?  Have your own impact investing story to share? Reach out to CMF’s impact investing team.