Investing for Social Equity

By Kerwin Tesdell, President, Community Development Venture Capital Alliance

Community development venture capital (CDVC) funds provide equity financing to businesses in underinvested communities in ways that promote entrepreneurship, wealth, and job creation.  They seek market-rate financial returns for their investors and create stronger economies where they invest.  Banks are finding CDVC funds to be a profitable way of both fulfilling their obligations under the investment test of the Community Reinvestment Act (CRA) and helping to build markets for their traditional business lending activities.  [See sidebar on Strategic Investments in CDVC Funds by TD Banknorth.]

CDVC funds are relative newcomers to the family of community development financial institutions (CDFIs).  From only a handful 10 years ago, there are now more than 80 CDVC funds operating in both urban and rural areas of the nation, as well as dozens more in other parts of the world.  Since 2000, capital under management in the United States has more than doubled from $400 million to more than $900 million in 2005. 

The Importance of Banks and Other Financial Investors

The industry has changed rapidly during the past 10 years.  Perhaps the greatest change is the increasingly predominant role of financial institutions as investors.  Foundations, government, and other social investors provided early capital when the industry was still in an experimental stage.  While these social investors continue to be vital to the industry, the large amount of capital that has fueled its recent rapid growth has come from banks and other financial institutions, such as pension funds and insurance companies.  Figure 1 below illustrates this change.  A look at aggregate historical investment in the CDVC industry shows that by 2003 banks had invested more capital—42 percent of total capital under management—than any other type of investor in the CDVC industry, while banks plus other financial institutions accounted for over half of the total.  However, looking at new capital committed in 2003 shows banks alone accounted for 48 percent of capital commitments, and banks and other financial institutions accounted for fully 80 percent of total new commitments in the year.

Figure 1

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CDVC funds have evolved to attract large amounts of capital from increasing numbers of financial investors.  Almost all new CDVC funds are adopting traditional market structures: 10-year limited partnerships or LLCs with 2-3 percent management fees, and incentivized management with a 20 percent carried interest going to fund managers and the remaining 80 percent going to investors.  Management teams are increasingly sophisticated, possessing both traditional venture capital and strong economic development experience.  On average, CDVC fund size, investment size, and geographic market scope have all increased substantially, and CDVC funds are moving to expansion-stage companies rather than early-stage deals.  And investors are providing a vote of confidence by reinvesting in existing management teams: seven CDVC fund management teams have successfully raised second and third funds, and more are in formation.  The model developed in the United States has been transported successfully to Western and Eastern Europe, as well as the developing world. 

Financial Returns

CDVC funds target areas of the country where other venture capital funds tend not to look.  Most traditional venture capital investment dollars go to companies located in only five states—California, Massachusetts, New York, Texas, and Colorado.  Even in those states, investment tends to be limited to certain regions and high-tech companies. CDVC funds focus on urban and rural areas outside of the traditional venture capital funds typical stalking grounds [See sidebar on RylaTeleservices].  This allows them to find deals others do not, keeping valuations reasonable and avoiding bidding wars that suppress returns in overcrowded markets.  In addition, many investors believe that—because CDVC funds invest in different geographies and often in different types of deals than typical venture capital funds—CDVC fund returns will behave differently than other investments in their portfolio, adding financial diversity. 

Financial returns cannot be measured definitively until a venture capital fund has completed a full investment cycle.  It is said that venture capital portfolios can be valued accurately at only two points, before any investments are made (when the fund has only cash) and after all investments are exited; at any point in between, valuation is highly speculative.  Because the CDVC industry is so new—the first traditionally structured 10-year partnership fund will not wind down for several more years—we have no definitive return data on the CDVC industry equivalent to the return-to-investor data published by the National Venture Capital Association.  However, in an effort to get an early answer to the important question of financial returns, the Community Development Venture Capital Alliance (CDVCA) has compiled return information from a model portfolio composed of all exited investments made between 1972 and 1997 by the three oldest CDVC funds.  All three had perpetual lives and primarily social investors, and two were not-for-profit organizations.  We looked at all of the 31 exits made during the period, including seven full write-offs.  Including these write-offs, the model portfolio yielded a 15.5 percent internal rate of return—very much in line with the long-run return record of the traditional venture capital industry.  We would expect returns for the more recent, for-profit, limited life funds to be higher, because of the increased pressure to achieve market returns applied by investors and the pressure to exit quickly (which tends to boost returns) resulting from the more recent funds’ limited life. 

CDVC funds achieve not only strong financial returns for investors, but also important social effects for communities.  Like most companies backed by venture capital, CDVC portfolio companies grow rapidly.  A model portfolio for which CDVCA was able to gather job growth data experienced employment increases of 169 percent annually.  And these jobs are concentrated among lower-income people.  A smaller portfolio for which CDVCA was able to distinguish low-income employment showed an employment increase of 89 percent, but with a 124 percent increase for low-income employees as compared with a 37 percent increase for other types of employees.  Most CDVC investments are in LMI areas, and a high percentage are in government-designated empowerment zones, new markets tax credit areas, and CDFI Fund hot zones. 

How to Invest in a CDVC Fund

Unlike many CDFIs, CDVC funds are for-profit entities.  They are usually organized as limited partnerships (LPs) or limited liability companies (LLCs), and an investor in a CDVC fund purchases a partnership or membership interest in the LP or LLC.  Because capital is invested in the form of equity rather than debt, the investor does not receive a set interest rate, but rather return on investment is dependent on the success of the fund’s underlying investments in companies.  Minimum investment sizes are typically in the hundreds of thousands of dollars, but a bank investment in an individual fund may be in the millions [To learn more, read our sidebar on TD Banknorth’s investing.]

While a CDVC fund typically has a life of 10 years, all capital committed to the fund does not remain with the fund for the full 10-year period.  At closing, a fund typically makes a “capital call” for only a portion of the amount committed by investors.  The fund will call the additional committed capital over time, as the fund starts making investments in companies. When a fund exits an investment, it will typically return the cash to investors, so the investor receives its invested capital (plus associated earnings) back over time. 

All capital is committed to the fund up front.  This means due diligence on an investment in a CDVC fund must be performed before the fund is operating and has a track record.  For this reason, venture capital fund investors put a great deal of emphasis on the skill, reputation, and investment track record of the persons involved.  Investors also consider such issues as market and investment strategy, fund and investment size, and economic terms offered to investors.  However, just as the three most important factors for a real estate investment are location, location, location, for an investment in a venture capital fund, they are management, management, management. 

To find a CDVC fund in your area, you can visit CDVCA’s Web site at www.cdvca.org.  Leading CDVC funds across the nation are listed, along with fund profiles and profiles of representative deals.  CDVCA operates a fund itself, which can accept capital in the form of debt, for banks that are more comfortable with that form. 

Conclusion

Although investing in CDVC funds can be more complicated than making a loan to another type of CDFI, the rewards can be substantial.  First, a successful fund can provide financial returns well above what a loan can offer.  But more importantly, CDVC funds can be powerful catalysts for economic growth in communities.  Bankers know better than anyone else that equity can be vital to the health and growth of a business.  And along with equity capital, CDVC funds provide substantial entrepreneurial and managerial expertise; they are active partners in the businesses in which they invest.  Equity capital and accompanying management expertise are rare commodities in LMI areas, and are vital to their economic growth.  Finally, the equity capital that CDVC funds provide helps promote business formation and expansion.  A CDVC equity investment often makes possible much larger senior loans to companies.  CDVC funds therefore not only offer banks financial returns in their roles as investors, but also can be important long-term partners in a bank’s core lending business.