Innovation in Community Impact Investing

According to US SIF: The Forum for Sustainable and Responsible Investing, Socially Responsible Investing (“SRI”) has reached the $12 trillion asset mark. Unfortunately, the vast majority — 97 percent, to be precise — comprises investments in the traditional capital markets in which decisions are made using Environmental, Social, or Governance (“ESG”) criteria. While I applaud people adding ESG screens to their portfolio, it is imperative that we find ways to support direct, community-level investments.

Innovative nonprofits are at the forefront of driving social change, but for them to scale they must attract significantly more capital. Fortunately, at Capital Good Fund (“Good Fund”), a nonprofit Community Development Financial Institution that provides small-dollar consumer loans to the economically marginalized, we have been testing a solution for over three years. Before diving into the solution, it is important to state the problem:

High-growth nonprofits with a revenue model face significant challenges when it comes to funding their growth: grant dollars are scarce, often come with restrictions, and are too small to allow for mid-to-long term planning. At the same time, since nonprofits are owned by the public, they cannot raise equity. This leaves a final source of growth capital — debt. Nonprofits are not legally limited in the amount of capital they borrow, but not all debt is prudent. Debt for asset purchases such as property or equipment, or to fund a loan pool, for instance, is not problematic because the liability is offset, and can be collateralized by, an asset. Debt to fund growth (such as personnel and technology) carries the significant downside of adding a liability, but not an asset, to the balance sheet. Like any business, an over-leveraged nonprofit’s existence can be threatened, as donors, investors and others may become less inclined to support the organization, philanthropically or otherwise.

The solution is to expand on an already common fundraising mechanism known as a Direct Public Offering (“DPO”). Many organizations, both for profit and nonprofit, have used DPOs to raise capital. Nonprofits in particular are well-suited for DPOs because they can use various federal exemptions, not available to for profits, that entail a lighter regulatory burden. Numerous CDFIs, including Good Fund, have used DPOs to successfully and inexpensively raise debt to fund loan pools or create other assets (buildings, vehicles, etc.). The innovation in our solution, however, is in how the DPO enables a nonprofit to borrow for “growth capital” — operating expenses that enable revenue generation over time — without the liabilities damaging the organization’s balance sheet.

Here’s how it works. The debt is issued, not by the nonprofit, but rather by a subsidiary organization controlled by the nonprofit. Structured this way, the liability is held on the balance sheet of the subsidiary, thereby preventing the parent nonprofit from becoming over-leveraged. To get the funds from the subsidiary to the parent, the proceeds of the investment are donated in the form of an unrestricted grant. The parent recognizes the grant as income on its profit and loss statement, increasing its net assets and therefore strengthening its balance sheet, much like an equity investment.

The parent now has money to make the operating investments needed to increase earned income. But how does the parent then get the funds back to the subsidiary to pay back its investors? Remember that the subsidiary is newly created and, as of yet, does not have any activity outside of issuing debt through the DPO. The answer is that the subsidiary can provide the parent a service, such as accounting, marketing, or loan servicing, with the value of that servicing contract equal to what’s due to the investors.

Let’s look at a case study. Imagine a nonprofit, Main Street Soup Kitchen (“The Kitchen”), that seeks to open a restaurant run by returning citizens that will, over time, generate enough revenue to cover its operating expenses. The Kitchen seeks $1 million in operating money to launch the restaurant. To do so, they create a subsidiary called Main Street Investment Club (“The Club”), which issues $1 million in debt at five percent to impact investors via a DPO. The term for the investment is 10 years with annual principal and interest payments. Ten investors — individuals, foundations, family offices, and others — each invest $100,000. The Club shows the $1 million as a liability on its balance sheet and donates the proceeds to the Kitchen, which books the money as an unrestricted grant. The Kitchen uses the funds to scale its operations, and soon the restaurant is generating revenue.

To make the annual loan payment of $115,000, the Club charges the parent nonprofit $115,000 for marketing services each year, which it uses it repay investors. In a sense, this approach allows a nonprofit to raise equity without it being equity. Yes, the Club must find a specific type of impact investor willing to make an unsecured, patient investment and, possibly, at a below market rate. But there are trillions of dollars going into ESG and other SRI investments that cannot approach the impact of The Kitchen’s work. Unlocking this capital for community organizations is going to fund deep social change. At a time of urgent injustices around the world, we need to provide investment vehicles that can drive solutions that meet the scale of these challenges, be they climate change, mass incarceration, or predatory lending.

Capital Good Fund has raised over $3.5 million via a DPO through our subsidiary, Social Capital Fund. This unrestricted capital has been essential to our growth, allowing us to increase our net assets by nearly 800% in three years. As more nonprofits leverage this mechanism, we can tap into hundreds of billions of dollars. This will also allow nonprofits to spend more of their valuable time fulfilling their missions instead of the endless “starvation cycle” of traditional grant-dependent organizations.

This article was adapted from Funding Challenge: Debt vs. Equity vs. Philanthropy, published in The Non-Profit Times.

 

Article by Andy Posner, who founded Capital Good Fund in February of 2009 while getting his Master of Arts in Environmental Studies at Brown University, where he was studying financing mechanisms for clean energy. After reading Banker to the Poor by Dr. Muhammad Yunus, the ‘Father of Microfinance’ and 2006 Nobel Peace Prize winner, he quickly realized that equitable financial services could unlock the potential of the poor just as they could do the same for clean energy technologies. At the same time, as the financial crisis of 2008 began to unravel the economy and devastate low-income communities, Andy decided to take action. He created Capital Good Fund with an eye toward using financial services to tackle endemic poverty, first in Rhode Island, and then nationwide.

Andy is a firm adherent of Dr Yunus’ dream to put poverty into museums; or, as Andy likes to put it, to put poverty out of business. Andy’s work has been featured in Providence Business News, the Providence Journal, the Providence Phoenix, the Federal Reserve Bank of Boston’s quarterly publication, the Rhode Island Small Business Journal, CNN and other print, radio and television media. He is also proud to be the Treasurer of the national Board of Directors of the Credit Builders Alliance, an organization of which Capital Good Fund is a member, as well as a member of the Board of the Community Reinvestment Fund, one of the largest nonprofit lenders in America.