Good lending practice caps how much money can be loaned to a small business based on their cash flow, as well as debt-to-asset ratios. Growing simply based on cash flow can result in very slow growth. Some communities have taken the next step and created Community Development Venture Capital Funds, funds organized to provide an equity investment component to enterprises whose growth will benefit the community with increased jobs and tax revenue. Investors are often local governments and banks motivated by CRA credit. Returns are anticipated to be higher than for loan funds, but the lifetime of CDVCA funds is usually 10 years and very few of them have closed yet as this is a somewhat new opportunity. The Community Development Venture Capital Association did a model portfolio study and concluded that returns of the oldest funds are likely to be around 15%. (Community Developments: Investments, Spring 2007). The struggle for all these types of investments is that in an arena of profit maximization, they are easily overlooked as “not market-rate” for their class.
A challenge for CDVC funds is finding enough opportunities to place capital when the pool of potential investments has been narrowed to explicitly avoid the kinds of deals that easily attract funds from traditional investors. The costs of finding these deals can be higher but is usually offset by partnering with a community development loan institution that can act as a screening/referring body and reduce the cost of due diligence.
The premise of working with lenders is that risk can be mitigated through relationship, and thus the CDVC firms can tolerate making investments where the winners don’t need to provide all the return from only 10% of the portfolio, because the potential for losing is reduced. Partnering with loan funds can also reduce costs through careful sharing of staff and office resources. This is necessary because the smaller size of community development VC funds (often 10 million or less) means lower potential for operating revenue – 3% on a $5 million fund is an annual revenue of 150,000, not much to pay staff or have an office. Like Venture Capital funds, these funds also take a percentage of profits at the back end, usually this is how fund principals are compensated in a traditional model, but they’re usually also wealthy capitalists who can afford to take payment on the back end. CDVC staff is more commonly salaried.
Leaning on the loan funds to do first-level due diligence saves resources, though likely the fund would want to identify other sources of deal flow, perhaps local universities. Going to traditional angel groups would defeat the purpose of working to place capital in underserved communities and industries. Having a clear definition of targeted social return will be important to aid in investment selection and avoid falling into “investments nobody else wants” as a primary target, which seems a recipe for failure. The measure most successful CDVC funds have in common is targeting job creation for low-income workers that leads them out of being low-income. Having a non-profit advisory service partner that can help the growing enterprise design career paths, provide employee training, help with recruiting and other challenges of growing an enterprise can improve the chances of success at minimal cost, as well as save the investee companies from the burden of doing the additional research and trial-and-error associated with implementing new internal systems.
What have other funds done? SJF Ventures in North Carolina capitalized its first fund in 1999 at 17 million and its second fund closed in 2007 at 28 million. They have a partner non-profit that offers technical assistance, including a “getting ready for equity” class. Their criteria: “Require $1 million to $5 million in equity financing to produce rapid expansion; Offer compelling solutions to urgent problems in large markets; Generate rapidly growing sales, typically already greater than $1 million per year; Represent management teams with deep domain expertise in their respective industries and a commitment to positively impact the world.” (SJF website) SJF works in social value on a deal-by-deal basis. In one case, for a company to receive funding they required the company provide health insurance for their existing and future employees – AND they were able to provide free assistance for doing that with their technical assistance partner. (Personal conversation with Bonny Mollenbrock). SJF Advisory Services, the technical assistance partner, does not appear to operate a loan fund.
CEI Community Ventures in Maine is organized as a wholly-owned subsidiary of their technical assistance non-profit. Their first fund closed in 1996 with a total of 5.5 million. Their second fund closed in 2001 with a total of 20 million. Their target investments: “$750,000 in a range from $500,000 to $2 million. We anticipate exiting each portfolio company at appreciated multiples within 5 to 7 years. Each fund portfolio is diversified by business stage, industry, geography and social benefit.” (CEI Ventures website). Their criteria: “Quality Management Team with relevant experience, visionary leadership, deep commitment and cohesive approach; Prospects for Attractive Return with an appealing market opportunity, realistic projections, appropriate valuation and pragmatic exit plan; Competitive Advantage through proprietary interest in technology, intellectual property, distribution system or other unique situation; Social Benefit including quality employment opportunities. Each portfolio company is required to sign an Employment and Training Agreement (”ETAG”), securing a commitment to hire individuals with low income backgrounds.”
Pacific Community Ventures closed their third fund, PCV III, in 2007 with $40 million, after a very well publicized successful exit for a prior portfolio company: Timbuk2. PCV II raised 13.2 million in 2003 and their first fund was 6.25 million, closed in 2001. They look to invest 1 to 5 million in a company in the southern California region. Their areas of focus are food products & distribution, non capital-intensive manufacturing, and green growth sectors of alternative energy, health & wellness. They also invest in education. Like the other funds, they look for traditional opportunities for growth: proven management, strong revenue growth, substantial margins and defensible competitive advantages. They have very well developed internal social metrics and they also look to develop a low-income workforce with opportunities for employee growth, both in on-job skills and life financial skills. And unlike a traditional VC, when they negotiated their investment in Timbuk2, they negotiated a stake for employees as well, resulting in over $1 million being distributed across 40 line workers when the company got bought.
A cleantech CDVC fund, partnered with a Green For All focused non-profit, is something I could really get excited about.