Community Development Venture Capital

Low-income communities often have a wealth of ingenuity and innovation, but lack the equity capital and entrepreneurial experience needed to grow a business and stabilize the community in the process. Community development venture capital (CDVC) funds use the tools of venture capital to create jobs, build entrepreneurial capacity, and expand the wealth of distressed communities. CDVC funds seek a “double bottom line,” pursuing both social and financial returns on their investments. From a handful of organizations just a few years ago, there are now more than 60 CDVC funds actively investing in the United States and managing more than $450 million in capital.

CDVC funds make equity, near-equity, and debt investments in for-profit businesses that promise rapid growth. In contrast to traditional lenders, CDVC funds invest cash in exchange for an ownership interest in the company, typically common or preferred stock. “Near-equity” investments are investments that include a debt component but are structured to capture an “upside” return; they include debt with warrants, convertible debt, and debt with royalties. In 2000, the average size of an individual CDVC investment was $331,000.

Many community development corporations lend to small businesses in areas where equity capital and entrepreneurial capacity are limited. The strength of equity capital is its flexibility and patience—unlike an amortizing loan, equity capital does not require that repayment begin immediately and follow a fixed schedule. Some of the businesses receiving loans from CDCs may be poised for substantial growth but lack the necessary capital and entrepreneurial expertise. CDVC funds—which invest in inner cities, rural areas, and other places that traditional venture capital funds often overlook—provide the patient capital and management know-how that can help these businesses realize their potential.

CDVC funds vary in size. At the end of 2001, for-profit CDVC funds had an average capitalization of $13.1 million; not-for-profit funds tended to have either less than $1 million or more than $5 million available for CDVC investing. For-profit funds started in the past few years have tended to be larger than older funds. Several funds were launched in 2001 with more than $20 million in capital under management. Banks are the single largest supplier of capital, contributing 58 percent of the capital under management at the end of 2000, according to research by the Community Development Venture Capital Alliance, an international association of CDVC practitioners and advocates. Corporations and foundations contributed an additional 13 percent each, and the rest came from federal and state governments, individuals, and other sources.

CDVC funds are one of the fastest growing sectors among community development financial institutions. In 2001, four firms that already had successful track records with one fund raised nearly $60 million for their second CDVC funds. Their success, which included the first capital commitment from a public pension fund, reflects growing investor confidence in the field.

Other firms are starting CDVC funds for the first time. These firms usually have management teams with substantial traditional private equity experience and connections to local financial leaders, including bankers, large corporations, and economic development agencies. Like the managing firms raising second funds, these newly formed funds have tended to adopt the traditional venture capital structure—a limited partnership (LP) with a limited lifespan managed by a separate firm that is either an LP or a limited liability company (LLC). The advantage to this arrangement, notes Michael Frankel, managing director of Southern California Community Ventures in Los Angeles, California, is that familiarity with the structure helps investors focus on the CDVC social mission.

The New Markets Venture Capital (NMVC) Program is also helping the CDVC field to grow. NMVC companies are private for-profit funds certified by the Small Business Administration (SBA) that make equity and near-equity investments in low-income areas and smaller enterprises, as defined by program regulations. In 2001, the SBA conditionally certified seven NMVC companies. During 2002 these first-round NMVC companies aim to raise between $5 million and $12.5 million each in private capital and an additional $1.5 to $3 million each in private operating assistance grants. SBA will match each pool of money—the investment pool and the technical assistance pool—on a dollar-for-dollar basis. When fully capitalized by the end of 2002, these seven funds will add nearly $100 million more in investment capital to the CDVC field. The SBA will conditionally certify a second round of NMVC companies in 2002.

Finally, a growing number of “emerging funds” have been initiated by organizations with substantial lending experience that want to offer more patient and riskier capital. The emerging funds tend to be not-for-profit loan funds that allocate a portion of their capital to equity and near-equity instruments in order to meet this untapped demand.

Like their traditional venture capital counterparts, a CDVC fund requires a management team with substantial investment experience. In addition, fund managers strongly urge $10 million as the minimum capitalization. These requirements present a Catch-22: Without the CDVC experience you can’t raise the funds to start, but without the fund you can’t earn the experience. So where does one begin? “Management capacity is key. If you don’t have it, get it or learn it,” is the advice of Nat Henshaw, president of CEI Ventures, Inc. of Portland, Maine, who successfully raised a second fund last year. Getting the experience may not be easy, but the social, financial, and professional rewards are worth the struggle.

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