Community development financial institution (CDFI) loan funds can be effective channels for generating deep social and environmental impact in communities. As patient, mission-first lenders, CDFI loan funds, which are typically nonprofits, can leverage tools — including time, technical assistance, and grants — to manage risk and support their borrowers in ways that most other financial institutions do not. This approach enables loan funds to effectively serve community needs. However, for new impact investors, CDFI loan funds’ unique characteristics can complicate the analysis of financial strength and performance.
Drawing upon our nearly 20 years of rating loan funds’ financial performance using both quantitative and qualitative analysis, we recommend that new investors focus on three critical areas:
1. The loan fund’s business model in its entirety;
2. The loan fund’s ability to effectively manage borrower risk; and
3. The adequacy of the loan fund’s capital.
The business model
CDFI loan funds’ business models are created to both achieve their mission and remain financially sound. Lending is always core to their operations, but loan funds may operate numerous other business activities that an investor must understand. One of the most common elements of CDFIs’ business models is the provision of technical assistance and coaching services (TA). These programs vary from loan fund to loan fund, as they are designed to advance the mission of the loan fund. TA is critical to borrowers’ success and to sustainably serving low-income, low-wealth communities. A comprehensive understanding of the loan fund’s business model is the foundation for understanding the loan fund’s financial performance.
Managing borrower risk
In my experience, CDFIs have rigorous underwriting and portfolio monitoring practices that are often on par with regulated financial institutions. In addition, beyond providing TA, CDFIs can be more patient in working through problems with borrowers and can bring additional resources to absorb risk, such as loss sharing and other credit enhancements from government, philanthropic, and mission-aligned partners. While portfolio performance may exhibit higher delinquencies, impairments, restructures, and/or write-offs than a conventional lender, CDFIs also typically have judicious loss reserves and robust capital protection to manage risk. These two areas, loss reserves and capital protection, are areas that should be reviewed and understood when evaluating any particular CDFI.
Understanding a nonprofit CDFI loan fund’s capital requires assessing both net assets and debt. Unrestricted net assets — built solely through operating surpluses and not through shareholder investments — are the most valuable protection for debt investors. Restricted net assets may be limited to certain uses according to donor specifications, but may provide additional protection if available to absorb credit losses. CDFI loan funds raise debt capital from a variety of sources. These can include banks, which are often motivated by regulatory requirements, as well as institutions and individuals whose social impact objectives align with those of the CDFI. Because CDFIs’ debt investors are usually motivated by factors beyond maximizing their return on capital, they will often offer CDFIs more favorable pricing and terms than purely profit-motivated debt investors.
These three areas represent a good starting place, but a comprehensive understanding of CDFI performance requires additional qualitative and quantitative analysis. Management and board, earnings, liquidity, and the full spectrum of assets should all be considered as well. Although it is tempting to rely on standard benchmarks to evaluate CDFIs, a standard approach does not adequately capture the variety and complexity of loan funds’ business models and operating environments. However, do not be deterred by this diversity. It is part of what has made CDFIs so successful in creating positive impact in the communities they serve while also responsibly managing their capital resources.
About the Author
Director of Ratings since 2013, Karen has performed and led Aeris’ analysis and rating work since 2004. Karen’s professional experience spans foundation program leadership, senior management of finance and lending in the CDFI industry, and a ten-year independent consulting practice. Her areas of expertise include program strategy, financial analysis, and investment in community, economic and sustainable development. Karen began her career as a financial auditor and earned an MBA from The Wharton School at the University of Pennsylvania. A tour of service in the Peace Corps in Malawi attracted her to the impact investing field.