Financial Innovations and Small Financial Innovations and Small Business GrowthBusiness Growth

Glenn YagoMilken Institute

October 2009

Small Business are Vital to the U.S. Economy

• 99.7% of the 5.5 million firms in the United States have fewer than 500 employees.

• Small businesses account for 50% of private-sector output, employ more than 50% of private-sector workers, and create about 75% of net new jobs per year.

• 2/3 of small businesses have less than 5 employees.

• 4/5 of small businesses are located in urban areas.

• 15% of small businesses are minority-owned; 24% are women-owned.

Low-Income Areas Suffer from a Lack of Capital

• From 1996 to 1999, small business loans in upper-income areas grew 13 times the rate of growth in low-income tracks.

• Of the 9.7% of individuals without bank accounts, 50.5% generate incomes below $10,000.

• Fifty-three percent of individuals living in poverty are racial minorities.

• Nearly forty percent of firms ranked in the InnerCity 100 were owned by minority entrepreneurs.

• Roughly 13% of U.S. small businesses with employees are owned by minority entrepreneurs.

The U.S. Minority population today is larger than the population of 93% of the world’s countries.

The Minority population will account for nearly 90 percent of the total 131 million growth in the U.S. population from 1995 to 2050.

The Minority population will most likely pass the non-minority population after 2050.

Minorities today account for $1.3 trillion, or 20% of the U.S. total $6.5 trillion purchasing power.

Minorities Grow in Importance

Increasing Role of Minorities in the Labor Market

Labor Supply Constraint

Since the 1970s, the U. S. workforce growth rate as been declining--from 2.7% in the 1970s, to 1.6% in the 1980s, to between 1.0-1.5% today. Projections over the next decade predict continued low rates of increase.

Meanwhile, by 2020, 70% of the workforce growth will occur among minorities.

Unless this workforce can be tapped, the lack of labor will act as a brake on economic growth.

Small Business’ Sources of Financial Services by Sales

0102030405060708090

100

CommercialBank

Thrift* Nondepositoryfinancial

institution**

Nonfinancialsupplier* * *

<25

25-49

50-99

500-999

2,500-4,999

10,000+

Percent

Fiscal Year Sales

(Thousands)

*thrift (savings institution, credit union); **finance company, brokerage, leasing company, other; ***family and individuals, other businesses, government

Small Business’ Sources of Financial Services by Ethnic Group

0

10

20

30

40

50

60

70

80

90

100

Nondepository Nonfinancial supplier Depository

White

Black

Asian / Pac.I slander

AmericanIndian /Alaska NativeHispanic

Percent

0102030405060708090

100

Liquid Asset Accounts* Credit Lines, loans, andcapital leases* *

Financial ManagementServices* * *

<25

50-99

500-999

2,500-4,999

10,000+

Small Business’ Uses of Financial Service Products by Sales

Fiscal Year Sales

($Thousands)

Percent

*checking, savings; **credit line, mortgage, vehicle, equipment, capital lease, other; ***transaction, cash management, credit-related, brokerage, trust and pension

0102030405060708090

100

Liquid Asset Accounts* Credit Lines, loans, andcapital leases* *

White

Black

Asian / Pac.Islander

AmericanIndian orAlaskan Native

Hispanic

Fiscal Year Sales

(Thousands)Percent

*checking, savings; **credit line, mortgage, vehicle, equipment, capital lease, other;

Small Business’ Uses of Financial Service Products

by Ethnic Group

Small Business’ Uses of Financial Service Products by Ethnic Group, cont.

0

10

20

30

40

50

60

70

80

FinancialManagement

Service*

Loan fromOwner* *

Personal CreditCard

Business CreditCard

Trade Credit

White

Black

Asian / Pac.Islander

AmericanIndian / AlaskaNativeHispanic

Percent

*Transaction services, Cash management, Credit-related, Brokerage, Trust and pension. ** excludes proprietorships

The “Unbanked”

0%

10%

20%

30%

40%

50%

60%

70%

80%UnbankedBanked

Breakdown of CRA Lending By Category in 1999

CRA - Related Lending by Institutions in Study (in Billions); Total -$130.3 Billion

$13.20 , 10%

$2.20 , 2%

$56 , 43%

$58.90 , 45%

Home Purchase andRefinance Lending

Home ImprovementLending

Small BusinessLending

CommunityDevelopmentLending

CRA –Related Small Business Loans are Profitable

Relative Profitability of CRA Small Business Lending to Non-CRA Small Business Lending

1%0%

13%

82%

4%

0%10%20%30%40%50%60%70%80%90%

Lower for CRALoans

SomewhatLower for CRA

Loans

About theSame for CRA

Loans

SomewhatHigher forCRA Loans

Higher forCRA Loans

Center for Emerging Domestic Markets“CEDM”

Definitive source of information, innovation, and interaction for financing Emerging Domestic Markets

Joint venture of the Milken Institute and the Capital Access Group, with initial funding provided by MBDA.

Provides information-based services and products to help investors, lenders, entrepreneurs, guarantors, regulators, universities, and philanthropic and government organizations.

Virtual and real-time conferences and on-going dialogues between participants.

A “lab” to develop and pilot market-based public policies and innovations intended to increase access to and deployment of capital for EDM businesses.

Milken Institute Study: Purpose

• Sponsored by the Ford Foundation.• Survey the small business capital access

environment, focusing on pilot initiatives testing new financial innovations, and/or mechanisms that may bring existing programs to scale.

• Analyze the situation surrounding capital access to small businesses in low income communities.

• Make recommendations to address the disparity of access to capital.

Milken Institute Study: Methodology

• In undertaking the study of capital access to small businesses in low-income communities, the Milken Institute conducted the following tasks:– Comprehensive literature review of current studies and

research in finance, economics, and policy concerning the distribution of public and private equity/debt to low-income entrepreneurs.

– Empirical review of data sources concerning barriers to capital access.

– Industry focus groups with industry leaders from mainstream and community financial institutions (depository and non-depository), investors, regulators, and others.

– Telephone interviews and surveys of industry practitioners.

Fundamentals of the Opportunity Large concentration of consumers who are

generally underserved Significant supply of inexpensive, strategically

located land Large concentration of labor pool Pro-growth environment Existing infrastructure Untapped market for investment Empowerment zones, enterprise communities, and

Brownfield initiatives Changing demographics

Obstacles to Financing• Lack of loan performance data

– Leads to higher perceived risk• Lack of standardized products & sufficient deal

size– Leads to higher cost

• Lack of networks – Leads to disinformation regarding to capital sources

• Lack of allocation of “value-chain” activities– Leads to inefficiency by small firms and non-

participation by large firms

The “Value Chain”

•   Product development

•   Marketing/origination 

•   Underwriting 

•   Pooling/funding 

•   Servicing/monitoring 

•   Packaging

• Liquidity

Some Consistent Themes• Perceived risk is higher than actual risk

– Better data is required• Small businesses need access to range of capital at all

stages of growth• Key factor is access and repayment terms, not interest rate• Community development financing is often not cost-

effective • Easier for smaller financial firms to innovate; Easier for

larger firms to roll out• Financial technology must be deployed• Mergers limit lending – offer opportunities for innovation• CRA could benefit from broader applications

Characteristics of Successful Innovation

In studying the past and present innovations in economic history, we have identified several important components of successful innovation:

– Strong leadership– Ability to experiment– Information– Business assistance– Replication and scale– Specialization– Cost effectiveness– Partnerships

Categories of Innovation

• Innovations in sources of capital

• Innovations in financing structures

• Innovations in tools supporting financing

• Innovations in means of ownership

Sources of Capital Examples

Insurance companies Impact Capital

• Angel pools – RAIN

• Consortiums – NYCIC, CEDLI

• Corporate partnerships – Shell Community Banking Initiative, Union Bank –Nix

Check Cashing, Union Bank - WEDC • Community banks

– Community Bank of the Bay• Pension funds

– CalPERS’ California Initiative• SRI Funds

Financing StructuresExamples

• Credit enhancement – Capital Access Programs• Public/private funds for guarantees and leveraging

– Chase Rural Development and Finance Corp• Revenue royalties - Sustainable Jobs Fund• Pooling and securitization

– Impact Capital• Pooling non-investment grade loans, turning them into

S&P rated, investment grade securities• Tribal bonds

– Southern Ute tribe gains tribal first independent AAA bond rating

• Receivables guarantees - ACTrade• “Debtquity” -CDVC Funds• Liquidation structures – Boston Community Capital

Study

Tools Supporting Financing Examples

• Technology – FleetBank Boston’s Community Link

• Standardization• Data collection – Merrill Lynch/CDTech• Credit Scoring

– ‘Count-Me-In’ and Fair, Isaacs • Mentoring/business advisory

– Runners’ Club, SVCV• TA certification

– CARAT Program• Financing professional services

– ITAC• Strong networks & intermediaries

– NCIF• CRA credit swaps

Forms of OwnershipExamples

• ESOPs– Pueblo Nuevo – Employee cooperative offers

training, living wage, benefits, growth opportunities, and profit sharing for low-income workers

• Minority-owned banks– East-West Bank’s Chinese Language Web-

Banking fills the demand of the Chinese immigrant community

• Faith-based financing– FAME Renaissance – financing, mentoring,

business assistance provided from a source familiar with the community.

• Minority suppliers

Packaging the Undervalued Assets of Low-Income Areas

• Low-income communities’ assets can be packaged and developed properly to create great value and opportunity for residents and investors:

– REITs

– Strategically developed land trusts

– Pooling small business loans

– Leveraging government incentives, funds, regulations effectively

– Capturing data

– Creating new financial structures, tools, and products

Innovations Small Business Finance Model

Loan SellersNon-Profit

Development Org

Banks

SBA Loans

Credit Unions

Municipalities

Non-DepositoryFinancial Inst

Market Rate Investors

Banks

Insurance Companies

Pension Funds

Corporations

Concessionary Investors

Foundations

Religious Institutions

Charitable Contributors

Foundations

Loan Pool

Credit Reserve

Fund

DOA (IRP), DOC-MBDA, EDA, DOE, EPA, DOT, SBA (7A, 8A)

Existing GovernmentGuarantors

Innovations Securitizing Community Development

• Securitizing community development loans is a potentially lucrative market:

– Variety of loan or receivable pools that can be securitized.

– Firms are constantly exploring possible products for securitization.

– Institutional investors may find securitization attractive.

• Identified pools of capital for a California pilot include:

– Contract receivables securitization.

– Senate Bill 661 - allows for securitization of community development funds backed by funds from CIDFAC.

– SBA Section 7(a) Loans – existing secondary market for guaranteed portion.

• Private funds active in securitization - Impact Capital, CNL Commercial, Women's Equity Mutual Fund

Innovations California Capital Access Program “CalCAP”

• Loans up to 2.5 million dollars are insured by premiums paid by borrower and lender, which are matched by government and placed into loan loss reserves; total premium of 8%.

• Verifiable 12-year history of defaults averaging 3.9%, 3.5%– Over time, as more and more loans are enrolled, a lender's loss reserve

account grows substantially.• Securitization of these loans are pending

– CNL Commercial Finance of Yorba Linda, California will securitize $100 million of CalCAP loans in the first year and $150 million each year thereafter.

– Loans will be real estate related, with an 80% recovery history, 25-year maturity, five years non-refund, 7.75 years average life and float at prime+1.

– Loans will be 85%-90% LTV and have coverage of 1.2 times. – Expectations for 90% of loans to be rated AAA and the remaining 10% to be

rated A

Innovations National Capital Access Programs

• Support for a National Capital Access Program:

– Currently, state Capital Access Programs (CAP) are small

business-lending programs available in 22 states and two cities.

– Over $1.2 billion loans have been issued, with losses running at

3.1% of all loan volume.

– Off-balance sheet, risk-less 20% profit return to CAP lender on

each deal after all expenses.

– U.S. Congress authorized, but not appropriated $200 million to

for a national CAP reserve, intended to replenish state portion of

CAP programs.

Innovations BridgeNotes

• BridgeNotes are subordinate-lien, “companion” loans developed by the Capital Access Group and designed to “bridge” the gap between the amount a bank is willing to lend and the small business borrower’s total financing need.

• Bridge Notes will:

– Increase bank lending to low-income communities.

– Increase community-lending capacity.

– Increase availability of data on loans to under-valued businesses.

Transaction Diagram($1,000 loan)

BridgeLineBridgeLine

CompanyCompany

TrustTrust

BankBank

1. Advances $1,000

2. Signs $750 senior note and $250 junior note; pays 2% insurance fee.

4. Gives $788 for senior note3. Sells $750 senior noteRetains $250 junior 5. Transfers $250 note

and $58 fee

6. Sells bonds; gives $250 cash

InnovationsBreaking up the Value Chain:

Micro-enterprise Training and Financing Program• USC Business Expansion Network, Liberty Hill, California

Community Foundation and CalFed Bank team up to tap the untapped market.

• MTFP will provide loans to small-scale businesses which require less than $10,000 of investment capital.

• Utilizing Specialization– USC BEN has a 14-year history of cultivating entrepreneurship

and will provide mentoring to the borrowers.– California Community Foundation covers the cost of full time

staff at USC BEN.– Liberty Hill has a stake in promoting social and economic

development in low-income communities and will share the risk with CalFed.

– CalFed Bank is able to provide the mechanics of loan processing, securitization, funding, and monitoring.

Innovations CRA Credit Swaps

• CRA credits can be traded among banks much like carbon swaps in environmental trading

– Banks specializing in CRA –related lending can “swap” with banks who are short of adequate CRA credits.

– CRA credit swaps encourage specialization and niche lending – familiarity with the people, business, culture and economy of their CRA assessment community.

– Banks unfamiliar with the low-income market will not make poor quality loans based on poor understanding of the market.

Broadened Application of Legislation and Regulation

• New Markets Tax Credit

• New Markets Venture Capital Funds.

• Community Reinvestment Act

Areas for Exploration

• Community Reinvestment Act

– Applications

– Weighting for Compliance

– New Technologies

– Unbanked

– Privacy

• Community Development Financial Institutions

– Loan/Investment Performance

– Reporting Standards

• Tracking New Markets Initiatives

– People versus Places