Demystifying CDFIs: How to Invest in a Loan Fund

By: Karen Seabury - Jan 12, 2016
Source: Locavesting

Aeris (formerly known as CARS) is an information and ratings service for U.S. community investments—you might think of them as the Moody’s or Standard & Poor’s of the nonprofit finance world. Aeris rates organizations on their financial strength and social impact to help investors make informed decisions. Karen Seabury, Director of Ratings at Aeris, shares her insights on investing in CDFIs.

If you’ve spent any time exploring local investing, you’ve probably encountered CDFIs. And it’s not unlikely that you were slightly confused about what, exactly, these organizations are. CDFIs can be befuddling to a new investor, in part due to the many shapes and sizes in which they come.

So what kind of investment opportunities do CDFIs offer? And what should investors look for and consider before investing in one?

CDFIs—short for Community Development Financial Institutions—are a type of financial institution that are certified by the U.S. Department of Treasury. They typically provide credit, capital and financial services to underserved communities in a specific geographic region. There are hundreds of these organizations across the U.S., and they serve on the front lines of impact investing in communities where capital is scarce.

Mission driven loans

For simplicity, we’ll focus on the most common type of CDFI: the loan fund. These community development loan funds have a more than 30-year track record of social and environmental impact across the U.S. Their business model is relatively simple: they borrow capital from mission-driven investors, including individuals and institutions, and lend those funds to local businesses, with the goal of generating social impact, earning interest and being repaid. Most loan funds are nonprofits that earn the majority of their revenue from lending, but many also raise grant funding to help pay for their high-touch borrower engagement (such as training and mentoring) as well as other community services.

Loan funds are attractive for many reasons. A fund (versus a direct investment) gives you the security that comes with pooling your capital with other investors, spreading your risk among a diversified portfolio, and entrusting it to trained financial professionals. Loan funds also have an equity base (or “net assets” in nonprofit accounting) that further protects investors. That, along with the hands-on support they provide to borrowers, has resulted in a long track record of minimal investor losses. CDFIs, for example, had lower loss rates than big banks through the recent financial recession.

In addition, loan funds offer investors a way to have a strong local impact—from building grocery stores in food deserts, to supporting minority entrepreneurs in inner city neighborhoods, to providing restructured mortgages to homeowners in bank foreclosure.

For example, a family foundation in the Pacific Northwest wanted to invest for impact in its home territories of Oregon and Washington. The family was particularly interested in the environmental impact its investments could have. After discovering Craft3, a regional loan fund in the Pacific Northwest, the family made a five-year, $200,000 investment to capitalize loans for land conservation, residential energy efficiency and other uses.

To better understand the impact performance and financial strength of Craft3, the family purchased a rating report from Aeris, a specialized rating and information service for investors in CDFI loan funds—you might think of us as the Moody’s or Standard & Poor’s for the CDFI sector.

Not all individual investors require the level of due diligence contained in an Aeris Rating Report, but they can benefit from understanding our rating system. Knowing how to “read” a CDFI’s Aeris rating can help you as an investor better understand the risk and impact of an investment you may be contemplating.

These scores are often publicly available: roughly half of rated CDFIs publish their rating on their web sites, and many of the others are happy to share their rating with prospective investors. For more information, Aeris sells reports with varying levels of detail at corresponding price points to serve the needs of a range of investors.

Aeris rates CDFI loan funds on two levels: their impact (AAA through B), and their financial strength and performance (1 through 5). We also collect real-time impact and financial data on CDFI loan funds for use by investors. These ratings and data can help investors make informed investment decisions and monitor their investments. For example, Craft3 reports data on 20 resilience metrics, including acres of land preserved (over 5,500 acres of working landscapes/ conservation lands during 2010-2014) and the number of gallons of contaminated water treated in connection with its financing (nearly 50 million gallons during 2010-2014).

Investors should conduct their own due diligence before making an investment in a CDFI, as with any investment. And there are a number of questions they should ask themselves. For example, what is the right balance between their impact goals and investment risk tolerance? An Aeris impact rating of AAA indicates clear alignment of the loan fund’s mission, strategies, activities, and data that guide its programs and planning. On the other end of the spectrum, a rating of B indicates that the loan fund may lack alignment, possibly due to being in the early stages of the organization’s development, lack of resources or other constraints.  However, B-rated loan funds may still present an attractive investment opportunity because of their specific lending activity.

Likewise, although CDFI loan funds as a group have a long track record of stability and minimal investor losses, there is a great deal of diversity among CDFIs with respect to financial strength. Investing in a CDFI is not without risk, and as with any investment, investors should thoroughly research any prospective investment. A CDFI’s Aeris financial strength and performance rating can be an important guide to help you understand that risk. A CDFI loan fund with an Aeris financial strength and performance rating of 3 or better is considered investment-grade. A rating of 4 or 5 indicates that the loan fund is vulnerable to changes in its operating environment—yet it may provide a stronger fit with investor impact goals (see above).

CDFI loan funds are just one of the many tools in the local investing toolkit currently available to investors. At Aeris, we think that the long and successful track record of investing for impact and repaying investors make CDFI loan funds worth a look for anyone seeking to invest in their community.

To help investors find loan funds that match their impact and risk objectives, our CDFI Selector lets them search by geography as well as by desired impact: e.g., women, the environment, education.