CREATING CAPITAL,jOBS AND WEALTH IN EMERGING DOMESTIC MARKETS

CREATING CAPITAL,jOBSAND WEALTH IN EMERGINGDOMESTIC MARKETSFINANCIAL TECHNOLOGYTRANSFER TO LOW-INCOMECOMMUNITIESGlenn YagoBetsy ZeidmanBill SchmidtResearch ReportjANUARY2003-m MI LKET STITUTEFORD FOUNDATION

CREATING CAPITAL, JOBSAND WEALTH IN EMERGINGDOMESTIC MARKETSFINANCIAL TECHNOLOGYTRANSFER TO LOW-INCOMECOMMUNITIESJanuary 2003byGlenn YagoBetsy ZeidmanBill Schmidt

Creating Capital, Jobs and Wealth in Emerging Domestic MarketsMilken Institute - January 2003ACKNOWLEDGMENTSThe authors wish to acknowledge the generous support of the Ford Foundation, particularlyMichele Kahane, in the research and development of this report. We also appreciate the manyindividuals who contributed important information and insights, as well as valuable time, throughparticipation in Working Group sessions in Los Angeles, New York and Washington, DC, throughinterviews with our staff, and by reviewing and commenting on drafts of the report. In addition,we thank our editor, Judith Gordon, researchers Liya Brook and Deana Carillo, administrativesupport Muriel Poussin and Megan Sharpless, and graphic designer and print productioncoordinator, Sallylynn James.Copyright 2003 by the Milken InstituteThe Milken Institute is an independent economic think tank whose mission is to improve the livesand economic conditions of diverse populations in the U.S. and around the world by helpingbusiness and public policy leaders identify and implement innovative ideas for creating broadbased prosperity. We put research to work with the goal of revitalizing regions and finding newways to generate capital for people with original ideas.We do this by focusing on human capital – the talent, knowledge and experience of people, and theirvalue to organizations, economies and society; financial capital – innovations that allocate financialresources efficiently, especially to those who ordinarily would not have access to it, but who canbest use it to build companies, create jobs and solve long-standing social and economic problems;and social capital – the bonds of society, including schools, health care, cultural institutions andgovernment services, that underlie economic advancement.By creating ways to spread the benefits of human, financial and social capital to as many people aspossible – the democratization of capital – we hope to contribute to prosperity and freedom in allcorners of the globe.We are nonprofit, nonpartisan and publicly supported.The Ford Foundation is a resource for innovative people and institutions worldwide. Our goals areto: strengthen democratic values, reduce poverty and injustice, promote international cooperationand advance human achievement. This has been our purpose for more than half a century.A fundamental challenge facing every society is to create political, economic and social systems thatpromote peace, human welfare and the sustainability of the environment on which life depends. Webelieve that the best way to meet this challenge is to encourage initiatives by those living andworking closest to where problems are located; to promote collaboration among the nonprofit,government and business sectors; and to ensure participation by men and women from diversecommunities and at all levels of society. In our experience, such activities help build commonunderstanding, enhance excellence, enable people to improve their lives and reinforce theircommitment to society.ii

Milken Institute - January 2003Creating Capital, Jobs and Wealth in Emerging Domestic MarketsTABLE OF CONTENTSKEY FINDINGS .viiOVERVIEW .1Introduction .1The Context.3Legislative and Regulatory Activity .5Changes in the Financial Services Industry .6Demographic Shifts-The Rise of Emerging Domestic Markets .9Economic Conditions – A Capital Crunch.10Implications for LMI Small-Business Finance .11Obstacles .11Opportunities .13INNOVATIONS .17Systemic Innovations .18Securitization and Secondary Markets .18Breaking Up the Value Chain .26Intermediaries – Consortiums and Partnerships .28Consortiums .28Bank-CDFI Partnerships .30Corporate Partnerships .31Faith-Based Partnerships .32Nonbank Financial Institutions .32Insurance Companies .32Factors and Receivable-Based Financing .34New Institutions .35De Novo Banks .35Government Programs .36Liquidity Vehicle – Publicly Traded Holding Company .39Ownership Models .40Employee Stock Ownership Plans .40Franchises .41iii

Creating Capital, Jobs and Wealth in Emerging Domestic MarketsMilken Institute - January 2003Minority-Owned Banks .42Community Ownership .43Product Innovations .43New Markets/New Products from Mainstream Banks .43Pension Funds .46Credit Enhancement .48Blended Fund Structures .51Revenue Royalties.52Angel Pools and Networks .52Equity Equivalent Investments .54Tribal Bonds .54Process Innovations .57Data .57Credit Scoring .61Technology .62Mentoring/Business Advisory .64RECOMMENDATIONS .69Model One: EDM Data Network. 70Model Two: Securitization and Credit Enhancement .72Model Three: EDM-Targeted Mezzanine Fund.74Model Four: Financial Innovations Lab & Learning Consortium.76Model Five: Bank-CDFI-Technical Assistance Exchange.78REFERENCES .81APPENDIX I: RESEARCH METHODOLOGY .85APPENDIX II: INTERVIEWEES AND WORKING GROUPPARTICIPANTS .86BIBLIOGRAPHY .94ABOUT THE AUTHORS.107iv

Milken Institute - January 2003Creating Capital, Jobs and Wealth in Emerging Domestic MarketsFIGURESFigure A: EDM-Targeted Mezzanine Fund Model.xviiFigure 1: Small Business’ Use of Financial Service Products by Sales.5Figure 2: Percent of U.S. Assets Owned by Institutions .7Figure 3: The Flow of Financial Innovation to LMI Markets.18Figure 4: Minority Business Finance Model .19Figure 5: Potential Secondary Market Issues .21Figure 6: Community Development Loan Securitization Model .23Figure 7: Multi-Bank Lender Securitization Model .24Figure 8: California Initiative Funds Support Companies in EachStage of Life-Cycle .47Figure 9: Sample BridgeNote Transaction .49Figure 10: EDM – Targeted Mezzanine Fund Model .75v

Creating Capital, Jobs and Wealth in Emerging Domestic MarketsviMilken Institute - January 2003

Milken Institute - January 2003Creating Capital, Jobs and Wealth in Emerging Domestic MarketsKEY FINDINGSThe United States experienced such an extraordinary surge in wealthduring the 1990s that even after the stock market decline of 2000-2001,Americans’ total net worth in 2002 remains almost 75 percent greaterthan it was just 10 years ago. As with previous episodes of economicexpansion, entrepreneurship and innovation, both technological andfinancial, fueled much of this growth. However, this growth wasunbalanced, with higher-income entrepreneurs more easily accessing thefull array of financial technologies and a wider range of sources ofcapital than smaller firms in emerging domestic markets (EDM).This circumstance is ironic, since small businesses represent the vastmajority of all firms and a driving force behind economic output and jobcreation. Ethnic-owned firms grew at twice the rate of all firms duringthe past decade, yet face capital gaps that limit their ability to expandand generate jobs in urban and low-and moderate-income (LMI)markets, home to a disproportionate amount of the increasingly diverseU.S. population.Resolving the EDM capital gap is critical to national economic health aswe experience a seemingly jobless recovery from a recession threatenedby the constriction of consumer demand. Closing this gap necessitatesthe transfer of financial technologies and market-based public policyinnovations from mainstream applications to emerging domesticmarkets, carving channels of capital from investors to entrepreneurs.I. Low- and moderate-income, minority- and women-ownedbusinesses have always faced greater challenges to accessing capitalthan the mainstream. Some are due to blatant discrimination, butothers arise from imperfect information about the firms and the natureof their business models and environments. These include: Lack of performance data on loans to these borrowers, leadinglenders to perceive them as riskier and beyond their legal risktolerance. Smaller sized loans, leading them to be more expensive for lenders toservice. Firms’ need for mentoring and technical assistance services inaddition to financing, increasing costs to lenders. Lack of professional and social networks linking borrowers andfinancial institutions. Historical concentration of business in the retail and servicesindustries, with little collateral to secure loans.The United Statesexperienced such anextraordinary surge inwealth during the1990s that even afterthe stock marketdecline of 2000-2001,Americans’ total networth in 2002 remainsalmost 75 percentgreater than it wasjust 10 years ago. However, growth wasunbalanced, withhigher-incomeentrepreneurs moreeasily accessingsources of capital thansmaller firms inemerging domesticmarkets (EDM). Resolving the EDMcapital gap is criticalto national economichealth.vii

Creating Capital, Jobs and Wealth in Emerging Domestic MarketsMilken Institute - January 2003 Lack of a viable secondary market for small-business loans.EDM and LMI areasoffer many featuresdesirable to aninvestor seeking amarket withquantifiable risk andreturn on investment. With their growingrates of businessownership, ethnicentrepreneurs andconsumerssignificantly impactthe overall economy. The currentslowdown in theeconomy is likely toimpact smaller banks,and hence smallerfirms, more severely.II. Nonetheless, EDM and LMI areas offer many features desirable toan investor seeking a market with quantifiable risk and return oninvestment. There is a large, untapped market for financial institutions servicingLMI populations. Advances in technology have made it moreaffordable to access the market. The lower cost of real estate – land and buildings – in LMI areas,whether urban or rural, offers a major advantage to businesses andinvestors. By partnering with Community Development Financial Institutionsthat have an extensive knowledge of their local market, mainstreamproviders of capital can evaluate, mitigate, and price riskappropriately and expand into LMI markets with new products.III. Several major trends in legislative and regulatory policy, financialservices industry development, demographic shifts and economicconditions provide the backdrop for considering and inventing thefuture. The U.S. is shifting from a bank-based to a capital-market basedfinancial system, disproportionately impacting small businessesbecause they have fewer nonbank options than larger companies. Servicing EDM communities can be difficult for large, mainstreambanks. The information asymmetries, and banks’ segmentedorganizational structure separating wholesale and retail productsinto separate divisions, run counter to the flexibility required to buildrelationships with small firms in LMI areas. Over the next 50 years, 90 percent of U.S. population growth willoccur among ethnic groups, reducing white Americans to less than50 percent of total population. With their growing rates of businessownership, ethnic entrepreneurs and consumers significantly impactthe overall economy. A slowing economy, uncertainty, and regulatory changes tightencredit and reduce business formation among all groups. Reducedentrepreneurial activity translates into reduced job creation andretention rates, and polarizing income and wealth distributionaltrends. The current slowdown in the economy is likely to impactsmaller banks, and hence smaller firms, more severely.IV. Adapting financial innovations to EDM/LMI small-businessfinancing can help overcome many of the challenges to serving thesemarkets, and enable a range of investors to tap into the opportunities.viii