Inside CDEs

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11 min read

Creating excitement in underserved communities

The New Markets Tax Credit Program – NMTC – created as part of the Community Renewal Tax Relief Act of 2000, aimed to partner business and government as a means to revitalize disadvantaged and economically neglected communities and increase job availability and wealth for their residents. The program’s success is exemplified by the close to 5,000 businesses financed, 200,000 jobs created or preserved, and more than 160 million square feet of manufacturing, office, retail and healthcare space supported throughout the United States.

The concept of encouraging private and corporate investment through tax credits was fairly straightforward. Not so clear-cut was how the program would work and how the tax credits should be apportioned and administered.

NMTCs are financed and administered through the Treasury Department’s Community Development Financial Institutions Fund (CDFI). But Treasury doesn’t give out the tax credits directly. Rather, much like the automobile industry’s method of selling cars, there is a “middle man.” And that is where the Community Development Entity – or CDE – comes into play. (Reader Warning: many acronyms to follow.)

According to CDFI, “A Community Development Entity is a domestic corporation or partnership that is an intermediary vehicle for the provision of loans, investments, or financial counseling in low-income communities. Certification as a CDE allows organizations to participate either directly or indirectly in the New Markets Tax Credit Program.” We might add that CDE certification is a demanding procedure involving the applying entity’s primary mission and its ability to fulfill that mission, as well as maintaining strict accountability to the government and to the residents and stakeholders of targeted low-income communities throughout the seven-year compliance period.

“There are four key sections to the application,” explains Charlotte Folmer, Executive Director of the Commonwealth Cornerstone Group (CGE), a CDE in Pennsylvania. “Business strategy, community outcomes, management capacity and capitalization strategy.”

CDEs don’t apply to the CDFI Fund for tax credits themselves, but for the authority to allocate a certain amount of credits in exchange for Qualified Equity Investments (QEIs). For investors to be able to claim their credits over the full seven years, “substantially all,” according to the IRS Code, of the money they put up must go into “Qualified Low Income Community Investments” in “Low Income Communities.”

“Substantially all” is not merely a technicality or term of art. Kevin Boes, President and CEO of New Markets Support Company – NMSC, a subsidiary of LISC, the Local Initiatives Support Corporation and one of the country’s most prominent CDEs – notes that this limits the types of deals that work: “In a number of cases, we’d love for the principal to be paid off before the seven-year period ends, but we have to leave the capital in the low-income community.” Current regulations require that 85 percent of the equity investment remain in the project for the full compliance period.

Shapes and Sizes
NMTCs support a wide variety of projects in diverse areas of the country, so it is not surprising that CDEs come in all shapes and sizes. Some operate strictly on their own, whereas others generally partner with other CDEs. Many, like NMSC, are subsidiaries of other businesses or nonprofit organizations. Boes’ organization has a national footprint, but most of its projects “bubble up from the 31 cities where we have program offices and our 70 rural partners.”

“A lot of the investors are also CDEs,” adds Folmer.

As PNC Bank’s NMTC project manager, David Gibson runs its affiliated CDE. “We work primarily within our retail footprint: in communities we know the best and with which we have the deepest relationships. We tend to partner with other CDEs, but we do some transactions where we’re the only ones. In one round, there were no allocations given to an Ohio-based CDE. There was a project in East Liverpool we’d been tracking, so we stepped in.”

The allocation authority is awarded in roughly yearly cycles, though there are no fixed time frames and the 2015 and 2016 cycles have been combined. “So if you didn’t apply in 2015, you’re out of luck,” says Folmer. The most recent allocations for a total of $7 billion were announced on November 17.

CCG is a mission-driven nonprofit CDE established by the Pennsylvania Housing Finance Agency “to enhance, strengthen and revitalize low-income communities throughout Pennsylvania and to stimulate economic opportunities for low-income residents through the creation of jobs, enhancement of wealth and the provision of services within these communities.” This is not an uncommon sort of mission statement for a CDE. The variation comes in size, operating area, focus, approach to partnership and means of selecting applicants. For example, CCG operates statewide, but it also works with other CDEs that concentrate on much smaller areas. CEI Capital Management, known as CCML, is a wholly owned, for-profit, tax-recognized subsidiary of Maine’s nonprofit Coastal Enterprises, Inc.

CCML does not partner with other CDEs but works closely with various Community Development Financial Institutions, specializing in non-metro rural areas, which represent about 80 percent of its portfolio.

“Everyone has a different focus,” Folmer comments, “whether it is business development, charter schools, grocery stores or healthcare: whatever is needed to improve an underserved community. We concentrate on housing and mixed-use, though the last couple of rounds we’ve moved partially away because of what was in our pipeline. In housing, we require 20 percent to be affordable, but we’re not on the same scale as LIHTC.”

In fact, one endeavor CDEs cannot pursue is strictly housing projects, which would be perceived as competing with LIHTC. “You actually have to be careful how ‘successful’ you are,” Folmer notes. “You don’t want your redevelopment pushing out low-income residents.”

On the far end of the spectrum from local CDEs, NMSC is large enough to take advantage of scalability. In addition to LISC’s New Market projects, it manages almost $400 million of development for client organizations. Its services range from helping with application writing to running client back-office operations. And as Boes adds:

“We are pioneers in the area of creating structured products that look like normal loans, but with the efficiency of having tax credits embedded. An example would be our flagship fund, Healthy Futures, which works with

Morgan Stanley and the Kresge Foundation. It certainly helps with deal origination when New Market allocation, equity and leveraged debt are all lined up.”

All of CCG’s investors are banks, including US Bank, PNC, Wells Fargo and Chase. CCML prefers to diversify its investment partners to maximize options.

Ready-to-go projects
A number of considerations go into CDFI’s decisions on allocations but all involved agree that major factors include a CDE’s track record and how well it has fulfilled its stated mission in the past. “You apply and then hope and pray that your track record speaks for itself,” offers Folmer.

There is a basic tension built into the system and the successful operation of a CDE is a delicate balancing act. If it can justify the request, a CDE can apply for up to $125 million in allocation authority, yet only about 30 percent of the requested allocations are granted. Despite the uncertainty of grants and vagueness of award timing, CDEs must have projects pretty much ready to go when grants are announced.

“You have to have a pretty dynamic pipeline that could span various pipelines,” says Gibson. “If a project is not ready for one cycle, that doesn’t mean we wouldn’t pay attention to you.”

“It is a little bit of a dance once you get the allocation,” Folmer concedes. “We’re all in competition with each other, but we have to work together. There is always a somewhat complex funding stack for each potential project. One may be large and require two or three CDEs.”

“It becomes a race to get these allocations out the door, speed versus projects that really need the allocation,” says Boes, “so Congress doesn’t think the money is not being spent properly, which makes it tough from the borrower’s perspective and the CDE’s. It really is an inherent conflict in the program. And what it has done is create a large industry of business consultants marketing projects to multiple CDEs.”

Which brings up the largest single consideration in the NMTC allocation process: How to decide which, among many worthy applications, to go with?

The but for test
“We use the ‘But for. . .’ test,” says Folmer. “But for New Markets Tax Credits, would the project not be achievable? And as we’re going through potential allocations, we need to know if the city is interested, and is it part of a bigger plan? We have over $500 million [worth of projects] in our pipeline and in the last allocation [before November 2016], we were awarded $45 million.”

“It’s not an easy task,” says Boes. “We have a large pipeline of deals. We assess them for the ability to put together the rest of the funding stack, for community impact, and for what we’ve told the CDFI Fund we’re trying to do.”

For Charlie Spies, CEO of CCML in Brunswick, Maine, the triage process is rigorous and as objective as possible. “We rate projects as they come in on an A-B-C basis: Are they non-metro? Highly distressed? Does the project offer good job prospects? How ready is it? We may talk to a potential developer two or three years ahead. A project that a year-and-a-half ago was a B might be ready to go now.”

“Many CDEs take a use-based approach,” says PNC’s Gibson. “Our strategy is built around what is needed in a particular area, whether it’s a grocery store in a food desert or a healthcare facility or a job-training site. This means an ongoing relationship with the community. We have people who have the right cross section of community development experience and technical expertise to bring these complicated transactions to closing. Our origination team has a strong background in needs assessment and spends significant time with local PNC lending and management.”

The process and the length of the compliance period suggests the need for intensive due diligence on the part of the CDE. “This is a full-contact sport. There is a lot of vetting up front,” Spies agrees. “You don’t want to get two or three years in and find out you’ve got a bad partner.  That’s nothing but trouble. We have a front-end investment team and we do site visits on every project. You have to be comfortable with who you’re working with and you want to know that the players are well-received in the community.”

One question that pervades the NMTC industry is whether the CDE method is the best and most efficient means of distributing CDFI Fund’s resources.

“I’d like to see the program made permanent and the cap increased so there could be a higher number of awards,” says Spies.

“And it would be nice to have a regular cycle every year,” says Folmer.

“But these are complex transactions with complex funding stacks,” Spies continues. “Everyone has to be very careful. The borrower gets a lower cost of funds. The investor gets a benefit. The community is improved. To me, this combination of public and private resources is a very powerful one.”

“It is an awkward structure relative to many other funding vehicles,” Gibson states. “And from a borrower or customer perspective, it is tough because it’s a difficult program to access. But at the same time, it is a highly efficient and flexible means of bringing capital into communities that most need it, for a wide variety of uses. CDEs can tailor strategies to meet very specific needs.”

“The beauty of the NMTC program is flexibility in the range of investments,” Boes concurs. “But I think there is an opportunity with tax reform under the new administration to fix the conflicts and step away from the rat race.”

And Folmer reflects, “When you see what some of these communities looked like before, and you come back after the development is completed to do an impact evaluation, when it’s built and you see what it can do for that community, it’s a very exciting program.”