In making underwriting decisions on community development loan funds, institutional investors are considering more than just the cause. These big-bank or pension-fund patrons also want returns, and peace of mind that their principal will be protected.
But standard risk measures like capital ratios or projected revenue are not always enough, or even appropriate, when judging nonprofits, where some money can be restricted from claims in the event of a default. "You really have to have an expertise, an understanding, of how to take apart the financials and their operations," says Paige Chapel, an expert on nonbank community development financial institutions. "It's not what you'd expect if you [tried to analyze] a regulated depository."
For the past eight years, dozens of institutional groups have turned to the CDFI Assessment and Ratings System (CARS), of which Chapel is CEO, to get more detailed evaluations of loan fund portfolios. Given the lack of uniform reporting standards-CDFIs may report nonaccruals vs. accruals differently, for example-CARS has found a niche in making comparable data available to investors.
CARS' reach is still relatively limited. It must be invited in by loan funds to conduct its analysis, and even those that open themselves up to a CARS evaluation don't always have the type of quarterly financials found in the commercial or corporate underwriting world.
CARS also has had to combat the notion that it's a booster instead of a watchdog for CDFIs. The perception can be easily traced back to CARS's recent past as a subsidiary of the Opportunity Finance Network, an umbrella group of 180 member CDFIs delivering bank-partner financing to low-income communities.
But CARS spun off as an independent ratings firm in January, and this spring received a $1 million grant from the Citi Foundation to develop an automated call reporting system that, when completed, will keep investors updated on the quarterly financials of member CDFI funds.
CARS does not provide ratings on individual loans or transactions, a la Moody's or Standard & Poor's. Nor does it analyze depository CDFIs such as the former Shorebank, which failed in August 2010. (Depository CDFIs already are subject to regulatory examinations).
CARS only rates nondepository CDFI loan funds, putting forward a peer-based analysis of a fund's risk parameters, performance and even the effectiveness of its social mission.
Since 2004, CARS has issued more than 300 ratings and annual reviews for 71 nondepository CDFIs that together manage $4.5 billion, representing nearly half the assets managed by entities certified by the government as CDFIs.
Supporters hope that CARS' improved reporting system and free-standing status will build a larger base of investment subscriptions, and cement faith in CDFIs as a growth opportunity for socially conscious investments.
"CARS reports have always had an enormous amount of depth and quality, and I think having CARS being independent can only enhance that-in part because I think it'll fail if the quality isn't there," says CARS board member Ellen Seidman, a former bank regulator who was long affiliated with ShoreBank's parent. She is now a visiting scholar at the Federal Reserve Bank of San Francisco's community development department.
Chapel says that with the economy recovering, CDFIs have been ramping up partnerships with banks looking for community investment opportunities, either for Community Reinvestment Act compliance purposes or because they believe CDFIs, with their knowledge of local conditions, are a relatively safe form of exposure to hard-hit areas. The problem, Chapel says, is how to "figure out which CDFI to put your funds into, and how do they compare to their peers?"
CARS has established a CAMELS-type rating system for CDFI loan funds, ranging from 1 (best) to 5 (poor). Only 6 percent of rated funds have earned top marks, but more than 85 percent are considered sound with a rating of 3 or better.
CARS' top-to-bottom analysis of loan fund portfolios also includes a breakdown of assets that may not be available as collateral due to grant-funding restrictions, as is sometimes the case with money earmarked for homeowner counseling or technical assistance to small businesses.
The evaluations have helped some loan funds clean up their portfolios. Shaw Canale, CEO of Mountain BizWorks of Asheville, N.C., says a CARS exam led her and her board to sell a local art gallery that the fund was operating despite its losing $10,000 to $20,000 a year. She says the fund is putting more emphasis now on the long-term sustainability of its lending decisions.
Like other CDFI ratings, the grade CARS assigned to Mountain BizWorks isn't public. But it is available to CARS' subscribers, who pay between $2,500 and $15,000 a year for the data. Subscription fees are the lone source of revenue for CARS now that its affiliation with OFN is over, but Chapel is hoping independence will open the door to new opportunities, like a possible contract with the Treasury Department for a role in the federal government's $1 billion-a-year CDFI loan fund guarantee program. "The appearance of conflict was too great for government to take a risk to work with us" before, Chapel says.
For CDFI loan funds, inviting CARS in for a review is entirely optional. But it may get tougher for nonrated funds to attract capital if more investors start demanding third-party analysis of the sort that CARS provides. (For now, CARS seems to have this small market all to itself.)
The community development arm of Bank of America Merrill Lynch was the first investor group to announce it was using CARS-rated CDFIs exclusively, for dispensing its $93 million in New Markets Tax Credit funds. That was six years ago. This year, Citigroup said CDFIs will need a CARS rating to participate in its $200 million community investment fund.
"An organization needs to get to a certain level of sophistication to be qualified to be rated," says Pam Flaherty, director of corporate citizenship at Citigroup and president and CEO of the Citi Foundation. "It's a validation tool for a CDFI to say, 'We're on the right track.'"
