Community capital is about empowerment of communities. It is a set of strategies that allows ventures to raise capital from their ideal investors within their own community, allows anyone of virtually any economic class to invest in their community, and allows communities to build wealth though a cycle of investment, growth, profit, and reinvestment. As I wrote in a separate post, Community capital can be raised directly through direct public offerings (DPOs) and Title III exempt crowdfunding, or indirectly through community investment funds (CIFs). Of these, CIFs have several significant advantages: scalability, efficiency, diversification, and opportunity for liquidity.
With this much going for them, one may wonder why CIFs are not far more common than they are. One would think that every community should have a least one CIF. Yet most do not – at least not yet. Setting aside cultural factors that I noted in my previous post, the other key reason for their scarcity is the regulatory environment. A CIF must navigate through two layers of securities law. The first, and more commonly understood, are the laws that regulate the offering of an investment to the community. This is regulated at the federal level by the Securities Act of 1933 and by each state’s securities laws. In essence, a CIF must do its own DPO to raise investment. While this must be done carefully, it is not so burdensome as to prevent CIFs from flourishing.
But there is a second layer of securities law that is unique to investment funds and presents another challenge. The Investment Company Act of 1940 (the 1940 Act) imposes burdensome regulations on an entity that raises money from investors and then invests that money in other companies. This is the law that regulates mutual funds, and the compliance costs are well into the six and seven figure range for funds of that type. Among other requirements, such a fund must conduct a full registration under the 1933 Act.
However, the 1940 Act also includes a number of exemptions. And that is where the opportunities lie for a small CIF that cannot afford 1940 Act compliance. With all that in mind, the following are four models for a CIF that can raise capital from its community without running afoul of the 1940 Act:
Charitable Loan Fund
The simplest (and by far the most common) type of CIF is the charitable loan fund. This is because the two key federal securities laws noted above (the 1933 Securities Act and the 1940 Investment Company Act) both have a blanket exemption for charitable organizations. To be clear, this does not work for other types of nonprofits, such as cooperatives and mutual benefit corporations. The entity must be truly charitable—basically a 501(c)(3) organization. Most states also have an exemption from securities offering registration for charitable organizations, though a few do not, including California.
With those exemptions, it can be relatively straightforward to set up a charitable loan fund – with good legal guidance, of course. It is still a securities offering, which requires comprehensive disclosure of all material facts, risk factors, state level review (in some states), and so on.
There are two key limitations of this model. First, the assets of a charitable organization may only be used for charitable purposes. And charitable is not the same as socially beneficial. While an analysis of what makes a loan charitable is beyond our scope here, let it suffice to say that a charitable organization needs to be careful, so as to avoid jeopardizing its charitable status.
A second limitation of a charitable loan fund is that it can only raise debt investment, not equity, because no one can own a charitable organization. Moreover, a charitable organization is forbidden from sharing profits with investors. And while a charitable fund could in theory raise debt investment and deploy it in equity investments in other local business, that kind of leveraged equity investment is considered too risky and therefore an unwise strategy. So, charitable funds generally only make outgoing loans with little or no opportunity for capital appreciation. Then, after subtracting a spread to cover its operating costs, the fund typically pays its investors a fairly low interest rate, again with no opportunity for capital appreciation.
And yet, the charitable loan fund is a very effective model for community investment and there are many success stories. Here are a few charitable loan funds that appear on CuttingEdgeX.com, along with their funding focus:
Real Estate Fund
The purchase by a fund of real estate is most likely not a securities transaction at all; and even if it is, the 1940 Act provides an exemption for funds that invest in real estate. Therefore, a real estate CIF need not be concerned about 1940 Act compliance. On the other hand, there is no exemption from the other federal or state securities laws for a real estate fund, so a true real estate CIF typically must raise capital via a state-registered DPO.
A real estate CIF can be a powerful tool for urban or rural revitalization. The concept is simple: The community invests in a fund that acquires, renovates and leases out properties that have become blighted. A portion of the profits may be reinvested in further revitalization, but any remaining profits are distributed to investors. As a result:
- New businesses are attracted to newly renovated properties;
- Property values rise as blight is eliminated;
- Safety improves, as more workers and customers generate more foot traffic;
- City tax revenues rise as all those people spend more money locally;
- Local investors share in the profits of the business and reinvest in the community.
We believe this model has enormous potential, and we hope it will be replicated in every city in need of urban revitalization. But there are other potential uses for a community real estate fund, such as:
- Affordable or workforce housing
- Agricultural land (perhaps in conjunction with a community land trust that acquires a conservation easement)
Equity Investment Funds
There is no general exemption from the 1940 Act for funds that make equity investments in other companies. To be sure, many modestly-sized funds do invest in other businesses: hedge funds, private equity funds, and the like. What those all have in common is that none of them is open to non-wealthy investors. In other words, they are not community investment funds.
But there are ways to build a true community investment fund that can invest in equity positions in other companies (along with other types of investments) and share profits with its investors. The idea behind this model is that the entity is exempt from the 1940 Act because it is not primarily in the business of investing in securities. We will discuss two variants of this model.
The first of these variants begins with Section 3(a)(1) of the 1940 Act, which excludes from the 1940 Act’s coverage any fund that is not primarily in the business of investing in securities, and where investment securities comprise less than 40% of the fund’s total assets. As we’ll discuss further below, this type of fund will necessarily be fairly diversified; hence we have called it the “diversified business fund.”
The first requirement for the diversified business fund is that the fund is primarily in some other business besides investing. In other words, the fund’s investing activities must be supplemental to another primary purpose. There is a lot of flexibility in the kind of primary business that would support this type of fund, but three business types that would work particularly well are a start-up incubator, a business accelerator, and a co-working facility – or some combination of those. The fund could also be in the primary business of providing education or other services.
The second requirement of the diversified business fund is that no more than 40% of the entity’s total assets consists of investment securities. Fortunately, there are several types of investments a diversified business fund can make that are not counted as investment securities for purposes of the 1940 Act. These include:
- Majority-owned subsidiaries: If the fund acquires a majority ownership position in a target company, that won’t count toward the 40%. Note that while such an investment would ordinarily be treated as a “security,” it is specifically excluded from the definition of “investment security” for purposes of the 1940 Act. One challenge here is that the entrepreneur behind a potential target company may (understandably) not want to give up a majority position in their company. That concern can be addressed through two sub-strategies. First, the equity structure of the target company can be designed to ensure the entrepreneur has majority voting power even with a minority ownership position. The second is that the investment can be coupled with a redemption right giving the entrepreneur the right to re-acquire a majority position at some time in the future.
- Real estate: As long as it is directly held by the fund, real estate is not a security at all, as noted earlier. A syndication interest, or an interest in a real estate partnership would likely be an investment security. But real estate that the fund owns for its own use or to lease to others would not be.
- Secured loans: For purposes of the federal securities laws, not every loan is a security. Where a loan is privately negotiated between lender and borrower, is not offered broadly to potential lenders, and is secured by assets, it will probably not be deemed a security at all, so it will not count toward the 40% threshold.
- Non-securities assets: The fund may also invest in equipment and other assets that are not securities.
So, as long as at least 60% of the entity’s total assets comprise these types of assets that are not counted as “investment securities,” the diversified business CIF will meet the second requirement. The remaining 40% or less can be any other type of investment, including minority positions in portfolio companies, as well as publicly-traded stocks, bonds and other investment securities. From an investor’s point of view, one key advantage of the diversification inherent in this model is that it may very well reduce the fund’s risk and make it a more attractive investment.
A second variant on the equity investment fund model is similar to the diversified business fund but doesn’t require the 60-40 split in its portfolio. Under Section 3(b)(1) of the 1940 Act, a company is exempt as long as it is clearly in a primary business other than investing in securities. For that reason we call this the “supplemental investment fund.” For this purpose, the following factors are considered important in determining whether it really is in another primary business:
- Company history: A company with a history as an operating company in some primary business other than investing is less likely to be deemed an investment company.
- How it represents itself to the public: If investors are likely to invest because of the investment portfolio, investing is more likely to be deemed its primary business.
- Activities of its officers and directors: Whatever the officers and directors spend most of their time doing is likely to be deemed the primary business.
- Nature of its assets: The more of a company’s assets that are associated with a line of business, the more that will be considered their primary business. However, courts have recognized that some businesses are asset-light, and that fact should not by itself transform an operating company into an investment company.
- Sources of its income: Both net and gross income should be considered. An activity that produces a majority of both will likely be considered the primary business.
We note that while business accelerators and other similar organizations in the US have often provided funding to their clients, to our knowledge none of them has yet done so using community capital. Therefore, the model as described here has not yet been utilized as of this writing, though CEC is working with several organizations who are pursuing this model.
Registered 1940 Act Fund / Business Development Company
We now come to the fourth model: A CIF could embrace, rather than avoid, the 1940 Act. While this strategy will clearly be out of reach for a small fund for cost reasons, it may be that a true community investment fund targeting a larger metropolitan area could achieve the scale necessary for full compliance with the 1940 Act to become cost-effective.
We won’t dwell on this model, except to point out that Calvert Foundation, through an affiliate, has offered a menu of Calvert mutual funds for several years. While they don’t have a specific geographic focus, they do have a strong social mission, and their success suggests strong potential for this model to serve large communities.
An interesting variation on the fully registered 1940 Act fund is the business development company (BDC), a type of investment fund that provides managerial assistance to its portfolio companies. While this model is technically an exemption from the 1940 Act, the BDC is exempt from only some of its more burdensome requirements. It must still register its offering with the SEC under the 1933 Act. And yet, a BDC with a state or regional focus could make financial sense. We will be observing a few BDCs (such as Hill Capital in Minnesota) with an eye toward the potential use of this model as a true community investment fund.
Other Possible Strategies
There are a number of other exemptions from the burdensome requirements of the 1940 Investment Company Act, each with its own limitations. At Cutting Edge Capital we will continue to explore alternative strategies that may work for community investing. Here are some possibilities:
- An intrastate fund: The 1940 Act includes an exemption for a fund of up to $10 million where all investors reside in the same state where the fund is based. While this sounds promising, it has two key limitations: First, it must be a “closed-end fund”—meaning that the fund has a specified life (say, 7 years); investors come in at one time and are cashed out at the end of the fund, with little opportunity to come in and out of the fund during its life. Second, this is not a self-executing exemption; rather, the fund would need to request an exemptive order from the SEC, and the SEC would have the power to impose any requirements they believe are needed to protect investors. This exemption has rarely, if ever, been used.
- Microloan fund: An exemption is available for a fund that makes “small loans”—a term that appears to be interpreted by the SEC to mean personal and consumer loans, not business loans. One possible example: A solar fund could use this strategy to make loans to homeowners to finance rooftop solar installations.
- Manufacturer/seller loan fund: Another exemption covers a fund in the business of lending to manufacturers and sellers of merchandise or services.
Finally, we should mention one more strategy that may not be a true CIF, exactly, but might be used to achieve a similar result: the investment club. This is where a group of investors pool their resources into a single entity (typically a limited liability company) to make investments. As long as every member of the club is actively engaged in the management of the club (i.e. votes on investment decisions, etc.), the club will not be deemed to issue securities to its investor/members, and therefore it will not be subject to the 1940 Act. Because of the requirement that every member of the club be actively engaged in management, it usually works best for smaller groups of investors; but it can be open to anyone, wealthy or not.
All of the Above
Of the models described above, there is no “best” model. At Cutting Edge Capital we envision a more localized economy in which every community is served by a constellation of community investment funds of various types, each of which responds to a need in the community. For example, a real estate fund could build workforce housing, if housing is in short supply; a charitable loan fund could lend to agricultural and food-related businesses; and a diversified business fund could invest in homegrown tech start-ups.
Together with DPOs by local ventures, these CIFs would contribute to a vibrant community capital market in which everyone can participate on a level playing field, and help build a more equitable and prosperous community.
Note that this discussion is for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Capital and the services we offer or to schedule a consultation, please visit www.cuttingedgecapital.com or email us at firstname.lastname@example.org.