Whether you call it impact, place-based, mission-aligned, values-driven investment, or something similar, the movement toward investing for “more than financial” return has gained significant traction over the past decade. The recent pandemic-induced economic downturn has only increased momentum in this direction, as it heightened awareness of the indispensable role of “Main Street” businesses within local economies. As a result, we’re seeing significant interest among a whole new group of aspiring impact investors looking to contribute patient, thoughtful capital to revitalize their communities. Unfortunately, for many would-be investors in this group, their ability to act on their motivations is extremely limited.
The term impact investing was coined nearly 15 years ago, and its practice has remained largely in the realm of foundations and high net worth individuals. This is due in part to the fact that these institutional and individual investors have not only a mission-driven motivation but also significant financial means to invest according to their personal or organizational values.
What is less well-known, however, is that institutional investors and wealthy individuals also have enjoyed an almost exclusive right to invest for impact due to US securities regulations enacted more than 80 years ago. Many investments are only available to people who are “accredited” investors in securities legalese; to be accredited requires having an annual income of over $200,000 (over $300,000 if a couple) and/or wealth (not including the value of a family home) in excess of $1 million.
The confluence of the desire of people of more modest means to invest for impact—combined with the critical need among local businesses for community investment—offers a watershed opportunity for the federal government to take meaningful steps toward creating more democratic access to capital.
Access to capital for Main Street entrepreneurs and business owners has long been a challenge. While they may not physically reside on a city’s main street, these small businesses—defined as 20 or fewer employees—comprise 89.1 percent of the 6.1 million employer firms in 2018 and employ one in six private sector workers nationally. Main Street businesses are further distinguished as companies that put down roots in a community, create jobs for their owners and residents, and circulate money throughout the local economy through the purchase of goods and services from neighboring businesses.
These were the companies hit hardest when the world shut down and business-as-usual was suspended throughout much of 2020. Many did not have a financial safety net due to chronic (often systemic) barriers to capital, which traditionally meant relying on credit cards, personal savings, or the slow reinvestment of profits to grow. Many now continue to struggle or are failing outright despite attempts by the federal government to support them through the crisis. The documented failure of banks to equitably distribute Paycheck Protection Program (PPP) loans last year is an acute reminder of long-standing pre-pandemic lending practices that marginalize small businesses owned by women and people of color.
It doesn’t have to be this way, however. A silver lining of the COVID-19 crisis is the increased interest among a growing number of Americans to support local businesses. Survey data shows that in 2020 millions of Americans engaged in quasi-donation activity, such as buying gift cards at businesses that were temporarily closed, to keep local businesses alive. Now many would like to invest in them as well. Indeed, the two impulses of donations and investment occurred simultaneously. As early as March 25, 2020, I began fielding calls from community organizers and concerned citizens around the country who’d heard that many Americans would be receiving coronavirus relief checks and who initiated our conversation with something along these lines: “I’m doing fine. My job is secure. I don’t need this money. How can I put it to work to help businesses in my community that are struggling to survive?”
A Limited Menu of Options
Citizens and organizations in communities nationwide can rally together to rebuild their local economies from the grassroots up. One way to do this is by setting up a Community Investment Fund (CIF) that welcomes investment from any citizen—regardless of wealth status—to provide patient capital to help local businesses get back on their feet and even help new ones get started.
Last year, the National Coalition for Community Capital (NC3), in collaboration with Solidago Foundation, published Community Investment Funds: A How-To Guide for Building Local Wealth, Equity, and Justice, a handbook co-authored by authors from NC3, the Initiative for Local Capital, and Cutting Edge Institute. As NPQ covered, the report lifts up examples of the few existing ways that communities can aggregate small investments to support local businesses.
A key phrase in that last sentence is “the few existing ways” because they are indeed few, if communities wish to secure investments from residents who are among the 90 percent of Americans who do not qualify as accredited investors. This restriction stems from the Investment Company Act of 1940 (also known as the 1940 Act) that was enacted by Congress to regulate the organization and activities of investment companies such as mutual funds, investment clubs, venture capital funds, and real estate investment trusts (REITs), to name a few. Community development financial institutions (CDFIs) are also governed under the 1940 Act and while they have a long and important track record of filling the funding gap for many small businesses, the vast majority exclude unaccredited investors from participation, again due largely to the restrictions of the 1940 Act.
One of the few options for unaccredited investors (or in SEC-speak, retail investors) is to invest in local businesses through Regulation Crowdfunding campaigns. Regulation Crowdfunding, or Regulation CF, was enacted in May 2016 under Title III of the JOBS Act and gives retail investors the ability to make direct investments into businesses via registered crowdfunding portals. Regulation CF was an important step in the right direction. And Investibule, an aggregator website that allows you to search for deals listed on over 30 crowdfunding platforms filtered by location, deal structure, theme (e.g. POC/women-owned, co-ops, eco), and category (e.g. energy, farms, real estate), makes it easier to find local deals.
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But sourcing local deals still requires considerable effort, and even once investors find suitable deals in their communities, due diligence typically falls on the shoulders of individual investors—many of whom lack the skill, time, or desire to take on this important task. It is so much easier for individuals to rely on investment advisory professionals to do this legwork. Unfortunately, while there is a nascent and slowly growing cadre of wealth management advisors willing to provide this service, most do so with a wary eye on compliance and limit the service only to their accredited clientele, leaving investors of more modest means once again on their own.
Another option would be to pool investments together with other like-minded investors into a “community scale mutual fund,” complete with professional management to source and evaluate deals and with the added benefit of diversifying risk. Most small investors, when they invest in the stock market, are not investing in individual stocks. Rather, they invest in index or mutual funds, in which investment risk is spread across a wide range of stocks and bonds. Is it possible for small local investors to use similar means to diversify? The answer is yes…but, right now, the law creates so many barriers as to make it financially infeasible for most communities to try to stand up a fund of this kind.
In essence, Regulation CF created the ability for anyone to engage in local impact investing, but the Investment Company Act of 1940 prevents skilled and licensed professional managers from assisting people of modest means to create diversified, well-researched portfolios. It’s time for a 21st century makeover of the 1940 Act to complement Regulation CF. Regulation CF enables everyone to invest in local small businesses that support their neighbors. It is time to ensure that they can do so with greater safety.
Making Local Impact Investment Safe for Investors of Modest Means
To better understand what changes are needed, let’s consider what can and cannot be done under the 1940 Act as it currently exists. As mentioned above, there are existing funds, albeit a limited number of them, that are organized under exemptions of the extant 1940 Act. These are not technically mutual funds, but they do diversify investment across a broad range of companies. The most common form is the Charitable Loan Fund, which is exempt from the 1940 Act purely by virtue of the fund itself being a charitable organization.
A Charitable Loan Fund (CLF) provides a reasonably straightforward regulatory path for community members to invest their capital into the local economy through a diversified, professionally managed fund that can include any type of investor. A great example is the Boston Impact Initiative, created in 2013 to “close the racial wealth gap by changing the rules about how capital flows through communities of color.” To date it has invested nearly $6 million in over 20 BIPOC and women-owned businesses in eastern Massachusetts. However, a limitation of CLFs is that they are restricted to making outgoing investments that are explicitly aligned with their stated charitable purpose, even when logic (and the desire for deeper community impact) might dictate greater flexibility.
Another key limitation of a CLF is that it must be structured as a loan fund. As such, it can only receive investment into the fund as debt and must pay a stated interest rate back to investors. Because of this, many CLFs choose to make their investment placements predominantly in the form of loans, even though equity deals are legally permissible, to help ensure there are sufficient regular returns to make the requisite loan repayments to investors. This too can hamstring fund managers who see a need in their communities for more risk capital (i.e., equity or quasi-equity). For example, many startups generate little cash in the early years to pay back loans, even though they can generate far more income in later years after they develop; these businesses, however, may never get support from the fund in the first place because of the fund’s loan repayment requirements.
Another commonly used exemption for community investment funds under the 1940 Act is a REIT. The 1940 Act [Section 3(c)(5)] exempts a fund that is primarily in the business of acquiring mortgages and real estate. The exemption allows investment into the REIT regardless of accredited status and could be used for multiple real estate-specific purposes, such as the following:
- An affordable housing fund could finance housing in the “missing middle” between low-income housing and high-end “market rate” housing. This could be particularly important in hot markets like much of California.
- An agricultural land fund could acquire and hold land for farming and related uses, keeping the land from being converted into tract homes and thereby preserving rural character. An agricultural land trust, which uses charitable money to acquire preservation easements and reduce land costs, could accompany the fund. Land held by the trust could be leased to farmers at affordable rates, while local investors also can earn a decent return.
A real estate fund is a powerful fund structure and works well for communities where real estate investment is warranted. The Iroquois Valley Farmland REIT is an example of this type of fund. In operation since 2008, it is open to all investors nationally.
For communities that see a need beyond real estate and debt financing, however, the opportunities are limited. A few simple revisions to the 1940 Act would create exemptions that allow community-scale funds to: 1) accept investment from retail investors; 2) give fund managers flexibility to structure investments according to the needs of businesses within their community and without charitable purpose restrictions; and 3) share profits for wealth-building opportunities among all investors.
A detailed policy proposal to this effect was submitted to the US Securities and Exchange Commission by NC3’s Community Investment Fund Task Force in spring 2021. The proposal was met with significant interest from staff within the Commission and now awaits the appointment of a full-time director to the Division of Investment Management to take the next steps toward implementation.
In the meantime, communities are laying the groundwork for creating a fund as soon as the policy revisions are enacted. For example, in 2019, a North St. Louis group that is now known as Elevate/Elevar Capital began researching the necessary steps to create a community investment fund to provide financing to cohort members of the Elevate/Elevar Accelerator, comprised of Black and Latinx entrepreneurs. As it bumped up against the 1940 Act restrictions on retail investor participation, Elevate/Elevar decided to take an interim step to create the Elevate/Elevar Capital Fund with investment from accredited and philanthropic investors first, to establish a track record for the fund while gaining valuable operating experience. If/when the proposed SEC changes go into effect, Elevate/Elevar stands ready to accept retail investors into the fund.
In many ways, the Elevate/Elevar Capital Fund model is a strong step forward that many communities could take today to launch a fund with more risk-tolerant wealthy investors while preparing to open the fund to all when SEC rules permit. A fully inclusive community investment fund will open important opportunities for Americans to invest in their communities through pooled investment vehicles that, if done well, could reverse the seemingly inexorable trend toward increasing wealth inequality. By so doing, impact investment from the grassroots could boost local businesses and help millions of Americans who currently lack savings build durable community wealth.