Raising Preferred Equity Through Capital Markets

Basics

CDFIs face growing pressure to strengthen their balance sheets and diversify sources of equity as demand for community lending increases amid high interest rates, inflation, and economic uncertainty. Many CDFIs are also reliant on federal funding and debt to capitalize their balance sheets. In this solution, investors would provide CDFIs with equity that supports additional lending in exchange for a fixed dividend on a subset of pooled loans. Preferred equity would require new operational structures and cooperation across large CDFIs. To operationalize this approach, several large CDFIs would aggregate portions of their portfolios through special purpose vehicles and offer preferred equity to private investors. In this model, CDFIs could retain their loans but transfer the value from the subsidiary to the for-profit holding company (upstream equity). CDFIs on the hunt for new sources of capital can explore raising preferred equity in the private marketplace.

Benefits

CDFIs with preferred equity investments would readily benefit from financial diversification, liquidity, and resilience. And unlike with debt financing, CDFIs with preferred equity would not have to make fixed repayments, which allows for more steady growth. The portfolio aggregation platform that enables these investments could modernize data collection, risk management, asset analysis, and monitoring across the CDFI industry. CDFIs that successfully participate in private equity markets could reach broader public capital markets, increase visibility, and attract a wider range of investors.

Background

For the CDFI sector, this is a potentially transformative, but untested, idea. Proponents envision aggregating loan portfolios of multiple large, well-performing CDFIs and offering preferred equity to private investors through a centralized portfolio aggregation platform. By pooling assets across institutions and sectors, the model seeks to diversify risk, increase scale, and create an investment vehicle attractive to conventional capital markets. Participating CDFIs would establish special purpose vehicles to hold loans and upstream equity. They retain loan servicing rights and organizational independence.

Evidence of Success

The CDFI Equity Project evaluated this model by aggregating the financial data of 10 large CDFIs. The test showed that a portfolio of $964 million in community development loans could be capitalized by $200 million in preferred equity. If successfully implemented, preferred equity could provide CDFIs with a durable new source of capitalization, reduce reliance on federal funding, and support long‑term growth in community development lending. External ratings agencies could further build investor confidence by publicly reporting on CDFI performance in secondary markets.

Potential Challenges

CDFIs that adopt this approach would need new legal structures, robust and consistent performance data, and greater coordination among groups of CDFIs. If investors seek concessions, preferred equity could be more expensive than other financing sources in the near term. There are also tax implications, governance complexity, and risks involved in separating earned assets from unsecured lenders. As a result, this innovation is most applicable to larger, highly rated CDFIs. At least for now, mature CDFIs have the scale, operational capacity, and record of financial performance needed for this market.

Bottom Line

The CDFI Equity Project provides a blueprint for how aggregated CDFI portfolios could support preferred equity investment at scale. Some large CDFIs are continuing to pursue the preferred equity framework set out by the CDFI Equity Project, signaling interest in this approach among established CDFIs.

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