How Guarantees Can Advance Community Development and Racial Equity – Non Profit News

Private foundations are best known for their grantmaking. However, each year, foundations nationwide invest hundreds of billions, often with the simple goal of maximizing financial returns to fund future grants. While many foundations screen their endowment investments based on environmental, social, and governance factors, only a few optimize their investment strategies for mission impact. 

At the same time, many community development nonprofits face challenges in securing the capital needed to carry out their core missions and, importantly, to test new ideas and strategies. This “tension” between philanthropies seeking economic returns even while nonprofits face capital gaps—especially for the kind of flexible capital that is needed to innovate—is nothing new. However, with IRS rules requiring an annual minimum of five-percent charitable payout often treated as a ceiling, and rising costs, more foundations are seeking ways to maximize the use of their balance sheet to achieve greater social impact.

At the most basic level, a guarantee is akin to automobile insurance.

There is, however, a way for nonprofits to gain greater access to “flexible” capital and for foundations to generate a financial return. And this is not just through program-related investments or endowment-based mission-related investments.

Financial guarantees are a powerful tool, yet they are underutilized in the social sector. Guarantees can support nonprofits’ capital needs while helping foundations advance both their social and fiscal objectives. Since December 2019, the nearly $50 million Community Investment Guarantee Pool has been testing guarantees in partnership with 16 philanthropic and other mission-driven investors. It’s still early days, but in the past three years, we’ve learned more about how guarantees can benefit both mission-driven investors and community groups.

Defining Guarantees

First, it is important to clarify what guarantees are. At the most basic level, a guarantee is akin to automobile insurance. Drivers generally do not expect to get into accidents. However, if something unexpected does happen, the insured driver will not need to bear the full financial cost. 

Financial guarantees function similarly. A guarantor promises to make a specified payment on behalf of another organization (the guarantee beneficiary) if certain unanticipated events occur.  

In the context of a loan or investment, a guarantor may agree to cover the gap between the required and actual payments if the borrower or investment recipient falls short. This facilitates taking on larger loans or investments at more favorable terms.

Unfunded guarantees, our focus here, only require the guarantor to “spend” money if certain predetermined events or conditions occur (nonpayment, and so on) that require the guarantor to make good on the guarantee. Until then, the guarantor can keep the funds invested where they are, though some agreements will require the guarantor to maintain a minimum level of liquidity to ensure funds are available when—and if—a claim is made.

This contrasts with funded guarantees in which the guarantor sets aside some or all the guaranteed amount in an escrow or similar account. The funded guarantee is more “secure.” However, this takes control of the funds away from the guarantor and may add transaction costs. 

The nature of unfunded guarantees makes them distinct from program-related investments, which provide actual funds for the nonprofit while generating a (below market) return for investors. A guaranteed project does not do this but instead is built on the premise that funding from other capital sources occurs alongside the guarantee. In doing so, a guarantee helps the nonprofit secure the funding it needs at agreeable terms. 

The Benefits of Guarantees for Nonprofits

Nonprofits can benefit from guarantees in many ways, depending on the nature of the nonprofit, its activities, and the type of capital it needs. 

For example, let’s say that a mental health nonprofit looking to build out its youth facilities has been unable to secure the needed construction loan due to a lender’s concerns about its ability to repay. In this case, a local foundation guarantee to cover any debt payment shortfall may allay the lender’s concerns and enable the lender to make the loan. Even in cases where the guarantee was ultimately not necessary for loan approval, it can help elevate the nonprofit in the eyes of lenders to get more favorable loan terms, such as a lower interest rate or more flexible repayment options.

A guarantee can also be a means of sharing financial risk. In the last example, if the mental health nonprofit’s loan repayment hinges on successfully launching a new type of youth drop-in program, the local foundation could agree to guarantee a certain level of cash flow from the new program as opposed to directly guaranteeing repayment. After all, nonprofit financial stewardship largely follows the same guidelines as other businesses; leaders and boards may be more likely to sign off on new, relatively untested activities if there is downside protection against losses afforded by guarantees.

Assuming a relationship exists, guarantees between a single foundation and a single nonprofit can be straightforward to arrange and their impact can be meaningful. However, these one-to-one guarantees lack the scalability possible with guarantees to community development financial institutions or other mission-driven capital providers. The latter can also test products or initiatives that stretch industry practices—such as predevelopment housing loans with reduced collateral requirements, business loans with flexible repayment terms (such as loans where the payment owed varies according to the firm’s revenues), alternative “due diligence” evaluation criteria that are conscious of the racial wealth gap, and nascent green technology financing strategies.

Guarantees allow [foundations] to support a mission-aligned project or nonprofit without immediately disbursing capital.

As noted above, a key benefit of guarantees is mitigating actual or perceived risks. Knowing there is a financial safety net, stakeholders may be more willing to authorize terms they would otherwise consider too “risky.” Another way guarantees can benefit nonprofits is by serving as a substitute source of capital. Nonprofits who must bring their own capital to the proverbial “table” to secure additional financing but which lack that capital, may be able to substitute a guarantee instead, demonstrating that they have access to capital, even if it is not yet (and if the guarantee is not called, will not be) on their balance sheets. 

Other benefits are more intangible but still important. A guarantee can offer a nonprofit signaling power. Simply having a guarantee from a financially strong, recognized investor can open doors to new opportunities. 

The Benefits of Guarantees for Foundations

For foundations, guarantees add another tool to their impact investment toolkit. Specifically, guarantees allow them to support a mission-aligned project or nonprofit without immediately disbursing capital. 

Even when a guarantee is called, foundations may be able to categorize the payment as a charitable contribution. While this depends on how the guarantee was structured and the charitable nature of the organization receiving the guarantee, this can alter the risk to the foundation, as the expense would count toward a foundation’s “payout” requirement rather than count as an investment loss. (This may, of course, reduce the funds available for other foundation programs or expenses.) It is also important to note that guarantors will want to regularly monitor their portfolio of guarantees to forecast the likelihood, timing, and amount of any claims.

Challenges with Unfunded Guarantees

Despite the benefits of guarantees, they have historically been underutilized. One confounding challenge is low field awareness. While common in some sectors like housing finance, these guarantees have typically been issued by public entities, not by philanthropy. And guarantees are much less common in other fields, such as community-focused renewable energy. 

The distinction between funded and unfunded guarantees adds confusion. Furthermore, many established guarantee programs have rigid, exclusionary requirements, which leads some to erroneously assume that this is an inherent feature of all guarantees and not worth investigating. The solution to these challenges is building awareness and support among various stakeholders, including potential guarantors and potential beneficiary organizations.

Adding to this complexity, many guarantors lack systems, policies, and procedures to manage guarantees. While technology, research, accounting standards, and legal guidelines are well established for grantmaking and increasingly impact-oriented loans and investments, the same is not true for guarantees. Guarantees may require an organization to invest resources and staff time to develop the knowledge and capabilities needed to manage them. This learning curve is understandably a barrier to deployment—especially when other, better-understood financial tools are available.

Building the Field: The Community Investment Guarantee Pool

In 2019, a group of 10 foundations and a health system came together determined to change the capital landscape, particularly for community development. These investors wanted to pool their resources to learn what would maximize impact and how best to scale guarantees. With an initial commitment of $32 million, they established the Community Investment Guarantee Pool and selected LOCUS Impact Investing, a subsidiary of Virginia Community Capital Social Enterprises, to manage the pool.

From inception, the pool was centered on community development financing activities and emphasized racial, gender, and economic equity. Notably, racial equity has become increasingly prioritized in the last few years, given the intense focus of racial reckoning following the murder of George Floyd. To focus the pool, the guarantors identified three primary sectors: affordable housing, small business, and climate justice. The guarantors established the general terms—including minimum and maximum guarantee sizes, term lengths, and qualifying transactions. Then they gave the LOCUS team the authority to operate the pool on their behalf while providing regular impact and learning updates. 

To date, 16 guarantors have committed $50 million. These guarantors provide guidance and learn from CIGP’s staff, evaluators, and each other. Risk oversight is provided by a dedicated credit committee comprised of guarantors, VCCSE leaders, and sector experts. CIGP manages the portfolio of outstanding guarantees, working with the beneficiaries. While no guarantee has yet been called, if one is, CIGP will aggregate funding from the guarantors on a pro rata basis—in other words, an organization that contributed 10 percent to the pool will pay a tenth of the called amount—and disburse the guarantee claim amount to the beneficiary.

So far, CIGP has organized 11 guarantee deals totaling over $25 million. From an impact standpoint, these are expected to catalyze over $200 million in additional capital—and have already led to financing projects and businesses that will ultimately provide over 2,200 affordable homes and help retain over 3,000 jobs. 

Importantly, the guarantees help beneficiary nonprofits redistribute the perceived or actual risk of trying out new strategies. For example, one nonprofit intermediary uses its guarantee to finance affordable housing developers who do not meet the Low-Income Housing Tax Credit industry’s liquidity and net-worth standards. These standards disproportionately harm BIPOC developers, who are often restricted to subcontractor status.

Two project-based examples below illustrate how guarantees can help address risk in different ways, and by so doing, advance equitable approaches to two very different issues—capital inefficiency of small community solar projects and improving responsiveness to small businesses struggling amid a pandemic to re-open.

A California Solar Co-op Case Study 

According to 2022 data from the Berkeley Lab, solar energy adopters in the US continue to be disproportionately higher income and White. At the same time, energy costs are a greater burden for low-income and many BIPOC families. 

For example, a 2020 survey by the American Council for an Energy-Efficient Economy found that Black households spent 43 percent more of their income on energy costs than White households. Against this backdrop, the People’s Solar Energy Fund, a nonprofit cooperative of BIPOC and low-income community-serving organizations (including Climate Justice Alliance, Co-op Power, NAACP, and Seed Commons) launched the People’s Solar Energy Co-op to more efficiently finance small-scale solar projects led and owned by the community that could serve a subscriber base of lower-income people and renters. PSEC’s structure aggregates smaller projects into “bundles” within a larger fund to generate transaction efficiencies in arranging tax credit equity, debt financing, and managing the projects. In addition to financing, PSEC also provides project design, construction, and management oversight. 

In 2022, CIGP provided PSEC with a $1 million, 10-year guarantee to support the development of up to 30 megawatts of small (less than three megawatts) community solar projects. Combined, the development costs of these project are over $10 million. The guarantee covers project debt service shortfalls so that cost overruns on one project do not negatively impact the entire bundle. PSEC anticipates that at least half of subscribers will be low-to-moderate income and/or BIPOC households, with an anchor commercial subscriber providing specific support for this goal.

A Small Business Case Study from Big Sky Country

MoFi (a community development financial institution previously known as the Montana Community Development Corporation) primarily provides loans to disadvantaged entrepreneurs and business owners. In response to COVID-19, the CDFI created a loan product to provide affordable and flexible unsecured working capital loans to small businesses that had lost access to bank credit across Montana, Idaho, Wyoming, Utah, Eastern Washington, and Eastern Oregon. With loan amounts up to $100,000, a two-year period when principal payments are not due, and a streamlined three-day underwriting process influenced by academic research and their experience issuing PPP loans, the nonprofit lender’s goal was to enable previously profitable businesses to recover and reopen after the initial COVID-19 shutdown.

CIGP initially provided a $500,000, nine-year loan loss reserve guarantee, which would cover up to a five-percent loss across the entire portfolio. Due to higher-than-anticipated demand, MoFi expanded the program and successfully sought to increase CIGP’s guarantee to $875,000 within months of the program’s launch. In total, MoFi made nearly $16 million in loans to 239 small businesses that supported nearly 1,600 jobs. They are also scaling the model through an additional fund and through technical assistance to other community lenders. 

Initial Lessons Learned

Three-and-a-half years into a planned 15-year term, CIGP is already offering some initial lessons, which we hope will inspire additional efforts in the field. First, there have been no calls yet on any guarantees. This initial “success” may indicate that conventional assessments of risk, even within community development, have been overly limiting.

Partnering with a mission-aligned guarantor should allow beneficiaries to take in new data and reassess risks to make enduring, equitable changes.

Demand has far outpaced capacity. The current pipeline exceeds the fund’s capacity for new guarantees tenfold. Of course, some of these opportunities are at a very early stage, but many are ready to proceed with the right backing. 

Like all forms of financing, guarantees are not for everyone or every occasion. A guarantee is a capital tool that provides unique flexibility but has some key limitations. As nonprofits consider including financial guarantees as part of their capital strategy, it is important that they be clear about the type of capital needed. Guarantees are very useful for nonprofits seeking to acquire debt, investment capital, and other forms of financing. They are not particularly useful for organizations seeking stand-alone grant funding.

To be clear, guarantees cannot be a panacea for the real capital challenges facing underserved communities and nonprofits. As with other philanthropic tools, these guarantees are meant to help drive systematic shifts where market forces contribute to, rather than extract from, the development of communities, especially those which have historically faced extraction. 

Partnering with a mission-aligned guarantor should allow beneficiaries to take in new data and reassess risks to make enduring, equitable changes—not create a perpetual stopgap where the market then “requires” credit enhancement. This risk aside, guarantees can be a highly efficient way for foundations and mission-driven investors to use their financial wealth to unlock capital for nonprofits testing newer strategies that promise to address the critical challenges of our times.