Entrepreneurship and innovation are crucial for sustained community development, as new ventures create new jobs and wealth. As entrepreneurs start and grow their companies, access to capital is a significant barrier. Communities nationwide have responded by initiating programs, policies, and practices to help entrepreneurs creatively leverage philanthropic dollars, government grants and loans, and private capital. But these individually promising solutions collectively amount to a national patchwork of support. Those who seek to scale promising ideas face a funding continuum that is filled with gaps, replete with high-transaction costs, and highly variable depending on each entrepreneur’s circumstances.
To help entrepreneurs better and more reliably access capital no matter where in the country they are, the Small Business Administration (SBA) should work with the other Interagency Community Investment Committee (ICIC) agencies to expand the SBA’s secondary market capacity. The SBA’s secondary market allows lenders to sell the guaranteed portion of a loan backed by the SBA. This provides additional liquidity to lenders, which in turn expands the availability of commercial credit for small businesses. However, there is no large standardized secondary market for debt serviced by other federal agencies, so the benefits of a secondary market are limited to only a portion of federal lending programs that support entrepreneurship. Expanding SBA’s secondary market authority would increase access to large pools of private capital for a larger proportion of entrepreneurs and innovative small businesses.
As a first step towards this goal, one or several agencies should enter into a pilot partnership with SBA to use SBA’s existing administrative authority and infrastructure to enable private lenders to sell other forms of federally securitized loans. Once proven, the secondary market could be expanded further and permanently established as a government-sponsored enterprise (GSE). This GSE would provide accessible capital for entrepreneurs and small businesses in much the same way that the GSEs Fannie Mae and Freddie Mac provide accessible capital, as mortgages, for prospective homeowners.
With the 118th Congress considering the reauthorization of SBA for the first time in 22 years, there is an opportunity to seize on this reauthorization to modernize the SBA. Piloting the SBA’s secondary market capacity is a crucial piece of modernization to increase access to capital for entrepreneurs.
Challenge and Opportunity
Access to capital changes the economic trajectory of individuals and communities. Approved small business loan applicants, for instance, report average income increases of more than 10% five years after loan approval. Unfortunately, capital for budding entrepreneurs is scarce and inequitably allocated. Some 83% of budding entrepreneurs never access adequate capital to start or grow their business. Success rates are even lower for demographic minorities. And when entrepreneurs can’t access capital to start their business, the communities around them suffer, as evidenced by the fact that two out of every three new jobs over the past 25 years has been generated by small businesses.
The vast majority of new businesses in the United States are funded by personal or family savings, business loans from banks or financial institutions, or personal credit cards. Venture capital is used by only 0.5% of entrepreneurs because most entrepreneurs’ businesses are not candidates for it. Public and mission-driven lending efforts are valiant but can’t come close to matching the scale of this untapped potential. Outside of the COVID-19 emergency response, the SBA annually appropriates $1–2 billion for lending programs. The Urban Institute found that between 2011 and 2017, Chicago alone received $4 billion of mission-driven lending that predominantly went toward communities of color and high-poverty communities. But during the same time period, Chicago also received over $67 billion of market investment—most of which flowed to white and affluent neighborhoods.
Communities across the country have sought to bridge this gap with innovative ideas to increase access to private capital, often by leveraging federal funding or federal programmatic infrastructure. For example:
- The Entrepreneur Backed Asset Fund is a philanthropically funded initiative that creates a secondary market for microloans made through Community Development Financial Institutions (CDFIs). This idea came from an experienced microlender who was frustrated with the illiquidity of microloans and subsequent need to constantly engage in time-consuming philanthropic fundraising.
- ESO Ventures is a nonprofit organization out of East Oakland, California, that combines competency-based curriculum and access to capital. As entrepreneurs grow their skills through the program, they receive access to increasing lines of credit to apply those new skills to their businesses. ESO Ventures has grown rapidly by using both federal recovery grants funneled through the state of California and access to private banks for credit lines. The organization’s goal is to create 3,000 more businesses and generate $3 billion in economic activity by 2030.
- Network Kansas is an entrepreneurial support organization born out of the first version of the Treasury Department’s State Small Business Credit Initiative (SSBCI) program under the Obama Administration. The organization leverages a Kansas state tax credit to provide below-market debt to rural entrepreneurs in the most remote parts of Kansas. Since 2006, Network Kansas has deployed $500 million.
These example programs are successful, replicable, and already supported by some of the agencies in the ICIC. These programs use traditional, well-understood financial mechanisms to provide capital to entrepreneurs: credit lines, insurance, shared-equity agreements, tax credits, and low-interest debt. The biggest obstacle to scaling these types of programs is financial: they must first raise money to support their core financial mechanism(s) and their dependence on ad hoc fundraising almost inevitably yields uneven results.
There is a clear rationale for federal intervention to improve capital access for entrepreneurship-support programs. Successful investment in marginalized communities serves the public interest by generating positive externalities such as increases in jobs, wealth, and ownership. Government can grow these externalities manyfold by reducing risk for investors and reducing the cost of capital to entrepreneurs through the expansion of SBA’s secondary market authority and ultimate creation of a GSE to create permanence, increased accountability, and further flexibility of capital access. With SBA reauthorization on the legislative docket, this is a prime opportunity to address the core challenge of capital access for entrepreneurs.
Plan of Action
Federal government should create standardized, straightforward mechanisms for entrepreneurs and small businesses across the country to tap into vast pools of private capital at scale. A first step is launching an administrative pilot that extends the SBA’s current secondary market capacity to interested agencies in the ICIC. An initial pilot partner could be the Department of the Treasury in order to recapitalize its Community Development Financial Institutions (CDFI) Fund. If the pilot proves successful, the secondary market could be expanded further and permanently established as a government-sponsored enterprise.
Recommendation 1. Establish an administrative pilot.
The SBA’s secondary market can already serve small business debt and debt-like instruments for small businesses and community development. The SBA currently underwrites, guarantees, securitizes, and sells pools of 7(a) and 504 loans, unsecured SBA loans in Development Company Participation Certificates, and Small Business Investment Company Debentures. Much like Federal Housing Administration and Veterans Affairs home loans offer guaranteed debt to homeowners, there are programs that offer guaranteed debt for entrepreneurs. However, there is no large standardized secondary market for the debt that extends across agencies.
An interagency memorandum of understanding between interested ICIC agencies could quickly open up the SBA’s secondary market infrastructure to other forms of small business debt. This would allow the ICIC to explore, with limited risk, the extent to which an expanded secondary market for federally securitized debt products enables entrepreneurs and small businesses to more easily access low-cost capital. Examples of other forms of small business lending provided by ICIC agencies include Department of Agriculture Rural Business Development Grants, Department of Housing and Urban Development Community Development Block Grants, and the Treasury Small Business Lending Fund, among others.
An ideal initial pilot partner target among ICIC agencies would be the Treasury, which could pilot a secondary market approach to recapitalizing its CDFI Fund. This fund allocates capital via debenture to CDFIs for them to make personal, mortgage, and commercial loans to low-income and underserved communities. The fund is recapitalized on an annual basis through the federal budget process. A partnership with SBA to create a secondary market for the CDFI Fund would effectively double the federal support available for CDFIs that leverage that fund.
It is important to note that while SBA can create pilot intergovernmental agreements to extend its secondary market infrastructure, broader or permanent extension of secondary market authority may require congressional approval.
Recommendation 2. Create a government-sponsored enterprise (GSE).
Upon successful completion of the administrative pilot, the ICIC should explore creating a GSE that decreases the cost of capital for entrepreneurs and small businesses and expands capital access for underserved communities. This separate entity would be a more independent body than an expanded secondary market created through SBA’s existing infrastructure. Benefits of creating a GSE include providing more flexibility and allowing the agency to function more independently and with greater authority while being subject to more rigorous reporting and oversight requirements to ensure accountability.
After the 2008 housing-market crash and subsequent recession, the concept of a GSE was criticized and reforms were proposed. There is no doubt that GSEs made mistakes in the housing market, but they also helped standardize and grow the mortgage market that now serves 65% of American households. The federal government will need to implement thoughtful, innovative governance structures to realize the benefits that a GSE could offer entrepreneurs and small businesses while avoiding repeating the mistakes that the mortgage-focused GSEs Fannie Mae and Freddie Mac made.
One potential ownership structure is the Perpetual Purpose Trust (PPT). PPTs work by separating the ownership right of governance from the ownership right of financial return and giving them to different parties. The best-known example of a PPT to date is likely the one established by Yvon Chouinard to take over his family’s ownership interest in Patagonia. In a PPT, trustees—organized in a Trust Steward Committee (TSC)—are bound by a fiduciary duty to maintain focus on the stated purpose of the trust. None of the interests within the TSC are entitled to financial return; rather, the rights to financial return are held in a separate entity (the Corporate Trustee) that does not possess governance rights. This structure, which is backed by a Trust Enforcer, ensures that the TSC cannot force the company to do something that is good for profits but bad for purpose.
Emulating this basic structure for a capital-focused GSE could circumvent the moral hazard that plagued the mortgage-focused GSEs. The roles of TSC, Trust Enforcer, and Corporate Trustee in a federal context could be filled as follows:
- Trust Steward Committee: The TSC possesses a fiduciary for the PPT and typically makes strategic decisions to pursue the PPT’s purpose. For a capital-focused GSE, the TSC’s role would be limited to governance. The TSC would be populated by a mix of stakeholders, such as entrepreneurs, community developers, investors, and support organizations.
- Trust Enforcer: The Trust Enforcer is an independent entity that rules on whether the TSC is sufficiently pursuing the PPT’s stated purpose. For a capital-focused GSE, this role could be filled by federal agency staff. The trust that holds the governance rights serves as the vehicle for the regulatory body to oversee the GSE.
- Corporate Trustee: The entity that holds the financial interest of the GSE could be sold to investors, granted to employees, or given away to relevant nonprofit and other stakeholder groups.
The ICIC agencies support and create many creative solutions that blend private and public dollars to increase entrepreneurship and community development. Yet the federal government stops short of providing the most important benefit: standardization and scale. The ICIC agencies should therefore create an entity that unlocks standardization and scale for the programs they help create, with the overall goals of:
- Unifying small-business and community-development underwriting
- Broadening private-actor participation in small business loan origination by creating the risk standards that allow for greater liquidity
- Opening the capital markets to lower the cost of capital for entrepreneurs
A first step towards accomplishing these goals is to establish an administrative pilot, by which interested ICIC agencies would use the SBA’s existing authority and infrastructure to create a secondary market for their securitized debt instruments.
If the pilot proves successful, the next step is to expand the secondary market and establish it for the long term through a GSE modeled on those that have effectively supported the mortgage industry—but with a creative structure that proactively addresses GSE weaknesses unveiled by the 2008 housing-market crash. The result is a stable, permanent institution that enables all communities to realize the benefits of robust entrepreneurship by ensuring that budding entrepreneurs and small-business owners across the country can easily tap into the capital they need to get started.
Precedents for this type of federal intervention can be found in the mortgage industry. Homeownership is a major driver of wealth creation. The federal government supports homeownership through mortgage guarantees by federal agencies like the Federal Housing Authority and Veterans Affairs. In addition, the federal government increases liquidity in the mortgage industry by enabling insured mortgages and market-rate mortgages to be securitized, sold, and purchased on secondary markets through government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, or wholly owned agencies like Ginnie Mae. These structures have created a reliable stream of capital to originate loans for homeownership and lower the cost of borrowing.
The mortgage GSEs are engaging in innovation to increase access to housing credit. Fannie Mae, for example, is taking a number of steps to extend credit and homeownership to historically disadvantaged communities, including by using documented rental payments to help individuals build their credit scores and using special-purpose credit programs to develop new solutions for down payment assistance, underwriting, and credit enhancement. These changes will have an outsize effect on the mortgage industry because of the central role a GSE like Fannie Mae plays in connecting private markets to potential homeowners.
COVID-19 relief efforts provide an application of this model specific to small businesses. The California Rebuild Fund (CARF) was a private credit fund for small businesses capitalized with a mixture of state, federal, philanthropic, and private investment. The CARF used government debt guarantees to push down the cost of capital to Community Development Financial Institutions that were best positioned to originate and serve small businesses most negatively impacted by COVID-19.
The CARF proved that a coherent and routinized process for accessing private capital that lowers interest rates, expands credit for small businesses, and creates operational efficiencies for entrepreneurial support organizations. For instance, there is a single application site that matches potential borrowers to potential lenders. The keys to the CARF’s success were its guarantee from the state of California and the fact that it provided relatively uniform offering to different investors along a spectrum of return profiles.
To begin the new entity, securitize or purchase securities from only government guaranteed loans. Even during the worst of the housing crash, the government-guaranteed mortgage-backed securities were more stable than non-agency loans. Beginning with guaranteed loans allows this new entity to provide explicit guarantees to guarantee-sensitive investors. However, a gradual push into new mechanisms, innovative underwriting, and perhaps non-agency debt should be a goal.
The guarantee of the loans should be explicit but only sit after the equity of the borrower and the agency guarantee.
Any privileges extended to the new entity, such as exemption from securities registration or state and local taxation, that results in measurable decrease in cost of lending should be passed on to the final borrower, as much as possible.
Assuming that the regulatory body, acting as a fiduciary of the trust, can implement policies that take into account demographics like race, ethnicity, and country of origin, the GSE should use special purpose credit programs to address racial inequalities in access to capital.
The authorizing statute for the SBA secondary market required the lender to remain obligated to the SBA if it securitizes and sells the underlying loan on a secondary market. To promulgate that obligation the SBA requires the lender to keep a percentage of the loan on their books for servicing. This is an operational hurdle to securitizing loans. Either there needs to be a more robust market to justify the operational expense or there should be another manner by which the lender remains obligated to the SBA.
The SBA recently announced a change in the interest rates that lenders can charge for 7(a) loans. While it is understandable that the SBA does not want the guarantee to run up the profit margin for lenders, the tradeoff is that some entrepreneurs will go without capital because lenders cannot justify the risk at the formulated interest rate. The authorizing statute, CFR 120.213, merely requires that interest rates be reasonable. This should give the SBA room to experiment with how it can deliver low-cost capital to borrowers. For example, if the usury cap was removed for some loans, could the SBA require the excess yield be used to push down the cost of borrowing for other loans?
The Interagency Community Investment Committee (ICIC) focuses on the operations and execution of federal programs that facilitate the flow of capital and the provision of financial resources into historically underserved communities, including communities of color, rural communities, and Tribal nations. The ICIC is composed of representatives from the Treasury, Small Business Administration, Department of Commerce, Department of Transportation, Housing and Urban Development, and Department of Agriculture.
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