Ever wish you could find a way to multiply your financial institution’s impact on the community and improve your CRA performance? Equity Equivalent Investments might be just what you’re looking for!
Equity Equivalent Investments, or EQ2s, are investment tools your financial institution can use to increase the capital base of your partner Community Development Financial Institutions (CDFIs). I’ve mentioned EQ2s before and how they can help your financial institution bring needed capital into the communities you serve and provide an income generating CRA qualified investment to your financial institution. Today I’m going to tell you how they work and how you can use this tool and potentially get both investment and lending credit on your next CRA exam.
As posted back in the Federal Reserve Bank of San Francisco’s Community Investment Publication, the EQ2 product is a long-term deeply subordinated loan with features that make it function like equity.
Since CDFIs typically don’t have access to deposits, they don’t have a strong permanent capital base necessary to support operations and to attract additional investments to effectively meet the needs of the economically disadvantaged communities they serve. EQ2 investments can shore up that gap with a flexible structure and a low cost basis that will enable CDFIs to expand the availability of patient capital and extend technical assistance within their local communities. Your single EQ2 investment can have a multiplier effect that allows your partner CDFI to attract additional capital and deploy more loans than they could with your EQ2 Investment alone.
Here’s a simplified example:
Your bank makes an EQ2 investment in Community CDFI for $1 million, representing 50% of Community CDFI’s total equity. Now that Community CDFI is better capitalized, they leverage the $2 million to borrow $8 million in senior debt, giving them $10 million in capital. Over the next two years, Community CDFI then deploys $7 million in community development loans! Your bank’s $1 million EQ2 was the catalyst that enabled $7 million into an economically disadvantaged community! There are few investment tools that allow you to make seven times the impact.
The multiplier effect also applies to your bank’s CRA performance. EQ2 investments may be eligible for both investment and lending credit. Lending credit is considered based on the bank’s pro rata share in community development loans made by the CDFI. Your Bank may receive $3.5 million in lending credit over the two years, since it’s EQ2 investment represented 50% of Community CDFI’s equity. Any amount of your Bank’s EQ2 not allocated to lending activities cmay be considered under the investment test. Given the technical nature of these provisions, it is imperative that you consult legal counsel before making an EQ2 both to ensure that the bank has the authority to make such an investment and how to claim performance under the CRA. Here is a related legal opinion as posted on the FFIEC.gov website. https://www.ffiec.gov/cra/letters/letter_19960627.htm
EQ2 investments have great benefits, but they need to be carefully packaged and implemented to be considered an EQ2. EQ2s must have these 6 features:
- Must be carried as an investment on the investor’s balance sheet.
- Must not be secured by any of the CDFI’s assets.
- Must be fully subordinated to the right of repayment of all of the CDFI’s other creditors.
- Does not give the investor the right to accelerate payment.The exception to this is if the CDFI ceases normal operations.
- Must carry an interest rate that is not tied to any income received by the CDFI.
- Must have a rolling term.
Any investment that does not pass this test will be treated as simple subordinated debt.
Equity Equivalent Investments by banks and other investors have been providing CDFIs with capital funds for over 20 years and there are all kinds of tools and assistance available to help you put your investment package together. Want to learn more about EQ2 Investments? Check out The FRBSF Community Investment Newsletter Excerpt EQ2 Overview and The FDICs Strategies for Community Banks to Develop Partnerships with Community Development Financial Institutions. Are you ready to get started? The CDFI Fund has a Sample EQ2 Agreement to help you get started!
Important Note! Especially since we got quite technical today!
This is intended only for educational purposes and is not intended to qualify as legal advice. CRA Today does not warrant the information, material, and content in this session and the official understanding of the federal government or any state or local government with regard to the Community Reinvestment Act (“CRA”) and related federal regulations and guidelines. All information, material, and content provided in this guide is offered as general information and is not tailored to or specific to any particular bank or regulator. No user should act on the basis of any material contained in this session without obtaining proper legal or other professional advice specific to their situation.
Cheers to you and this important work! Linda