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Changing the Contours of Capital
Aug 01, 2005
Publisher: Inner City Economic Forum

Inner City Economic Forum

The United States experienced an extraordinary surge in wealth during the 1990s. Even after the stock market decline of the first years of the new century, Americans' total net worth remains almost 75 percent greater than just 10 years ago. As with previous episodes of economic expansion, entrepreneurship and innovation--both technological and financial-- fueled much of this growth. However, this growth was unbalanced, with higher-income, largely white entrepreneurs more easily accessing the full array of financial technologies and a wider range of sources of capital than smaller firms in our emerging domestic markets (EDM).

The Milken Institute defines emerging domestic markets as people, places or businesses facing capital constraints due to systematic undervaluation arising from imperfect information. This includes inner city and rural communities, ethnic- and women-owned firms and companies serving ethnic and/or low-income populations. The capital gaps faced by EDM businesses limit their ability to expand and generate jobs. Given America's evolving demographics, closing the EDM capital gap is not only important to the emerging businesses and communities, but also critical to sustain aggregate economic growth in the U.S. macro economy.

Small businesses represent the vast majority of all firms and a driving force behind economic output and job creation. Ethnic-owned firms grew at twice the rate of all firms during the past decade, and women-owned businesses at over two times the rate. ICIC's own State of the Inner City Economies research reveals the growth in urban population and identifies the share of middle-income earners in inner cities as greater than their nationwide share. With overall U.S. job growth slowing, and returns on investments down, EDM markets offer investors important opportunities: they are still relatively untapped, lower-cost and faster-growing.

Identifying the gaps
Explanations for the capital gap include factors as varied as continuing discrimination, size and scale of the businesses, their specific financing needs, inexperienced entrepreneurs, slower growth industries, and tenuous business networks. But, most importantly, there is a lack of comprehensive, reliable and cost-effective data on EDM businesses. Two key types of data are lacking: market data on firms and markets, and financing data covering debt and equity.

The former provides a reasonable estimate of the market opportunities; the latter helps show the structure and size of firm funding, as well as the performance of the loans and investments. The lack of information yields both a reduced awareness of the opportunity, and a significant misperception (and thus mispricing) of the risks of operating in these markets.

No new financial market or asset class has emerged over the past thirty years without considerable investment in building the informational infrastructure about firm and project finance characteristics, financial and economic performance, and relation to macroeconomic and institutional dynamics. There is a clear need to expand the availability and accessibility of data to enable further analysis on, and product development for, this important market. Transferring financial technology to EDM communities requires frequent and detailed research with increasing granularity of information and analysis to inform and develop investor confidence in these emerging markets and asset classes serving them.

Preventing duplication
It is exciting to witness the data collection underway among a number of EDM subgroups. These activities include both demographic and financial information gathering, and include the CDFI Fund's Community Investment Impact System, the CDFI Data Project, the Kauffman Foundation's Panel Study on Entrepreneurial Dynamics, the RISE report on double bottom line funds, NAIC's report on minorities and venture capital, Bank of America's tracking of its Fund of Funds, as well as periodic reporting from the SBA and Census, and private data collections--some proprietary (e.g., individual banks) and some available for purchase (e.g., Dun & Bradstreet).

These efforts however operate independently, without much communication, but perhaps with duplication of effort. There is currently no mechanism to cross-reference these diverse pools of information. The solution lies in developing a relational database, masked to enable data sharing among users. This would enable financial service providers to analyze and develop potential customers and products, business academics to research this market, and financial and policy practitioners to build the case for new business and public policy interventions supporting market growth. Together, these groups could demystify EDM and facilitate the growth in capital flows.

Creating such a system would facilitate critical data assembly, generate a continuous learning process for lenders and investors supplying the data, standardize the process, and reduce the cost of information management.

Relational database architecture allows the warehousing of disparate databases that can cover various levels of aggregation (including geographic region, type of financial institution, firm characteristics, and type and performance of security, etc. While many large financial institutions (e.g., Bank of America, Wells Fargo) make large enough numbers of small business loans that they have internal risk-assessment processes (similar to credit-scoring), smaller lenders cannot achieve the kind of scale necessary to gather as full a picture as this kind of pool would provide.

A road map for change
With the support of the Ford Foundation, the Milken Institute's Center for Emerging Domestic Markets is building a "data map," as an initial step toward a relational database. This map will provide a visual schematic of the range of types and sources of data, data points, the ways in which data may be structured, cross-referenced and integrated, and the links to other data sources. Ultimately, such data should lead to increased supply of and demand for capital markets products for emerging domestic markets.

There are several innovative financial technologies currently being tested for the EDM space. These include rated securities of community development loans, using federal and state "dead" assets as credit enhancement vehicles for EDM securities, geographically targeted EDM collateralized loan obligations and facilitating educational institutions' use of bequeathed assets to support increased capital flows to EDM projects.

The Milken Institute's Financial Innovations Lab explores such ideas. The Lab model brings practitioners, researchers and policymakers together to work through specific challenges that limit the flow of capital into particular markets. The model is unusual in its uniting of diverse parties, with shared interests but rare interaction. The Lab aims to build market-based solutions by considering the appropriate financial technologies and the relevant adaptations required for non-mainstream application. The solution is then piloted by one or more participating institution, refined by the Lab, and then, broadly deployed.

This model has several benefits. Engaging financial institutions in the pilot design increases their sense of ownership. Access to a potentially lucrative new product creates an incentive for financial institutions to partner in such initiatives. Finally, engaging both the potential suppliers and users of new capital maximizes the likelihood of developing a viable product serving the interests of both parties. The development of a relational database with needed EDM data would support the efforts of such action-oriented labs. It would help them develop specific financial products across asset classes, which can then be tailored for use by traditional providers of capital in emerging domestic markets.

Betsy Zeidman is Director of the Center for Emerging Domestic Markets (CEDM) at the Milken Institute.