Opening the Gates
Practical Observations on Equity in Due Diligence and Investment Evaluation
Increasingly, philanthropy is using local impact investing to address systemic inequities in communities. Many, like the racial disparities in homeownership rates and household wealth, are direct legacies of our country’s racially-biased systems. By channeling capital back home to communities, philanthropy can bring flexible resources to build local economies and institutions that work for all. However, part and parcel of any local investing practice is due diligence: the important – but often unexamined – process of determining whether a deal can meet an organization’s risk, return, and community impact expectations. Due diligence is a necessary link in the investment decision-making chain, offering local impact investors very real benefits beyond financial analysis. This stage in the investing process is where foundations get comfortable with the structure and terms of the proposed deal, and how those terms mutually satisfy the interests of the investee and the foundation.
Vital as it is to the investment decision-making process, philanthropy’s relative “newness” to local investing frequently results in defaulting to standard assumptions and paradigms about what constitutes a viable transaction – the same paradigms perpetuating the systems that historically underserve black and indigenous people of color (BIPOC). For foundations seeking to make substantive inroads towards more equitable prosperity, these financial ”artifacts” should be scrutinized, deconstructed, and reimagined into instruments that are centered around equity values.
Across the country, there are institutions already mounting efforts to address the gate-keeping effect of traditional due diligence, risk management, and credit policies. Near the end of 2020, Beneficial State Foundation – whose mission it is to change the banking system for good – founded the Underwriting for Racial Justice National Working Group. Throughout 2021, this working group will interrogate underwriting practices employed by regulated financial institutions to understand the changes needed to ensure racially equitable access to credit and wealth building. As recently as mid-February, ImpactAlpha covered the Due Diligence 2.0 initiative – a commitment by 25 asset owners and managers to rethink due diligence practices and bring more capital in the private markets to BIPOC (Black and Indigenous people of color) managers, communities, entrepreneurs, and stakeholders.
Foundations that are practicing local impact investing, however, often have lingering questions about how to operationalize the values increasingly being adopted and spread by these national movements. In creating a more inclusive and equitable due diligence continuum, it can be helpful for local investors to examine both pipeline and due diligence processes. Below, we’ve collected some potential tips on how to center racial equity in investment evaluation:
Ensuring an equitable pipeline process (pre-due diligence)
Establish a local investing evaluation rubric:
Prior to fielding a potential deal, foundations can create a standardized local impact investing rubric detailing the characteristics that make up an optimal, acceptable, or undesirable investment opportunity. When created along multiple dimensions (e.g., financial, reputational, community rootedness, and potential impact), this precursor to formal due diligence sets up an early, standardized decision-making matrix that counters implicit biases when sorting through investment opportunities. To take it a step beyond controlling for implicit bias, foundations can seek to understand the potential equity impact of an investment by including racial equity as an evaluation dimension in and of itself.
Develop a standard interview protocol/application:
Standardization is also key to rooting out bias in the set of common interview protocol/application questions that each potential investee is asked to complete. By coordinating an evaluation rubric with the interview protocol, foundation investors can ensure the investee is only providing relevant information that is needed to determine whether an opportunity should proceed to formal due diligence. Additionally, this streamlines the process, making it more accessible to a wider range of community stakeholders.
Right-size (tier) the evaluation process to the investment size (and term):
Though standardization can reduce bias in the investment decision-making process, it is equally important to consider a tiered set of criteria based on the potential size and term of an investment opportunity. For example, if a foundation wishes to drive more capital to smaller, younger financial intermediaries – like revolving loan funds or microfinance organizations – that invest in entrepreneurs of color, this foundation may consider a smaller, flexible investment, say $100,000. In this case, it may not be reasonable to hold this potential borrower to the standards that one would hold a large, established community development financial institution (CDFI) seeking a $1,000,000 investment. For an example of such a tiered set of criteria, check out the Kalamazoo Community Foundation.
Be transparent about the foundation’s goals and selection criteria:
Local impact investing can be a powerful tool to drive new impact, partner with new organizations, and reach new community members. In service of this “new approach” to community leadership, it can be advantageous for foundations to develop a public-facing communication strategy and accompanying outlet (website) to detail clearly their local investing goals and eligibility criteria. Whether or not a foundation makes the investment application publicly available, ensuring that the eligibility criteria are readily accessible for potential investees will help a foundation attract a wider and more racially diverse applicant pool, ensure high impact alignment before the diligence phase and hedge towards better equity outcomes.
Bringing more equity consciousness to the due diligence review
Push boards and committees to think flexibly about financial criteria:
Often, philanthropic institutions are led by boards and investment committees composed of individuals with experience in banking, accounting, and investment management – industries with traditional orientations to risk and risk mitigation strategies. By “wearing a traditional finance hat,” philanthropic boards may unintentionally adopt the standards and criteria – specifically, loan-to-value, credit, equity, collateral – developed by and for financial institutions operating under a regulatory framework with a fundamentally different purpose from the philanthropic sector. For example, regulated financial institutions are only allowed to make a certain number of loans that are above 80-90% loan-to-value (LTV). Philanthropic impact investors are not restricted in the same manner and should think seriously about how offering loans at a higher LTV – say, 100% or greater – might expand capital access to more organizations, businesses and individuals that may not have the same equity levels to bring to a transaction because of the racialized wealth gap.
Do your homework and find the right secondary data and benchmarks:
Moving past traditional due diligence paradigms, tools and standards is an important aspect of expanding access to capital to communities of color and organizations led by people of color. This can require that a foundation find new secondary data sources and benchmarks to better contextualize a potential investee and to understand how structural racism has influenced the current reality. For example, if a foundation is looking to invest into a smaller CDFI led by a person-of-color and primarily serving people-of-color, it can be important to understand how these CDFIs fair in terms of capitalization compared to their white-led peers. This will help the foundation contextualize the CDFI’s finances in a way that acknowledges the structural conditions impeding development for some and advantaging others. Check out a few of our go-to secondary resources: the National Equity Atlas; this report from the Stanford Institute for Economic Policy Research on the capital access disparities between Black and White-led startups; this report from the Expanding Black Business Credit Initiative on Black-led CDFIs supporting Black entrepreneurship; and this report from CHASE on diverse entrepreneurship trends.
Look for different indicators to evidence certain qualities/characteristics:
The whole purpose of due diligence is to answer a concise question: to invest or not to invest? Again, traditional underwriting uses benchmarks and industry norms that historically and perpetually disadvantage organizations and businesses led by people of color. For example, many banks rely on credit scores and collateral appraisals to establish a borrower’s financial strength. They might inquire about an organization’s or business’ tenure to establish operational stability, or they will determine the amount of outside equity in a deal to establish investor buy-in. These traditional indicators can disadvantage potential BIPOC investees and communities while failing to speak to these groups’ real strength and assets. Instead, foundations should consider asking questions during due diligence that establish an organization’s or business’ community rootedness and community engagement processes. The process should create a forum for the potential investee to demonstrate how they effectively leverage community networks and the resources they have to create new and innovative programming. One of the best ways to get to know a potential investee is to ask what they are doing well and what is special about their work. You may be surprised to hear about the innovative ways that they are going about having impact in your community!
For More Thoughts
For more from LOCUS on creating a better, simpler, and streamlined due diligence process for local investing, check out our new primer on the topic: Lessons Learned: Simplifying the Due Diligence Process and Better Equipping Decision-Makers. Click the below button to download this resource for foundations and other mission-driven local impact investors. Other resources and field building materials are available by emailing email@example.com.