Doing Well by Doing Good? Community Development Venture Capital
In a new working paper, Josh Lerner and I explore how the venture capital (VC) model can be harnessed to achieve socially targeted ends by examining the investment record of community development venture capital (CDVC) firms. Our results are mixed. Investments made by CDVC firms are less likely to succeed than are investments made by traditional VC firms. This lower probability of success persists even after controlling for the fact that CDVC firms invest in industries and geographies that have, on average, lower success rates. However, we do find that CDVC firms have the benefit of bringing traditional VC firms to underserved regions; controlling for the presence of traditional VC investments, we find that each additional CDVC investment draws an additional 0.06 new traditional VC firms to a region.
What Is Community Development Venture Capital?
Broadly defined, community development venture capital is equity capital invested with the goal of increasing economic opportunity and promoting investments for underserved populations in distressed communities. In the United States, these efforts can be traced back to the Small Business Investment Company (SBIC) program, the Minority Enterprise Small Business Investment Companies (MESBICs), and the numerous community development corporations set up in response to the “War on Poverty” in the 1960s, which sought to alleviate poverty through the application of business principles.
More recently, beginning in 1992, the Ford Foundation and the John D. and Catherine T. MacArthur Foundation began backing a trade association of CDVC funds, the Community Development Venture Capital Alliance (CDVCA). The establishment of the U.S. Department of Treasury’s Community Development Financial Institution (CDFI) Fund, which was established by the Riegle Community Development and Regulatory Improvement Act of 1994, also boosted investment activity.
We identify CDVC firms from two sources. The Community Development Venture Capital Alliance has maintained a roster of members on its website. We use the current and archived versions of this list (obtained through web.archive.org). Additionally, the Treasury’s CDFI Fund has undertaken periodic surveys of entities receiving its funds. We identify from these surveys all CDFI funds that have made equity investments. We then match these lists of VC firms against the firms identified in VentureXpert. Of fifty-seven potential CDVC firms identified, we match thirty-two VC firms to VentureXpert. Twenty-eight of these firms have made U.S. investments tracked by VentureXpert.
CDVC Firms Are Different from Traditional VC Firms in Their Locations and Investments
We first examine how the composition of investments by community development venture funds differs from those of traditional groups. We find substantial differences: Community development fund investments are far more likely to be in nonmetropolitan regions and in regions with little prior venture activity.
Similarly, CDVC investments are likely to be in earlier-stage investments and in industries outside the venture capital mainstream (Internet, biotech, and communications and electronics). Investments in which traditional VC firms invest alongside CDVC firms share many of these features, but are more likely to be in the traditional VC industries.
We find the CDVC sector to be relatively small in terms of investments that are comparable to those made by traditional VCs; in total, we find 305 investments by twenty-eight CDVC firms, compared with more than 65,000 investments by more than 5,500 non-CDVC funds. We also document several other significant differences between the two types of funds and their investments.
The CDVC firms are more likely to invest in earlier financing rounds, reflecting an orientation toward seed and early-stage investing.
The firms backed by CDVC firms have fewer venture investors participating in the rounds and have undertaken fewer financing rounds in total. However, in part, this may reflect these firms’ relative youth (see below).
The CDVC-backed firms are substantially less likely to have gone public (1 percent versus 13 percent) or to be successful (18 percent versus 33 percent). Again, the relative youth of these firms must lead us to be cautious in interpreting the results.
The CDVC-backed investments were likely to occur later than non-CDVC investments even though we begin the sample in 1996, reflecting the relative youth of the sector.
CDVC Investments Are Less Likely To Go Public or To Be Acquired
When we turn to considering the success of CDVC investments—as measured by the probability of going public or being acquired—we find that the types of deals in which CDVC investments are concentrated have a lower probability of success in general. Even after controlling for this unattractive transaction mixture, however, the probability of a CDVC investment being successfully exited is lower.
CDVC Firms May Have Broader Impact
Investment returns are not the only possible measure of success of CDVC firms. While the relationship between the number of VC firms and the number of VC investments in a region is inherently difficult to estimate, we investigate whether the presence of CDVC firms and CDVC investments is associated with an increased number of non-CDVC firms. Controlling for the presence of traditional VC investments, we find that each additional CDVC investment results in an additional 0.06 new traditional VC firms in a region. Of course, this result must be interpreted cautiously because it is possible that CDVC firms are simply investing in areas where traditional VC firms are planning to grow. If CDVC firms really do increase the likelihood that traditional firms locate or invest in underserved regions, they play an important indirect role in facilitating economic growth. A number of papers document that traditional venture capitalists play an important role in facilitating growth (see, for example, Kortum and Lerner (2000).
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.
Anna Kovner is a senior financial economist in the Federal Reserve Bank of New York’s Research and Statistics Group.