Small business success is one of the cornerstones to the vitality of our communities. A variety of tools are available to local governments interested in supporting their small businesses. In this continuing series of blog posts about how local governments can assist small businesses, we will review common tools used to offer financing, how to capitalize these finance tools, methods to promote entrepreneurship, and new trends such as crowdfunding.
Across North Carolina, multiple local governments operate some type of loan fund to support their local businesses. These programs operate with several common goals including business recruitment/expansion, job creation, and increase in quality of life. The majority of these loan funds are operated as revolving loan funds.
What is a revolving loan fund?
Simply put, a revolving loan fund is a replenishing source of funding from which loans are made. The fund revolves when loans (principal and interest) are repaid. There are four main roles with a revolving loan fund: fundraising, marketing, underwriting, and servicing. Local governments can either conduct all of the roles themselves or contract with an entity to provide one or more of these roles. The most common approach is for the local government to manage all four roles.
In addition to these four roles, a revolving loan fund typically has a Loan Review Committee that determines which loans to approve. This Committee is sometimes the local government’s Council or an independent committee of non-elected community members.
What are the advantages/disadvantage of a revolving loan fund?
As an independently operated fund, the local government has full control of the approval process. This enables the local government to have the option of providing loans at below-market rates. Other local governments design their program to act as a “lender of last resort” by requiring potential borrowers to first seek the loan from a traditional lender first and only apply if they have been denied.
Revolving loan funds are not a perfect structure. There are several disadvantages to this structure:
- They typically require ongoing operating subsidies because they are not financially self-sufficient. For example, loan funds with asset size between $1 million and $5 million have a self-sufficiency ratio of 39 percent. This means revenues generated by the fund cover only 39 percent of the fund’s expenses. As asset size increases so does the self-sufficiency ratio. Strategies to address this lack of financial self-sufficiency include scaling up loan volume and forming strategic partnerships with local organizations that could reduce costs or increase revenues.
- RLFs operated by a local government have higher default rates. Local governments that operate RLFs sometimes do not have the professional expertise needed to properly underwrite loans. Therefore, some lower quality loans are approved.
- Risk tolerance is dependent on the Loan Review Committee. It is important for the Committee to have some, but not all risk-adverse members. The Committee also needs to include risk-taking individuals that understand small businesses.
The extent of these advantages and disadvantages depend on whether the local government chooses to manage the four functions themselves or seek support from contracting with a financial institution or other entity.
What makes a revolving loan fund successful?
Research of revolving loan funds operated by local governments primarily in North Carolina identified three strategies that will help these funds be successful.
- Assemble a Loan Review Committee that is willing to take risks. Committee should include several experienced entrepreneurs.
- Implement an active marketing strategy that involves more than press releases and brochures. One recommended strategy is to develop relationships with local banks to refer loan applicants they denied.
- A pipeline of qualified applicants is critical to ensure loan capital is not idle. The money is of no use to the community if it sits in the fund without being deployed. Relationships with the local small business center can assist with developing qualified applicants.
The revolving loan fund structure provides local governments with the control to design the program as needed. This benefit comes at a cost, the required subsidies needed to operate these programs. The next blog post will discuss an alternative structure called a loan-loss reserve fund.
Jordan Jones, a UNC-Chapel Hill graduate student pursuing a joint master’s degree in Public Administration and City and Regional Planning, is a Community Revitalization Fellow at the School of Government.
Aspen Institute’s “Approaches to CDFI Sustainability” (July 2008)