Equity Equivalent Investments—Multiplying Future Impact

Do you wish you could multiply your financial institution’s impact on the community and improve your CRA performance? Equity Equivalent Investments might be just what you need!

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). Equity Equivalent Investments 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. In fact, you can use EQ2s to potentially get both investment and lending credit on your next CRA exam!

According to 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.

Why you might partner with a CDFI

Partnering with another financial institution may sound counterintuitive, but it’s actually a great way to serve your community and provide access to “riskier” loans. 

As you know, your bank must make safe and sound loans that meet your underwriting and regulatory requirements. Sometimes these restrictions prevent you from making smaller loans and loans that push your underwriting and regulatory boundaries. This is where partnering with a CDFI comes into play. 

CDFIs are often nonprofit organizations that don’t have the same regulatory oversight and restrictions as you do. Their whole goal is to serve economically disadvantaged communities and make a real difference to those they serve. Because they don’t have strict oversight, they can provide more flexible funding than traditional financial institutions. They also pair their loans with technical assistance, which creates a powerful combination to serve those who don’t typically have access to credit. 

However, CDFIs don’t typically have access to deposits. So they lack a strong, permanent capital base necessary to support operations and attract additional investments to effectively meet the needs of the economically disadvantaged communities they serve. EQ2 investments from banks like yours can shore up this gap and give CDFIs the capital they need. 

When you partner with and invest in CDFIs, that institution can then reinvest your capital and resources into the community in creative ways that may generate income (interest income and maintain deposits), as well as earn CRA credit for your bank. 

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 allowed $7 million to go to an economically disadvantaged community! Few investment tools 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 its EQ2 investment represented 50% of Community CDFI’s equity. And any amount of your bank’s EQ2 not allocated to lending activities may be considered under the investment test. 

Note: Given the technical nature of these provisions, it’s imperative that you consult legal counsel before making an EQ2, both to ensure that your bank has the authority to make such an investment and learn how to claim performance under the CRA. Here is a related legal opinion as posted on the FFIEC.gov website.  

The 6 parts to a qualified EQ2

EQ2 investments have great benefits, but they need to be carefully packaged and implemented to be considered a qualified EQ2. EQ2s must have these six features:

1. It’s carried as an investment on the investor’s balance sheet

2. It’s not secured by any of the CDFI’s assets

3. It’s fully subordinated to the right of repayment of all of the CDFI’s other creditors

4. It doesn’t give the investor the right to accelerate payment. The exception to this is if the CDFI ceases normal operations

5. It carries an interest rate that is not tied to any income received by the CDFI

6. It has a rolling term  

Any investment that does not pass this test will be treated as simple subordinated debt and won’t benefit your institution nearly as much. You can’t get CRA credit for subordinated debt!

Equity Equivalent Investments by banks and other investors have been providing CDFIs with capital funds for over 20 years. There are all kinds of tools and assistance available to help you put your investment package together. To learn more about EQ2 investments, check out this 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!

And if you’re new to the CDFI partnership game, download this free checklist to help you get started.

Download the checklist

What to do after making an Equity Equivalent Investment

Once you’ve made an Equity Equivalent Investment, you need to properly track and report the data. Work with your contact from the CDFI throughout the investment term to ensure that all data is up to date and you have everything you need to report this EQ2 on your next CRA exam. 

Many banks use complicated spreadsheets to track and manage EQ2s and other investments. But spreadsheets are time-consuming, difficult to manage, and hard to report. 

Kadince software makes it easy to track, manage, and organize your institution’s EQ2s and other investments. Kadince is an all-in-one, easy-to-use software that will make your investment management process much smoother, no matter your institution size. 

With Kadince, you can:

• Keep supporting documentation tied to each EQ2 

• Create detailed reports in minutes (and easily share reports between team members, examiners, and other parties)

• Route investments for CRA review and qualification

• Always be prepared for your CRA exam

• Automatically geocode EQ2s and other investments

• And more

Instead of manually tracking your EQ2s and wondering if the data is quite right, Kadince makes this process easy. And when it’s time for your CRA exam, you can give examiners limited, read-only access that shows only the data you want them to see.

Schedule a 30-minute demo to learn more.

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Important Note! Especially since we got quite technical today! 

This article is intended only for educational purposes and is not intended to qualify as legal advice. Kadince and CRA Today do 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.

None of Kadince, Inc., its affiliates, or its respective employees, directors, officers, and agents (collectively, “Kadince”) are responsible or liable for any content or information incorporated herein. Read full disclosure.

*This article was updated on September 9, 2024 to reflect CRA and EQ2 changes.