Doing Well by Doing Good? Community Development Venture Capital

• Published date: 01 September 2015
• Date: 01 September 2015
• DOI: http://doi.org/10.1111/jems.12100

Doing Well by Doing Good? Community Development

Venture Capital

ANNA KOVNER

Federal Reserve Bank of New York

New York,NY 10045

anna.kovner@ny.frb.org

JOSH LERNER

Graduate School of Business Administration,

Harvard University, Boston, MA 02163

josh@hbs.edu

This paper examines the investments and performance of community development venture capital

(CDVC). We find substantial differences between CDVCs and traditional VCs: CDVC invest-

ments are far more likely to be in nonmetropolitan regions and in regions with little prior venture

activity. CDVC investments are likely to be in earlier stage investments and in industries outside

the venture capital mainstream that have lower probabilities of successful exit. Even after con-

trolling for this unattractive transaction mixture, the probability of a CDVC investment being

successfully exited is lower. One benefit of CDVCs may be their effect in bringing traditional

VCs to underserved regions—controlling for the presence of traditional VC investments, each

additional CDVC investment results in an additional 0.06 new traditional VC firms in a region.

1. Introduction

The past two decades have seen increasing interest in harnessing the venture capital

model to achieve socially targeted ends. Features of the venture capital model, such as

extensive due diligence, the use of convertible preferred securities with many control

rights, formal and informal involvement in the governance of the firm, and the use of

equity to incent management, are now widely understood to be effective in addressing

agency problems and uncertainty (for evidence and a review of the literature, see Gom-

pers and Lerner, 2004 and Kaplan and Stromberg,2003). The desire of policymakers and

foundations to harness these tools to address broader social needs is understandable.

Reflecting this desire, numerous policy efforts have sought to encourage what are

termed “community development” venture capital funds. In recent years, the Obama

administration has designated as much as $5 billion in tax credits annually (more than

25% of the entire amount of venture capital funds raised in the United States in 2009)

for its “New Markets” venture capital initiative.1Similar efforts have been undertaken

by the European Community and a number of member states (most notably, Great

We thank the John D. and Catherine T. MacArthur Foundation and Harvard Business School’s Division of

Research for support of this project. We are grateful to Julia Sass Rubin and participants at the Kauffman

Foundation Conference on Early Stage Investing for helpful comments. We thank Greg Bischak, Jim Greer,

and Kristle Kilijanczyk for help with the CDFI Fund data and Dafna Avraham and Zachary Mozenter for

research assistance. All errors and omissions are our own. The views expressed in this paper are those of the

authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal

Reserve System.

1. According to the U.S. Treasury, “the New Markets Tax Credit (NMTC) Program permits tax-

payers to receive a credit against Federal income taxes for making qualified equity investments

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 3, Fall 2015, 643–663

644 Journal of Economics & Management Strategy

Britain), by a number of major foundations, and by a diverse array of other nations.

These funds are characterized by a self-described “double bottom line” orientation: that

is, an attention to both private and social investment returns.

As compelling as it seems to apply a proven business strategy to community

development, the process of marrying the venture capital model with community de-

velopment is not necessarily obvious. One of the critical aspects of the venture capital

process is the alignment of incentives so that all parties benefit from the same outcomes

at similar times—that is, at the time the investment is liquidated. With the presence of

multiple objectives, it can be hard to ensure an optimal alignment of interests. Second,

the aspiration of aligning private and social returns may be a false hope. It is possible

that transactions refused by traditional VCs offer neither as attractive financial returns

nor as wide-ranging social benefits. Finally,even if the community development venture

capital model could work, the rules and limitations—for instance, on investment deci-

sions and compensation—placed on firm by the funding bodies, whether governments

or foundations, may undermine its prospects (Lerner, 2009).

Despite these challenging issues, community development venture capital funds

(CDVCs) have received remarkably little attention in corporate finance. This paper seeks

to take a systematic look at these funds and their impact. Using a sample of 65 thousand

venture capital investments in the United States between 1996 and October 2009, we

proceed in three parts.

First, we 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. CDVC investments are likely to

be in earlier stage investments and in industries outside the venture capital mainstream.

Deals in which traditional VCs invest alongside CDVCs share many of these features,

but are more likely to be in the traditional VC industries.

Second, when we turn to considering the success of CDVC investments—as mea-

sured by the probability of going public or being acquired—we find that the types of

deals where 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.

In the third section, we examine the broader impact of these investments. Although

the relationship between the number of VC firms and the number of VC investments

in a region is inherently difficult to estimate, we look to see if the presence of CDVCs

and CDVC investments is associated with an increased number of non-CDVC firms.

Controlling for the presence of traditional VC investments, each additional CDVC in-

vestment results in an additional 0.06 new traditional VC firms in a region. Of course,

this result must be interpreted cautiously because it is possibly that CDVCs are simply

investing in areas where traditional VCs are planning to grow. If CDVCs really do in-

crease the likelihood that traditional firms locate or invest in underserved regions, they

play an important role in facilitating economic growth, even if their actual investments

are not profitable, as a number of papers document that traditional venture capitalists

play an important role in facilitating growth (e.g., Kortum and Lerner,2000; Mollica and

Zingales, 2007).

in designated Community Development Entities (CDEs). Substantially all of the qualified equity

investment must in turn be used by the CDE to provide investments in low-income communities”

(http://www.cdfifund.gov/what_we_do/programs_id.asp?programID=5,accessed May 6, 2010).