Economic Development Finance

Karl F. Seidman

• Publisher: SAGE Publications, Inc
• Year: 2004
• ISBN:
  9781506315935
• Edition: 1
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

Economic Development Finance is a comprehensive and in-depth presentation of private, public, and community financial institutions, policies and methods for financing local and regional economic development projects. The treatment of policies and program models emphasizes their applications and impact, key design and management issues, and best practices. A separate section addresses critical management issues for development finance programs: program and product design, the lending and investment process, and capital management. Case studies are included throughout the book to help readers develop their skills and apply policies and tools to real practice issues. A glossary of finance terms is also included.

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PART I

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Introduction

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1	Capital Availability and Economic Development

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The Growing Field of Economic Development Finance

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In recent decades, finance has emerged as a large and increasingly complex field within American economic development practice. State governments were early innovators in development finance, creating new programs in the 1980s to help restructure their economies.¹ Many local governments used federal grants to create revolving funds to advance their economic development agendas, while applying their taxing and bonding powers to facilitate new development projects or revitalize downtown districts. Grassroots community organizations built their unique brand of economic development finance with nonprofit loan funds and community development credit unions that raise capital from socially oriented investors. Meanwhile, banks and other private financial institutions expanded partnerships with government and community-based organizations to better address economic development needs. While there is no census of economic development finance programs, several thousand exist across state and local governments, the nonprofit sector, and for-profit financial institutions. As their numbers grow, these programs are expanding their organizational diversity and employing new finance tools.

The prominence of finance programs in economic development strategies is evident among the Empowerment Zones (EZ) and Enterprise Communities (EC) designated by the U.S. Department of Housing and Urban Development (HUD) in 1994 (Hebert et al., 2001). Sixteen of eighteen sites studied in HUD’s 5-year evaluation established programs to improve access to capital as part of their job creation and business development initiatives.²

With the expansion of economic development finance programs, a growing need exists for skilled professionals to staff and manage these programs. Economic development finance practitioners require specialized knowledge and skills that cut across several fields. In addition to analyzing financial statements and understanding how firms and development projects are financed, they need to comprehend key areas of public policy and how municipal finance relates to economic development. A solid grounding in how capital markets operate must be combined with knowledge on how to link finance programs to broader economic and community development goals. Development finance practitioners also need diverse management skills that encompass market analysis and program design, overseeing investment transactions, building partnerships to advance development outcomes, managing assets, and raising new capital.

Practitioners who do not manage finance programs also are affected by the growing innovation and diversity in the development finance field. They need to understand which program models and finance tools are best suited to their economic development goals and capital markets. Over a dozen program models exist to expand capital availability. Consequently, it no longer suffices for local professionals to select a federal grant source and set up a revolving loan fund. Instead, they must know which models will advance their goals, how to attract private funding to their program and projects, and how to fit programs and tools together into a comprehensive development finance tool kit. While each community differs, practitioners can benefit from the lessons and experience of the many existing finance programs to effectively adapt program models to their situation. Furthermore, existing programs within a region and the tools available under federal and state laws are assets that economic developers can deploy to enhance their effectiveness. With a deeper understanding of business and project finance, available finance tools, and the capabilities of different finance models, practitioners will be better equipped to help finance growing firms, implement projects, and build stronger collaborations between finance programs and other services.

The Purpose and Design of This Book

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The bottom line is that all economic development practitioners need to be well versed in the basics of development finance and the state-of-the-art application of program models, policies, and tools. Economic Development Finance is written to provide a comprehensive treatment of the field geared to both students studying the subject for the first time and practitioners seeking to expand and update their knowledge. Scholars will also benefit from the extensive information on economic development practice collected in this volume. It covers the technical skills needed by professionals who oversee transactions and manage programs and surveys the current breadth of economic development practice in the United States, covering key concepts, tools, and program models. To address practitioner, student, and academic needs, this book covers the following topics:

• Foundation skills in accounting, business, and real estate finance, and financial statement analysis (Chapters 2 through 7)
• Policies to expand capital availability by private financial institutions (Chapters 8 and 9)
• Program and institutional models for economic development finance (Chapters 10 through 13)
• Federal and municipal economic development programs and tools (Chapters 14 and 15)
• Management of development finance institutions (Chapters 16 through 18)

The Role of Finance in the Economic Development Process

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Before delving into the technical aspects of economic development finance, a working definition of economic development is needed along with an understanding of how finance contributes to the economic development process. Economic development is often viewed as the process of generating new jobs and economic activity within a defined area. However, there are two limitations to this definition. First, the outcome of economic development transcends jobs, income, and wealth. It includes an area’s quality of life. Although less tangible than jobs or income, quality-of-life goals are part of many economic development strategies. Examples include a safe and healthy environment, access to rewarding leisure activities, and opportunities for community celebration and civic engagement. Postwar economic revitalization in Pittsburgh demonstrates the role of quality-of-life issues in economic development. One of the city’s priorities was reducing air pollution and implementing comprehensive air pollution control as a first step in making the city attractive for new investment.³ Second, economic development is a process that must be sustained over time for regions to reproduce positive economic and social results. Albert Shapero makes this point when discussing Jane Jacobs’s comparison of Birmingham and Manchester, England. Birmingham remained a dynamic city into the mid-twentieth century not because of static economic results but rather due to its successful adaptation to new economic conditions.⁴ Thus, the economic development process creates assets that enable a region to sustain and recreate its desired economic and community outcomes over time. Incorporating these two broader considerations, our definition of economic development is

A process of creating and utilizing physical, human, financial, and social assets to generate improved and broadly shared economic well-being and quality of life for a community or region.

Within this definition, finance has two explicit roles. First, it is one input into the process that generates the desired outcomes of jobs, income, and quality of life. As one input into this process, it is a necessary but insufficient factor for successful economic activity. Businesses, the primary units of economic activity, require many conditions and inputs to be viable:

• A market for their goods and services
• Transportation access to get their goods or services to customers and receive inputs
• Information and technology to efficiently design, produce, deliver, and service products
• Labor and its embedded skills for production, administration, management, and service aspects of the business
• Management and entrepreneurial capacity to design and coordinate the process
• Materials and energy used in production
• Facilities and equipment needed to operate all aspects of the business
• Financial capital to purchase these inputs and bridge the time gap between when cash is spent and revenue is received

This list shows that financing is not only one of many factors in an enterprise, but it comes relatively late in the business development process. In other words, financing becomes a constraint to business formation and growth when the other production factors are in place but appropriate financial capital is not available.⁵ Nonetheless, when financial capital is not available to firms or projects that can use it productively, economic activity slows as new firms are not started, existing firms postpone investments, and existing enterprises contract or fail. Sustained capital availability problems, as redlined urban neighborhoods have experienced, can undermine an area’s desirability and well-being as businesses fail and leave, the housing stock deteriorates, and community infrastructure and facilities are not maintained and upgraded.

A second implication of this list is that capital availability not only concerns the funding of enterprises, it also affects the quality and supply of other inputs into the economic development process. Since businesses are the primary generators of economic activity, economic development finance practice focuses on the direct financing of firms. However, regions also need to finance the infrastructure that supports business activity, the land and real estate facilities to house firms, and the education and training for a highly productive and innovative workforce. Consequently, this book addresses tools and programs used in real estate and infrastructure finance. These two areas overlap with business finance in economic development practice since several tools and programs that finance firms can be applied to real estate and infrastructure projects. The basics of real estate finance and its capital availability issues are covered in Chapter 7; later chapters on tools and program models address their application to both real estate projects and businesses. Chapter 15 covers municipal finance—the primary means for funding infrastructure projects.

Beyond funding specific enterprises and projects, economic development finance concerns the creation of institutional capacity to ensure sustained capital availability for communitywide economic development needs. This challenge transcends the use of specific tools and programs to encompass broader issues of practice, program design, and management. It requires a view of practice that embraces building bridges and active collaboration with private financial institutions, ongoing program innovation and adaptation, and identifying new investment sources to meet evolving regional capital needs. The treatment of program management in Chapters 16 to 18 also incorporates this view of economic development finance as regional asset and institutional capacity-building.

Capital Availability and Capital Market Imperfections

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Economic development finance practice is inherently intertwined with the operation of private capital markets. In simple terms, development finance interventions fill private capital market gaps; their goal is to ensure capital availability when private financial markets fail to supply capital to firms and projects that can productively use it. This conception of economic development practice is reflected in the two-part theory of development finance intervention elaborated in this chapter. The first form of intervention is working with private financial institutions to reduce market imperfections, eliminate regulatory barriers, and remove other obstacles that prevent private markets from supplying development capital. The second type of intervention is creating alternative institutions to directly supply capital to markets, projects, and firms that private institutions cannot serve due to their risk level, transaction size, social benefits, or other reasons. When such interventions succeed in filling capital gaps, new economic activity results, as financing is provided to start, grow, or maintain a business, or to develop a real estate project, that would not otherwise receive the requisite capital. When a program delivers financing that can be secured from private markets, it substitutes its capital for what private market institutions will supply and no new economic activity results. As the primary pitfall of development finance, avoiding capital substitution is the practitioner’s North Star to true economic development impact.

Since economic development finance is about filling private capital market gaps, sound practice requires a theory of capital market gaps: what they are, what causes them, and how to address them. The balance of this chapter is devoted to these issues. First, capital market gap is more fully defined. Second, the theory of competitive markets is considered to identify the conditions under which capital markets may fail to supply capital to projects or firms. Next, the structure and operation of private capital markets is examined to uncover the actual sources and occurrence of capital supply gaps. A final discussion addresses how the nature of capital market gaps shapes economic development finance practice and elaborates the two-pronged theory of intervention: (1) expanding capital availability by addressing the causes of market imperfections within private financial institutions and markets; and (2) creating new programs or institutions to fill gaps that can’t be addressed through market-perfecting policies.

The theory of competitive markets argues that when competitive market conditions exist, capital is efficiently allocated to investments that offer the highest return to capital, adjusted for investment risk. Thus, a capital market gap exists when capital markets fail to allocate capital to firms and projects, or entire classes of firms or projects, that offer a rate of return equal to that offered by other investments with the same level of risk. In other words, when market imperfections exist, capital is not allocated to firms and projects that can use capital most productively. When systematic conditions ...