Mainstreaming Minority Business: Financing Domestic Emerging Markets by Michael Harrington and Glenn Yago Executive Summary Economic growth and equity are linked. Despite the U.S. economic recovery since the 1990-91 recession, aggregate growth has not mitigated income and wealth polarization patterns. Inadequate growth shared unequally will not sustain long-term competitiveness. Minority communities represent the most potent potential market force in the American economy. Minority groups are experiencing higher rates of population growth than whites. By 2050, minorities are projected to comprise almost 50 percent of the U.S. population. Minority businesses are growing even faster than the population in terms of both numbers of new firms and revenues. This is an "emerging" and largely untapped domestic market. However, this rapid growth is a catch-up phenomenon for a historically underserved business market and is being constrained by inadequate capital access. Capital access is a prerequisite for increased participation in the mainstream economy. Minority businesses are underserved by capital markets for four primary reasons:

1. a lack of credit information and resulting misperceptions of minority businesses as small, unprofitable, and unfavorably located;

2. minority firms' overdependence on commercial bank lending due to low levels of net worth and net financial assets among minority entrepreneurs and a lack of access to alternative forms of finance;

3. government policies that have focused on bank lending, while increased regulation, capital restrictions, and consolidation have made commercial bank lending to small businesses less attractive; and

4. Small Business Administration (SBA) financing rules that have constrained equity financing in small minority businesses and that have focused policy on the least-profitable industry sectors and firm sizes.

To sustain growth, minority businesses need greater access to supplies of capital at all critical stages of business development: equity and seed capital, mezzanine debt, and senior debt. The following policy proposals support an overall strategy with two principal objectives:

1. Increasing the total supply of capital accessible to the minority business sector; and

2. Shifting the emphasis to equity investment vehicles for early stage financing.

This strategy utilizes a public-private partnership encompassing government programs and private capital markets. The partnership would work to consolidate existing programs and use them to leverage the supply of private capital and, hence, to carve new channels of equity and debt to "emerging" minority businesses. The proposals would:

• Develop securitized Collateralized Loan Obligations (CLOs) from a pool of minority business loans and establish Special-Purpose Vehicles (SPVs), ideally through an existing government agency, to implement a secondary market for CLOs to fill financing gaps. The SPVs would administer pools of small business loans purchased from lending institutions and would promote credit enhancement through aCredit Reserve Fund (CRF) that insures the loan pools against default and prepayment risk. The loans would be repackaged for resale to private investors.

• Establish industrywide efficiencies in the small-business lending market through development of standardization in credit scoring, standardized loan documentation, and borrower education. Support the securitization effort with an agency initiative to expand information gathering and performance monitoring of business loan programs.

• Promote the use of the Community Reinvestment Act of 1977, as amended, and the use of its guidelines to qualify securitized CLOs for CRA consideration as qualified investments under the CRA investment test. Encourage large bank lenders to fulfill their CRA investment test requirements through providing capital to private funds that are focused on minority entrepreneurs, including Small Business Investment Companies (SBICs), venture funds, and leveraged buyout funds that support small business. Effective commercial bank compliance with CRA guidelines may increase the feasibility of wider participation by other financial service entities in CRA-type small-business programs.

• Deregulate the SBA's SBIC program by revising rules governing tax policies and capitalization guidelines. These revisions will create greater incentives for equity investment and participation in minority businesses.

• Pool minority-targeted government and business financing programs with Native American capital resources to expand the scale of pooled funds and increase opportunities for the secondary market

transactions for debt and equity investments in minority business.

Introduction Background Minority-owned businesses have grown explosively over the past 10 years. In fact, they are growing at double the rate of all firms in the U.S. economy, both in numbers of new firms and total sales. Recent estimates place the number of minority-owned firms at nearly 2 million with total sales of $205 billion. Of these, nearly 25,000 firms have sales of more than $1 million. Skill-intensive areas such as finance, insurance, real estate, and business services were the fastest-growing kinds of minority enterprises. Minorities, who now represent approximately 26 percent of the U.S. population, will grow to nearly 50 percent over the next 50 years. By the year 2050, the U.S. population will have increased by 120 million, with 90 percent of the growth occurring in minority communities. These communities are gaining new importance as both producers and consumers of products and services. In addition, many minority communities are located in key population centers of the United States, such as New York, Los Angeles, Chicago, Houston, and Miami, resulting in concentrated areas with significant purchasing power and market demands.1 The synergies created by these changing demographics and a rapidly growing minority business infrastructure present a myriad of investment opportunities to the financial community and benefits to American consumers and businesses. Despite these opportunities, this emerging market continues to be overlooked and untapped due to misperceptions and lack of information. Demand for capital in the minority business community is estimated to be in excess of $144 billion per year, of which only a small fraction currently is being satisfied. The continued growth of the minority business sector and the minority community will result in skyrocketing capital demand over the next 20 years. Innovative banks and financial institutions as well as credit unions and community development banks recognize these opportunities and are making profitable investments in this market.2 Clearly, knowledge of business trends and investment in this growing sector will provide a competitive advantage to financial institutions as they move into the next century. New research on bank lending in the small business credit market sheds additional light on the business financing environment that minority entrepreneurs face. Minority businesses are significantly more likely to be denied bank credit and, when successful, receive smaller loans relative to comparable nonminority businesses. A 1998 study by Blanchflower et al. contrasts business lending with mortgage lending in the black community.3 The unexplained gap between rates of denied loans for blacks and whites is 3.5 times greater for blacks in the small business credit market compared with the mortgage market. The authors attribute this difference to the existence of special programs and regulatory incentives that encourage banks to increase mortgage lending in minority communities and also to the well-developed secondary market for mortgage loans. In other words, pooling loans and then reselling them in the secondary market appears to reduce the likelihood of racial discrimination in credit lending.

In addition to the profit potential, investment in minority-owned enterprises yields other benefits. Despite the economic recovery since the early 1990s, overall economic growth has not reduced income and wealth polarization in the United States. For the United States to maintain its overall competitiveness and sustain lasting prosperity, different sectors of the economy must grow in tandem. Given current population trends, minority businesses and minority communities cannot continue to be marginalized. Inadequate growth shared unequally will not sustain long-term competitiveness. Entrepreneurship generates innovation, expands employment, and creates new wealth. Economic participation through broad-based business ownership is key to net job creation, particularly in communities that historically have been underserved. However, business expansion requires sufficient capital and labor inputs. With relatively tight labor markets, the United States continues to attract and develop skilled and educated workers, managers, and entrepreneurs. Yet, growth in certain sectors and industries is constrained by inadequate access to capital. This is particularly true for minority-owned business. The disparity between what should be labeled the "new majority" and its share of capital resources is made even starker by recent projections. Some representative statistics illustrate the case:

• Entrepreneurial business growth has proved to be the most successful avenue for wealth accumulation for lower- and middle-income groups. In total, small businesses in the United States employ about 56 percent of the private workforce, contribute 47 percent of all sales, create most of the new jobs, and produce 55 percent of innovations. Smaller establishments with fewer than 500 employees created virtually all the net new jobs from 1992 through 1996 (Figure 1).

• Minorities are still underrepresented in the ranks of the self-employed. Of the total

self-employed, Asians (4.4 percent), blacks (6 percent), and Hispanics (6 percent) are all underrepresented relative to nonminority males. However, a growing pool of educated and managerial-experienced minorities entered the labor force due to increased college attendance since the late 1960s. This pool of talent has reached an age cohort of 35-50, when entrepreneurial potential is at its peak.

• Minority groups represent 26.1 percent of the population but own only 11.6 percent of the nation's businesses. This 11.6 percent share receives only 6.2 percent of total sales (Figure 2).

• Demographic projections show that by 2010, all minorities will represent one-third of the population—the same share as nonminority males. By 2050, the total minority share is projected to rise to almost 50 percent of the population—roughly double the share for nonminority males (Figure 3).

• According to the most recent estimates, the total size of the minority business

sector is $205 billion, comprising:4

o 621,000 black-owned firms with total sales of $32.2 billion

o 772,000 Hispanic-owned firms with total sales of $72.8 billion

o 504,000 Asian-owned firms with total sales of $91.7 billion

o 102,000 Native American-owned firms with total sales of $8.0 billion

• Recent trends show minority-owned businesses growing at double the rate of all firms in the U.S. economy, both in numbers of new firms and total sales (Figure 4). In the five years from 1987 through 1992, the number of all firms increased at a 4.7 percent annual rate while sales grew at a 10.75 percent annual rate. By comparison,

o The number of black-owned firms increased 7.9 percent with sales growth of 10.25 percent per year

o The number of Hispanic-owned firms increased 12.8 percent with sales growth of 24.11 percent per year

o The number of Asian-owned firms increased 10.0 percent with sales growth of 23.98 percent per year

o The number of Native American-owned firms increased 37.0 percent with

sales growth of 55.0 percent per year

• Minority firms are more likely to employ minority workers and thus provide an important entry point into the labor market for these workers.

• Small business investment financing is very dependent on paid-in equity capital, borrowers' credit histories, and heavily collateralized bank financing. Minorities have significantly lower net worth and liquid financial assets (Figures 5 and 6). Thus, minority-owned firms are overly dependent on commercial bank credit and receive smaller and fewer loans.

• Existing minority-financing programs, such as 7(a) SBA-guaranteed loans and Community Reinvestment Act of 1977 (CRA) obligations, focus largely on commercial bank lending. Yet, small businesses require equity financing. It is estimated that of the total amount of equity capital invested in the United States, minority businesses receive 1-2 percent. New and existing minority firms are thirsting for capital resources.

• Banking and other financial intermediary regulations (e.g., Basle accords, FIRREA) have significantly reduced the amount of commercial bank credit accessible to small business. These regulatory changes have been compounded by a long-term structural shift of investment capital away from commercial banks toward nondepository institutions such as mutual and pension funds.

The capital market gap in the minority business sector is largely due to financial structural factors that impede the flow of funds to both equity and debt capital. Equity-linked debt instruments are specifically lacking in the capital structure of these businesses. This situation presents an opportunity to serve the capital market by designing and developing innovative financial instruments and policy mechanisms. Obstacles Why does the minority business market potential remain unrealized? The most important obstacles are:5

• The misperception of minority businesses as small, marginally profitable traditional businesses, such as "mom-and-pop" retail stores and personal services. In reality, the fastest-growing minority business segment is composed of larger

firms in rapidly growing industries such as wholesale trade, professional services, finance, insurance, and real estate.

• Asymmetric information between suppliers and users of capital due to the lack of standardization among small business investment products and the short track record of most minority businesses. In short, lenders and investors are largely unaware of the growth potential of this domestic emerging market.

• The special nature of small business financing needs, with the emphasis on seed capital and equity participation rather than commercial lending alone.

• The small number of venture capital, buyout, and special-situation investment funds that invest in minority businesses.

• The focus of many government programs on commercial and residential lending and the incentives for commercial lenders to target collateralized lending, especially real estate, with a lack of secondary market liquidity to expand this credit sector.

• The geographic focus of government programs which inhibits minority business development by restricting entry into mainstream markets.6

• Increased regulation, capital restrictions, and industry consolidation in the commercial lending market, which has contributed to a general shift of capital funds away from depository toward nondepository institutions.

Democratizing capital access, formation, and accumulation is the way to ensure, first, that all groups share more equitably in economic growth and, second, that economic growth is sustained. Home ownership is a good analogy. Home ownership rates in the United States were, at the end of 1998, at a record high of 67 percent. Since 1994, 43 percent of all new homeowners have been minority families. The growth and development of the home loan market in the United States, particularly the growth achieved in the affordable housing lending industry, presents clear evidence that an effective national effort to address access to credit and capital for an emerging market can be successful. We should identify the critical elements that were addressed and important accomplishments made within the affordable housing lending market that must be replicated in the small business arena to achieve the desired results. The success in this market is based on the industry's development of "market efficiencies." These efficiencies have been achieved through consistently applied principles and approaches throughout the entire lending process. Borrower education and equity assistance from public sources for down payments support and augment the efficiencies achieved through standardized applications, credit scoring, underwriting, and secondary market products. These efficiencies are carried out consistently by all participants in the process from the borrower application to the securitization and sale of pools of loans. Financial service industry programs are developed and operated in support of reaching all segments of this market. The development of an efficient market for small business lending and investments will permit lenders and investors to price, measure, monitor, and control risks while engaging in emerging small-business-lending market opportunities. This successful model of expanding capital access to underserved markets should now be extended to business ownership as well. The policy community has recognized the financing of minority-owned business sectors as a critical policy dilemma for some time. Important, yet sometimes symbolic efforts, such

as CRA, have sought to legislate increased commercial lending to these businesses. However, increased banking regulation and industry consolidation simultaneously reducedbank lending as a source of small business financing. Policy at cross-purposes with market trends explains the limited effectiveness of past approaches. A more innovative approach combining public and private sector initiatives offers the greatest chance of success.

The Emerging Domestic Market This section presents data on: (1) the growth potential and the distribution of minority firms by industry, (2) the economic size of the minority business market, and (3) the composition of financing according to the source of capital. The two more important trends are the expansion of the minority business market in overall size and the shift from traditional firms in stagnant industries to new "emerging" industries. In addition, minority firms' capital resources show a paucity of equity and mezzanine debt plus an overdependence on an inadequate supply of commercial bank credit. Divergence between Traditional and Emergent Minority Business Over the past 30 years, previously excluded groups have entered the mainstream U.S. economy and have transformed the economic and social landscape of American business. Segregation gave rise to a secondary economy where minority-owned businesses served a predominantly minority clientele, effectively creating an insulated and protected market for these businesses. Traditionally, the typical firms in the black community have been small retail food stores, beauty parlors, and barber shops. Similarly, in the Asian community, laundries, food stores, and restaurants made up the bulk of firms as of 1960. Because owners lack financial and human resources for expansion, these traditional businesses are characterized by their small scale, high failure rates, and low job creation. Studies have shown a steady decline in these types of businesses over the past generation. This is due to many factors, but mostly to the changing nature of American society. Desegregation in the 1960s and 1970s opened up the broader market of nonminority businesses to minority consumers and also encouraged nonminority firms to enter markets they previously had shunned. Longitudinal studies on minority businesses by the primary academic authority in this field, Timothy Bates, has revealed a divergent trend among different segments of the minority business market.7 Bates analyzes the changing industry distribution of minority self-employed individuals to show how progress in new fields of business is counterbalancing a steady decline in traditional lines of businesses. Growth rates were most rapid in business services; finance, insurance, and real estate; and wholesale trade industries. Manufacturing and transportation, communications, and utilities showed more moderate but still significant growth. There was little to no growth in construction and retail trade, while personal services experienced a steep decline. Further analysis shows that emerging firms' owners possess higher levels of education and greater managerial skills, and they cater to a racially diverse clientele. In contrast to traditional firms, these firms are characterized by larger scale, lower failure rates, and more job creation. They require and obtain higher levels of financial investment and represent the greatest opportunity for growth for minority business. These trends display

a move toward greater diversity and firm size that will typify the minority business community of the future. The major constraint facing emerging minority businesses is the inadequate supply of equity and mezzanine debt capital.

The Size of the Emerging Market The Existing Market of Minority Firms Minority-owned firms are having an increasing impact on the U.S. economy as these businesses represent a large and rapidly growing sector of American business. To restate, minority-owned firms represent a total of almost 2 million firms with total sales of $205 billion:8

• 621,000 black-owned firms with total sales of $32.2 billion • 772,000 Hispanic-owned firms with total sales of $72.8 billion • 504,000 Asian-owned firms with total sales of $91.7 billion • 102,000 Native American-owned firms with total sales of $8.0 billion

In the top four metropolitan areas of New York, Los Angeles, Chicago, and Houston, minority businesses represent more than 291,000 firms generating more than $31 billion in sales. These figures are Census estimates for the market of all minority businesses with $500 or more in sales. However, the subset of larger minority businesses with sales greater than $1 million, for which an expanding pool of finance capital is most critical, is also deep and broad. This submarket represents 24,727 firms generating $106 billion in total sales.9 The breakdown in this segment by groups was:

• 3,028 black-owned firms with total sales of $14.4 billion • 9,194 Hispanic-owned firms with total sales of $37.6 billion • 12,505 Asian-owned firms firms (including Pacific Islanders and Native Americans)

with total sales of $54.4 billion

These larger firms represent a wide variety of industries and present the greatest potential for capital investment. Table 1 presents selected data by sales and industry for all minority firms while Table 2 shows data for those firms with sales greater than $1 million. The industry distribution of larger firms shows the highest concentration in wholesale and retail trade, which contains roughly 50 percent of total firms and earns 51 percent of total sales revenues. The next-highest share in terms of number of firms is in services, with 21 percent of firms. Manufacturing; construction; and finance, insurance, and real estate follow with roughly 8 percent each. The fewest firms are in transportation and public utilities and in agriculture, forestry, fishing, and mining.

Stagnant and declining sectors of minority business, such as retail trade and services, represent significant potential for consolidation. These sectors are characterized by a large number of small firms with low yields. The need for scale economies and reorganization to achieve critical mass and improve efficiency make these firms excellent candidates for mergers and acquisitions by new or existing minority enterprises. The increased integration of domestic and foreign markets also represents an important growth opportunity for larger emerging minority firms. This is especially true for markets in North and Central America and Asia, from which many minorities have recently immigrated and still maintain strong economic ties. Market Growth Trends Current Market Projections

The growth rates from 1987 through 1992 can be used to project the current size of the minority business market. The number of minority firms increased at an annual rate of 10.1 percent during 1987-92. This contrasts with an annual growth rate of 4.7 percent for all firms. The average annual growth in sales for minority firms was 21.0 percent versus 10.8 percent for all firms. Applying these growth rates to the 1992 baseline of 1.9 million firms with $204.7 billion in sales yields a 1998 estimate of 3.5 billion firms with $653 billion in sales. This sales level ($653 billion) implies, in turn, a market value for these firms of almost $265 billion.10 This market projection for total minority firms can be broken down into smaller firms with less than $1 million in sales and larger firms with more than $1 million in sales (Table 3).

Projections Of Ownership Change Another important source of minority business capital demand is created by the transfer of ownership through buyouts, mergers, and acquisitions. Recent data show that slightly more than 10 percent of all existing businesses were acquired through purchase, while roughly 70 percent were begun by founders. The ownership change market is growing as the number of retiring owners increases and the trend toward restructuring and corporate focus continues to yield divested businesses. Using this 10 percent estimate of annual turnover, the potential market for ownership change encompasses 535,000 firms. Using the same valuation assumptions as above yields a market valuation of $222 billion. As of 1992, the minority share of the total number of firms with employees in the United Stateswas 5.9 percent. This share of a $222 billion market yields a minority share of $13.1 billion in the change-in-ownership market. Assuming a capital structure of 60 percent senior debt and 40 percent mezzanine/equity, the change-in-ownership market yields a potential capital demand for mezzanine/equity financing of $5.25 billion and senior debt financing of $7.88 billion: Presently, the minority share of firms is significantly underrepresented relative to the minority population share (26 percent). Given the high growth rates among minority firms, the 1992 figure of a 5.9 percent minority share is expected to double or triple in the near future, with a corresponding increase in the amount of financing that will be required. Estimated Capital Demand and Supply Demand Combining all the above data, we can imagine a range of the size of the minority business market—current and future—based on population and business demographic trends. One study, summarized in Table 4, estimates the capital needs of this emerging

market by six categories, or stages, of financing. These estimates are based on conservative assumptions of new firm growth and existing firm expansion.11 The combined estimate for all financing is roughly $144 billion per year in constant dollars. The subtotal for seed and venture capital is $1.095 billion while the subtotal for secured financing is $143 billion.

Current Supply Available sources of private equity capital include venture capital funds, leveraged buyout funds, insurance companies, pension funds, mutual funds, finance companies, Small Business Investment Companies, and Specialized SBICs (SSBICs). The largest of these sources are the public and private pension funds. Recent estimates of the amount of investment capital from these sources show:

• Pension funds control approximately $4 trillion in assets,

• More than $18 billion of the $4 trillion controlled by pension funds is allocated to private equity capital,

• The estimated total amount of investment funds allocated to private equity capital from all sources is $85 billion, and

• Of this $85 billion, the amount of private equity capital managed by minority-owned firms and specifically targeted to minority businesses is estimated to be $1 billion to $2 billion.

The existing pool of commercial bank lending can be broken down by loan size to provide an estimate of the proportion that could be leveraged through securitization. As of June 1997, commercial banks had $117 billion in small commercial and industrial loans outstanding and $67 billion in small commercial mortgage loans for a total of $184

billion in bank credit to small businesses.12 This figure had increased to $188 billion by June 1998. Small Business Administration financing offers another benchmark by which to judge the size of the investment pool. In 1996, the total amount of gross loans and investments outstanding to SBICs was slightly more than $4 billion and the total for SSBICs came to $471 million. Since only about 1 percent of minority businesses participate in the SSBIC program, we can infer that this $471 million represents only 1 percent of a potential $47 billion market for investment capital. Under the 7(a) and 504 guaranteed loan programs,the SBA currently guarantees over 50,000 loans totaling over $11 billion annually. The Native American population represents an overlooked but significant capital resourcefor minority business investment. Income and assets derive from numerous sources, including gaming revenues, oil royalties, natural resource sales, and existing tribal asset management accounts. Recent estimates of total Native American financial resources include more than $13 billion in annual revenues and $4.5 billion held in Bureau of Indian Affairs Trust Accounts and Tribal Asset Management Accounts.13

Traditional Funding Sources and the Changed Lending Environment A recent survey reported that the most common sources of borrowed capital for minority entrepreneurs were commercial bank lending (reported by 73 percent of entrepreneurs), private investors (reported by 14 percent), SBA-backed funding (reported by 9 percent), and minority-lending programs (reported by 3 percent). Only 1-2 percent relied on corporate investors, consortium funds, finance companies, public pension funds, or venture capital funds as sources of capital.14 Recent developments in the banking sector have aggravated the overdependence of minority firms on traditional commercial lending. The two most important have been the consolidation of the banking industry with acquisitions of local independent banks by larger regional bank holding companies and regulatory changes that have tightened lending practices to the small business sector. The effect of both of these developments has been to reduce the amount of commercial bank debt allocated to small businesses in general and minority businesses in particular. The Effect of Banking Consolidation Though small businesses represent more than 40 percent of total business assets, debt, and net worth, the small business share of measurable business financing is less than 10 percent. 15 Small businesses continue to rely mostly upon their own internal resources and a tight supply of commercial bank debt. Despite tremendous advances in the growth of the venture capital, mezzanine debt, corporate bond, and asset-backed securitization markets, the vast majority of small business firms do not have access to the valuations and financing technologies available to larger companies. Federal Reserve Flow of Funds data reveal the problem: The increasing concentration of capital funds has moved toward nondepository institutions, particularly mutual funds, which have become the major repositories of capital. However, the remediation of those funds into the economy toward firms that offer the potential for investment returns and

growth in employment remains largely absent. The critical need of smaller-sized firms for startup, later-stage, and operating capital remains. Trade debt and commercial mortgages remain the largest sources of finance. Because of limited access to equity capital markets, small business is disproportionately more dependent on banks than larger firms: Two-thirds of small firms get their funds from commercial banks. However, as commercial banks participate in a declining share of the financial services market (decreasing from a 51 percent share in 1950 to a 23 percent share in 1997), small businesses have been affected to a greater extent because they have fewer nonbank options than larger companies. This shift in small business loans from depository to nondepository institutions is demonstrated by data from The National Survey of Small Business Finances, conducted by the Federal Reserve (Table 5). In the six years from 1987 to 1993, commercial banks' and thrift institutions' market share of small business loans outstanding fell from 70.6 percent to 65.3 percent. These losses of market share primarily accrued to finance companies, leasing companies, and brokerage firms. This shift fell disproportionately on minority borrowers as their share of bank versus nonbank credit fell 13.2 percent over the same period (Table 6).

The Effect of Regulation Regulatory changes also have contributed to the tightening of commercial lending to small businesses. Vice-Chairman of the Federal Reserve, David Mullins, acknowledged this fact in 1993: Indeed, there is every reason to think that recent regulations and statutes may have changed the nature of supervision and regulation. The process has become progressivelymore standardized and mechanical, more dependent on documentation, analytical formulas, and rigid rules as opposed to examiner judgment. This may have disproportionately affected small business lending, which often takes the form of character and cash-flow loans, requiring judgment, and where the bank's return comes through knowledge and a working relationship with the borrower. These loans may be heterogeneous in nature, and they may be less amenable to the increasing standardized nature of supervision and regulation.16 Regulatory measures have affected the capital markets at many different levels and in many different market segments. Those regulatory changes with the most measurable impact include:

• The 1989 establishment of risk-based capital standards proposed by the Basle Committee on Banking Regulations and Supervisory Practices. Under risk-based capital standards, banks are forced to shift lending from the private sector as an asset class to the U.S. Treasury and other government securities in order to preserve their capital base without reducing deposits. The impact of Basle risk-based capital standards upon business lending was reflected in a precipitous fall in loans from 1989 through 1992 above and beyond measured business cycle effects.

• Various state-level banking regulations that have constrained branch banking, interstate banking, bank holding companies, and usury limits on corporate borrowing. This has reduced the diversification and scale economies that have benefited interregional banking.

• U.S. Treasury restrictions limiting highly leveraged transaction (HLT) loans that impeded acquisition-related debt available from commercial banks for divestitures and buyouts. These were later rescinded after considerable damage was done to this market.

• Restrictions on ownership changes through anti-takeover legislation in 38 states.

• Addiitional state measures that tightened investment-grade ratings for insurance companies. This effectively dried up the market for below-investment-grade private placements by major life insurance companies.

• The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), which introduced federal regulation of thrifts and savings and loan institutions and limited the high-yield market and commercial and industrial lending.

Most small business financing is heterogeneous by nature and adversely affected by shifts toward tighter regulation and creditworthiness based on homogeneous standards and rigid formulas. The net result of the shift to nondepository accounts and the imposition of stricter lending rules have greatly reduced the total amount of commercial bank credit accessible to small business and minority business in particular.

Policy Innovations and Initiatives The overall strategy is to consolidate existing fragmented policy initiatives into a public-private partnership that would leverage government participation to build a capital market that could finance the domestic emerging market of minority businesses. The proposed strategy will result in new profitable opportunities for private investors that are competitive with alternative investments and will also align private interests with public policy goals. Accordingly, policy recommendations fit into an overall strategy with two major related goals:

1. Develop loan securitization instruments and a secondary market to fill financing gaps. This will leverage the supply of private capital and carve new channels of equity and debt capital to emergent minority businesses.

2. Deregulate and reform existing public minority finance programs and leverage these programs through complementation and coordination with private capital markets. Specifically, this strategy targets the Community Reinvestment Act and the SBA's Small Business Investment Company program.

One of the weaknesses of existing public efforts to promote minority business development has been the tendency to target the traditional business sectors of the minority community through commercial bank lending. Studies show that this sector of the market has been in steady decline for the past generation while at the same time the capacity of commercial bank lending has decreased. In addition, the investment incentives acting upon the agents of public funding have channeled these funds into financing instruments inappropriate to the needs of the target market. Increasing Liquidity through Loan Securitization Investment banks and managers have leveraged debt through the issuance of collateralized bond and loan obligations (CBOs and CLOs) since the late 1980s. Prior to December 1996, few commercial banks had applied this technique to fund corporate lending activity. Currently, however, that market has grown to approximately $47 billion. The dramatic growth of the $2.5 trillion securitization market is not just making all kinds of loans marketable; more important, it is reshaping the lending business.

Investor demand for securitized loans is increasingly driving the credit-granting business—determining what sorts of loans are made and who makes them. This financial technology remains largely untapped in addressing the capital gap for funding growth in the emergent minority-owned business sector. Leveraging a managed fund or pool of loans is not a new concept. Mutual funds, offshorespecial purpose vehicles, investment funds, and other methods of carving the flow of capital from institutional investors to entrepreneurs and growing companies have been key aspects of innovative financial technology. If government credit enhancements are built into the financial structures of these securitizations, either through guarantees, tax incentives, or insurance, the financial market certainly will come to finance the businesses and entrepreneurs that can build this emergent growth sector.17 To date, securitized assets primarily have consisted of investment-grade corporate loans. Some, however, are syndicated or represent participation in loans originated by other banks. Nevertheless, there is no reason why the logic of these financial innovations cannot be extended to senior and mezzanine debt financing. By enabling investment liquidity, these financial innovations can massively increase capital flows into this sector. A CLO, simply put, is a debt obligation collateralized by loans. Some programs have developed (SBA, South Carolina, Norwest Bank) to package seasoned loans and expand capital available through securitization. Loan pools to increase liquidity in this market could come from a variety of lending institutions, including

1. commercial banks, 2. community-based financial institutions such as credit unions and thrifts, 3. economic development agencies, 4. revolving loan programs of state and local agencies, 5. foundations, and 6. insurance companies and other financial service companies.

Loans could originate from the balance sheet of these organizations. A rating agency calculates the probability of expected loss on a portfolio using credit scoring and details the required collateralization. Potential buyers of minority business CLOs would be those that buy other securitized instruments (asset-backed securities, high-yield bonds, etc.). These buyers would include U.S. and foreign banks, thrifts, insurance companies, corporations, pension funds, mutual funds, and other institutional investors. The existing regulatory environment, in spite of CRA, constrains the ability of banks to expand credit access in small business finance. Commercial banks and insurance companies, because of heightened risk-based capital guidelines and other regulatory limitations, may want to take loans off their balance sheet, providing additional liquidity. Figure 7 presents an overall view of potential secondary market structures that would carve a new channel of capital into the minority-owned business sector. CLOs would be diversified by industry, geography, and other characteristics (startup, buyouts, etc.) in order to standardize and commoditize the risk that is in the loan pool. Standardization of credit analysis and accounting methods, standardization of prepayment risks, and application of credit scoring would increase cash flow predictability, reduce costs, and reduce contingent risks in such a loan portfolio. Credit enhancement could derive from a partial government guarantee (or pooling of existing guarantees for these instruments);

tax incentives to enhance loan values; a private insurance guarantee; or overcapitalization of the loan pool to achieve an investment-grade rating.

Essentially, market-based public policies enable this market to emerge by underwriting and prescribing transaction costs in the construction of these instruments. By lowering processing costs, standardizing loans and covenants, and providing credit enhancement, insurance, and over-collateralizations, a viable market can be developed. Existing guarantees should be pooled to leverage and expand capital accessible to these businesses. Securitization with the related development of a secondary market can help fill the significant gap in senior and mezzanine debt access for minority firms. Leveraged debt is the foundation of important secondary stages of financing, such as secured and asset-based expansion capital for the growth of existing companies. It is also the basis for merger and acquisition financing for consolidations and employee and management buyouts. An increase in accessible senior and mezzanine debt will provide most of the financing necessary for the rapid expansion of emergent minority firms in capital-intensive industries. In addition, an increase in senior and mezzanine debt will also increase liquidity for equity investors such as SBICs and venture capital funds. This reinforces positive market incentives to investment professionals in the private sector to bridge the gap between equity institutional investment funds and the minority business community in the seed

capital and early-stage funding for new ventures. Securitization could also lead to the creation of finance companies focused on the minority-owned business sector. Aside from CLO/CBO structures for firm financing, other securitized vehicles might also be mobilized for developing urban business physical infrastructure. Specifically, Real Estate Investment Trust (REIT) structures could provide diversified risk and capital flows to large-scale real estate consolidation in areas targeted for redevelopment. SBA 8(a) contract receivables could be bundled into a separate security to leverage the resources of that particular program's objectives. Again, existing government guarantees could be consolidated and leveraged for increased impact. The grazing, mineral, and gaming rights and operations held by Native American tribes comprise yet another untapped asset source that could leverage substantially large investment for economic development. Utilizing some portion of these resources for asset-backed securitization would generate funds for housing, infrastructure, and business loans among Native American businesses in partnership with other minority business initiatives. The remarkable growth in Native American assets could facilitate joint ventures and strategic investment alliances between groups within the minority business community. Given the growth in these assets and their long-term appreciation, Native Americans could play an important direct and financial intermediary role in this process. An Implementation Strategy The way to meet the credit needs of minority borrowers not adequately served by existing programs is to create a secondary market for the sort of loans that small businesses need but that the SBA cannot guarantee. This secondary market should be based on special investment securities that also qualify for CRA credit. This security, a CLO that could be labeled a community development security (CDS), would consist of pooled small and minority business loans packaged into notes and bonds for sale to private investors. The nature of these securities could vary by function and source to include several different pools to fulfill the different functions and needs of various public agencies. A CLO with an investment-grade rating could be an attractive rationale for extending CRA-type obligations to other financial service entities. The flow of funds in and out of the secondary market is illustrated in Figure 8. The loan pools create a conduit through which channels of capital can be carved from investors to lending and equity-investing institutions. This conduit ultimately increases the capital available to the untapped minority business community. An implementation strategy for initiation and organization of this market would include the following elements:

1. Establishment of Special-Purpose Vehicles (SPVs), ideally through an existing government agency, to coordinate the various public and private participants in the market. SPVs would underwrite startup transactions costs for market participants and provide marketing support to promote the public-private partnership. The startup phase could require funding of up to $10 million. Continuing administrative and transaction costs would be borne by buyers and sellers in the market.

2. The SPV would administer a pool of small business loans purchased from lending institutions. The loans would be packaged into notes and bonds for sale to private investors. These securities could be similar to mortgage-backed pass-through

securities that pay down principal with interest.

3. The SPV would promote credit enhancement through a Credit Reserve Fund (CRF) that insures the CDSs against default and prepayment risk.18 This would mitigate the information asymmetries associated with these securities and meet the ratings requirements of pension funds, mutual funds, insurance companies and other large institutional investors. The CRF can be sustained by several different methods:

o Pooling existing subsidy programs and government guarantees on CLOs o Purchasing a private insurance guarantee paid by transaction fees o Using tax incentives to increase the value of reserve funds o Overcapitalizing the loan pools to secure an investment-grade rating

1. A government agency initiative to support information gathering and performance monitoring of business loan programs on a timely basis. The lack of accessible and timely information on the experience of minority business loan portfolios is one of the critical impediments to private lenders and investors receptive to these markets. For a pilot program, a model security profile could be derived from various sources of existing performance data. An annual survey of minority business would also monitor the impact of this program. To insure the economic viability of the pilot program, the loan pool size should be at least $50

million.

2. Procedures and rules to facilitate credit scoring and loan standardization for future loans. These rules include standardized accounting and credit analysis procedures. This can be implemented through a Request for Proposal (RFP) for a public-private contract. Ultimately, as the secondary market is developed, private credit agencies and accounting firms will assume this function.

3. Lenders selling loans to the pool would recapitalize their loan portfolios, greatly increasing liquidity in this market. Lenders would be required to meet certain standards regarding underwriting and servicing performance. In addition, lenders would need to retain some of the risk in each loan sold to the pool in the form of loan-loss reserves or residual interests. The SPV must target the lending community to initiate these requirements and facilitate participation.

4. Rules regarding CRA obligations and Community Development Funds to qualify "community development securities" for both originators and buyers. This would enhance the flow of loans into the pool while recapitalizing the loan portfolios of lenders. It would also make these securities more attractive to buyers with CRA obligations. Revising CRA guidelines may help to widen participation in the program to other financial service entities such as insurance companies, finance companies, credit unions, and asset management companies.

5. "Build It and the Market Will Come": Target underwriters within the financial community during the implementation, emphasizing the opportunity for favorable returns from this secondary market in CDSs, especially in light of the emerging vast potential of the primary minority business sector. The pooling of credit support by the government will greatly enhance the marketability of these securities.

The key points of intervention outlined in these steps are technical assistance and marketing support, data and information gathering on loan performance, credit enhancement, and insurance. Utilizing the financial innovations and technologies that are responsible for the expansion of the U.S. corporate economy, the government would help lead the effort to organize the needs of the private market—finance credit scoring and loan standardization—and provide credit support through pooling existing guarantees. These tasks are fundamental to the development of a thriving secondary market in securitized loans. Related Existing Programs Increased access to financial capital for minority firms has been a policy goal of the federal government since the mid-1960s. Policy instruments have focused primarily on debt and working capital loan guarantee agreements and to a lesser extent on equity investments. The major existing programs include:

1. The SBA Section 7(a) guaranteed loan program and 8(a) contracts program.

2. The Minority Enterprise Small Business Investment Company Act of 1972 (MESBIC). This resulted from the Nixon Administration's urban initiative Project Enterprise. MESBICs are vehicles for encouraging the mainstream business community to assist in the creation and expansion of minority-owned small

businesses. For each dollar contributed by the corporate sponsor of a MESBIC, the federal government provides up to three dollars in federal funds. MESBICs were chartered and administered by the SBA. They are now referred to as Specialized Small Business Investment Companies (SSBICs) and are part of the larger SBIC program of the SBA.

3. The Community Development Financial Institutions Fund (CDFI) and the Bank Enterprise Award program established in 1994. CDFIs are a diverse collection of banks, bank-owned community development corporations, credit unions, and loan funds that have received government funding to serve low-income inner-city communities. The fund is a wholly owned government corporation that provides financial and technical assistance to CDFIs. It contains several provisions aimed at curbing the practice of "reverse redlining" in which nonbank lenders target low- and moderate-income homeowners, minorities, and the elderly for home equity loans on abusive terms. It relaxes capital requirements and other regulations to encourage the private sector secondary market for small business loans.

4. The Community Reinvestment Act of 1977. This act was designed to encourage depository institutions to meet the credit needs of the communities in which they operate, consistent with safe and sound banking practices. Compliance is by review of loan portfolios according to defined criteria. The Act was revised in May 1995, redefining and simplifying criteria for compliance.

In addiition to these business development programs, various government agencies, including the SBA, the Departments of Agriculture, Energy, and Transportation, the Environmental Protection Agency, and the Economic Development Agency, administer programs of grants, loans, subsidies, and guarantees to fulfill many different policy objectives. These programs are important complements to the securitization proposal. They represent a pool of existing resources that might be leveraged with private capital to increase the overall level of financial resources available to meet policy objectives. A multi-agency task force could coordinate program efforts. CRA-Related Efforts The CRA has been criticized for being used as a political tool by both interest group activists and financial institutions. These abuses threaten the economic and social legitimacy of the program. The CRA has also resulted in an emphasis on residential real estate lending at the expense of business and commercial lending. This is partly due to the more standardized nature and measurable risk profile of asset-based real estate investments and partly due to lenders' unfamiliarity with alternative equity and debt securities that could be crafted to meet CRA participation. There are two legitimate objectives to CRA-based policy initiatives to address these weaknesses:

1. Increase the overall level of commercial bank credit available to minority businesses;

2. Increase the portion of equity investments relative to collateralized lending.

In general, the current CRA regulations permit banks and thrifts to invest in private equity funds for minority entrepreneurs if these investments are deemed to promote community development. Under these CRA regulations, community development

includes "[a]ctivities that promote economic development by financing businesses or farms that meet the size eligibility standards of the Small Business Administration's Development Company or Small Business Investment Company programs." Under the CRA regulations, the term "community development" also includes "[a]ctivities that revitalize or stabilize low- or moderate-income geographies." The Office of the Comptroller of the Currency has initiated an information-based effort targeted to the community banking industry to promote equity investing in small business to fulfill CRA obligations. A number of commercial lenders have responded to the changing lending market by developing more effective programs to serve the minority business community. Two notable cases are Norwest-Wells Fargo and the BankBoston Community Banking Group. In California a legislative effort to include insurance companies in the CRA programs is under way. Community-based financial institutions are important conduits for the continued flow of savings, investment, and credit. The extension of CRA participation, the qualification of securitized loans to meet CRA obligations, and the use of CRA to increase investments in private equity funds all can facilitate the flow of capital into community business development. Deregulation of SBA Programs SBA-guaranteed loans have always been relatively easy to sell because of their federal backing. Yet, the 7(a) program has limitations that mean it cannot be the only answer for all small business credit needs. One such limitation is that only commercial banks and a small number of nonbank lenders can make SBA-guaranteed loans. Thus, many organizations that specialize in small and minority business lending—SSBICs, community development finance institutions, and minority-oriented commercial finance companies—are unable to participate in the program. Second, SBA underwriting policies, borrower eligibility requirements, and interest rate and fee ceilings reduce the flexibility of the SBA program, making guarantees unavailable for certain types of loans and small business borrowers. The MESBIC-SSBIC program is the sole government small business assistance effort focused on increasing equity investment in minority firms. The SSBIC program is important because it concentrates on funding the principal agents of venture equity and "patient" capital in the minority sector. Unfortunately, this effort has met with mixed success because most SSBICs are not equipped to meet the most critical financing needs of the minority business community.19 SSBICs are more likely to hold assets in cash or asset-based lending than to take equity positions. SSBIC lending additionally tends to focus on working capital needs and is predominantly short-term. Ultimately, SSBICs are not large enough to cope with the risks of venture equity and long-term capital investing. To the extent current operating CDFIs suffer these same constraints, they run the risk of being relegated to the least-promising investment opportunities. The structural weaknesses faced by the SSBIC program can be summarized as follows:

• Too many small SSBIC firms cannot achieve the economies of scale and portfolio diversification necessary for venture and equity capital investing. Small SSBICs also lack the resources to attract professional investment managers.

• SBA rules limiting short-term credit lending constrain diversification of SSBIC

portfolios. This favors the heavy use of cash equivalents.

• SBA financing in the form of debentures creates a fundamental mismatch between sources and uses of funds. Debentures reduce the cash flow flexibility of SSBICs to take long-term equity positions.

• The present capital gains tax-free rollover legislation has a ceiling of $50,000 thatmust be reinvested within a 60-day time frame. This tax break is inadequate to attract serious equity investors.

The following policy reforms address these weaknesses:20

1. Focus policy efforts on large SBICs that conduct asset-based lending and equity investment. Encourage small, nonviable SSBICs to cease operations and impose minimum size requirements.

2. Rely on tax breaks to attract significant private capital into equity-investing SBICs. Increase the tax-free rollover ceiling from $50,000 to $2 million and extend the reinvestment period to 180 days.21

3. SBA funding to SBICs should be in the form of preferred stock purchases rather than fixed debentures. Continued debenture financing should match maturities between sources and uses of funds.

4. Encourage SBICs to meet their liquidity needs with short-term lending rather than holding money-market assets. Allow short-term loans such as revolving credit lines; allow short-term loans to constitute up to 20 percent of SBIC total assets.

5. Encourage SBICs to sell small business loans in secondary markets. To increase secondary market accessibility, permit SBICs to qualify as participants in the SBA 7(a) guarantee program.

6. Design all aspects of the SBIC program to minimize barriers to pension fund investments into large equity-investing SBICs.

7. Encourage banks and thrifts to fulfill their CRA obligations by, among other things, investing in SBICs focused on providing private equity capital to minority entrepreneurs.

8. Liberalize regulations governing SBA 7(a) and 504 guaranteed loan programs to expand the number of Small Business Lending Companies servicing community and minority business development loans.

9. For tax-exempt investors, qualify minority venture capital funds as program-related investment under prudent man standards. Create a Guaranteed Investment Contract for equity-investing SBIC funds to attract investments from nonprofit foundations and pension funds.

The coordination of the three policy initiatives of loan securitization, CRA obligations, and SBIC deregulation serve a comprehensive program of increasing capital access to minority businesses. Securitization increases the overall amount of funds available to

commercial banks, SBICs, and private investment funds, while refining the CRA and SBIC programs promotes the shift from small asset-based lending to equity and venture capital investing. The increased participation of private capital will leverage existing capital resources to meet the needs of the underserved, emerging market of minority businesses.

Supporting Research on Minority Business Differences between Minority and Mainstream Business Many studies have tried to explain the disparity between minority, especially black, and white-owned businesses in terms of success and failure, longevityand creditworthiness. Many intuitive explanations assume that minority businesses are disadvantaged due to factors related to the urban ghetto milieu. Such factors include crime, lack of education and skills, and stagnant or declining consumer market demand, among others. All these factors have contributed to an overall perception of high risk and low return for economic investment. However, with the rise of an educated minority class, the desegregation of consumer markets, and the increased integration of minorities into nonminority neighborhoods, these explanations are less and less persuasive. Through several studies on these issues, formal statistical analyses evaluated the differences between black and white businesses and tested popular perceptions of these differences.22 The most relevant finding points out the fallacy of the prevailing paradigm of minority businesses.

• The most important determinants of entrepreneurial success are the level of human and financial capital inputs. Financial capital is primarily a function of available sources of equity capital plus access to traditional and nontraditional sources of credit. These sources of capital include owner equity, family loans, former owner loans, home equity loans, commercial bank loans, finance company loans, and credit cards.

• Many potential minority businesses never get off the ground because they are unable to assemble the needed financial capital. The phenomenon of the "discouraged entrepreneur" chiefly afflicts capital-intensive lines of business, such as manufacturing.

• The amount of capital invested at startup is a powerful determinant of firm size and the appropriateness of certain types of businesses.

• Small firms often generate insufficient funds for long-term viability and adequate return on investment to the owner. Small, poorly capitalized firms are more likely to cease operations, contributing to

the cycle of failure that shapes perceptions within credit markets.

As Bates argues in his comparative study of black- and white-owned business enterprises, these three outcomes of limited capital access—discouraged entrepreneurs, small firms, and small business closures—reinforce a pattern of circular causation that effectively strangles prospects for small business parity between minority- and white-owned businesses. This disparity across groups is evident in data on the supply and demand for startup capital. 1992 Economic Census survey data of business owners shows that 66.5 percent of black owners and 58.6 percent of Hispanic owners used less than $5,000 of startup capital versus 53.9 percent for nonminority males. In contrast, 10.1 percent of nonminority males used $50,000 or more of startup capital, while only 6.7 percent of Hispanics and 2.9 percent of blacks used more than $50,000 (Table 7).

Small business financing relies heavily on both equity capital and bank loans, and these two factors are positively correlated. Borrowers with more equity receive greater debt leverage. Multivariate regression analyses evaluated the different patterns of borrowing between black and white businesses. Bates controlled for educational level, managerial experience, and other personal characteristics such as marital status and gender.23 His results show:

• Black-owned businesses start with less equity capital (mean values of$12,224 versus $17,488 for whites). Blacks' lower levels of equity capital are rooted in lower levels of household net worth.

• Black businesses are less likely to utilize borrowed funds at startup.

• Black firms are less likely to receive bank financing, and those that

do on average receive smaller bank loans than their white counterparts. Black borrowers receive on average an extra $0.92 per equity dollar, other factors constant, while whites receive $1.17 per equity dollar.

• Black borrowers needed to access less-favorable forms of consumer credit, such as credit cards and home equity loans (29.6 percent of black borrowers used these credit instruments versus 18.4 percent of white borrowers).

Further evidence illuminating the inaccessibility of bank credit to minority-owned firms is provided by a recent analysis of small business finances using the 1993 National Survey on Small Business Finance.24 The analysis reveals:

• Prospective lenders (primarily commercial banks) are four times more likely to deny credit to firms owned by blacks than to firms owned by non-Hispanic whites.

• Prospective lenders are twice as likely to deny credit to firms owned by Asians than to firms owned by non-Hispanic whites.

These differences are statistically and economically significant, even after controlling for differences in the type and size of the prospective loan; in the age, experience, education, and creditworthiness of the firm's primary owner; in the age, size, capital structure, profitability, organizational form, creditworthiness, and industry of the firm; and in the types and length of pre-existing relationships between the firm and its prospective lender. The loan rejection rates for minority groups are significantly higher at commercial banks than at nonbanks. A second analysis of the same data contrasts comparative loan denial rates for small business loans against mortgage loans within the black community.25 The gap between black and white loan denial rates is 3.5 times greater in the small business credit market than the mortgage market. The authors attribute this difference partly to special programs and regulations such as the CRA that encourage banks to increase mortgage lending to minorities. The other factor that helps explain this difference is the fact that mortgages represent collateralized obligations with a well-developed secondary market for reselling mortgages. The depersonalization and risk pooling of loans thus reduces the likelihood of discrimination in credit scoring and loan approvals. Differences in Household Net Worth and Financial Assets In two studies on black and white wealth, in 1988 and 1995, data show significant disparities in household net worth and net financial assets. These data are summarized in Table 8.

• In 1988, the median net worth for white households was $43,800 versus $3,700 for black households (mean values were $95,667 versus $23,818).

• Median net financial assets for white households was $6,999 versus $0 for black households (mean values were $47,347 and 5,209, respectively).26

• 1995 data confirm this continuing disparity with a total median net worth of $115,000 for white households versus $24,750 for blacks and $29,650 for Hispanics (mean values were $263,739 versus $71,587 for blacks and $79,658 for Hispanics).

• For net financial assets, the median value for whites was $17,300 versus $400 for blacks and $78 for Hispanics (means were $72,571 versus $12,780 for blacks and $10,585 for Hispanics).27

These comparisons serve to reinforce the conviction that the major constraint on the formation, growth, and diversification of black business has been inadequate capitalization. While various social programs such as school desegregation and affirmative action have successfully increased educational achievements and minorities have made significant strides in the workplace, the disparity of wealth accumulation and the traditional conventions of small business financing appear to thwart private sector growth of minority businesses. Michael Harrington is a visiting research associate and Glenn Yago is the director of capital studies at the Milken Institute.

Notes 1A report, Social Compact with America's Neighborhoods, was released in December 1998 by the Social Compact, a coalition of financial industry leaders formed in 1990. This report analyzes emerging markets and investment opportunities in the greater Chicago area. Contact The Social Compact Inc., Washington, DC. 2BankBoston Development Company and Norwest–Wells Fargo are two prominent examples of participating institutions. 3David G. Blanchflower, Phillip B. Levine, and David J. Zimmerman, "Discrimination in the Small Business Credit Market," NBER Working Paper 6840 (Cambridge, Mass.: National Bureau for Economic Research, 1998). See also Rebel Cole, "Availability of Credit to Small and Minority-Owned Businesses: Evidence from the 1993 National Survey of Small Business Finances," Journal of Economic Literature (forthcoming). 4These are defined as at least one half-owned by a specified minority and include individual proprietorships, partnerships, and subchapter S corporations. Large public corporations are not included in the data set. 5Extensive empirical research has been conducted on these issues, some of which is presented and discussed in Section VI of this report. 6See Margaret C. Simms and Winston J. Allen, "Is the Inner City Competitive?" In Thomas D. Boston and Catherine L. Ross., eds., The Inner City: Urban Poverty and Economic Development in the Next Century (New Brunswick, N.J.: Transaction Publishers, 1997), 213-19. 7These studies and their respective findings are discussed in greater depth in Section VI of this report. See Timothy Bates, The Changing Nature of the Minority Business Community: 1960-1995, paper prepared for the White House Conference on Small Business (1994). See also Timothy Bates, "Do Black-Owned Businesses Employ Minority Workers? New Evidence," Review of Black Political Economy 16 (1988). 8The Census Bureau publishes the Survey of Minority-Owned Businesses once every five years for the years ending in 2 and 7. The most recent data available is from the 1992 survey and new data from the 1997 survey will not become available until after 2000. 9Data may be overstated because of an overlap of group categories. 10This assumes an average profit margin of 5 percent and an average price/earnings multiple of 8. 11Assumes 90,000 new firms per year in micro-seed and 750 new firms in pre-seed. Venture capital demand is based on the backlog of unmet SBA MESBIC financing for internal expansion and M&A. Secured financing is based on an average of $500,000 for 25,000 large-scale firms per year. Franchising demand is based on an average of $200,000 for 15,000 new franchises. 12U.S. Small Business Administration, Office of Advocacy, Small Business Lending in the United States, 1997 Edition (1997 Banking Study). Amounts represent the total amount of small business loans according to loan sizes of less than $250,000. 13DLA Financial, Inc., San Francisco. 14Reported in The Wall Street Journal, February 19, 1993. 15Glenn Yago, The Jobs/Capital Mismatch: Financial Regulatory Chokeholds on Economic Growth, working paper(Santa Monica, Calif.: Milken Institute, forthcoming 1999). 16Federal Reserve Bulletin (May 1993):394. 17An example of government credit enhancement for small business loans is the Capital Access

Program, which is a lending program operating in 20 states. Under CAPs, the bank and the borrower pay an up-front insurance premium, typically between 3 percent and 7 percent of the loan amount, which goes into a reserve fund held at the originating bank. The state matches the premium with a deposit into the bank's CAP reserve fund. See U.S. Department of Treasury, "Capital Access Programs: A Summary of Nationwide Performance" (1998). 18Credit ratings of securitized CLOs are based on default risk, prepayment risk, and market risk. Default risk may be calculated from experience while prepayment risk may require conditional restrictions on borrowers' refinancing options. A three-year prepayment limitation could limit prepayment risk. 19Timothy Bates "The Minority Enterprise Small Business Investment Company Program: Institutionalizing a Nonviable Minority Business Assistance Infrastructure," Urban Affairs Review 32 (1997): 683-703. 20The analysis focuses on the weaknesses of specialized SBICs because these have been the principal vehicles for financing minority firms in the past. However, for future policy it is important to go beyond the SSBICs and utilize the SBICs in implementing the following recommendations. 21As of this writing, a House bill sponsored by Representative William J. Jefferson of Louisiana contains provisions to liberalize capital gains rollover and capital gains exclusion rules for SSBICs. 22See Timothy Bates, Banking on Black Enterprise (Washington, D.C.: Joint Center for Political and Economic Studies, 1993); Timothy Bates and Constance R. Dunham, "Facilitating Upward Mobility through Small Business Ownership," in George E. Peterson and Wayne Vroman, eds., Urban Labor Markets and Job Opportunity (Washington, DC: The Urban Institute Press, 1992): 239-81; and Timothy Bates, "Unequal Access," Journal of Urban Affairs 19 (1997): 487-95. 23Bates, Banking on Black Enterprise (see note 22). 24Cole, "Availability of Credit to Small and Minority-Owned Businesses" (see note 3). 25Blanchflower, Levine, and Zimmerman, "Discrimination in the Small Business Credit Market" (see note 3). 26The category of financial assets includes real estate, business equity, bank deposits, stocks, IRA/Keogh plans and bonds/mortgages. Melvin L. Oliver and Thomas M. Shapiro, Black Wealth/White Wealth (New York: Routledge, 1995). 27The 1995 Health and Retirement Study (HRS) reflect only those households that possess the relevant assets, with imputed values for non-responses. James Smith, "Racial and Ethnic Differences in Wealth," Journal of Human Resources 30, Supplement (1995), 158-83.

Acknowledgments In the fall of 1998, the Minority Business Development Agency, U.S. Department of Commerce, created the Capital Access Task Force. The Task Force is chaired by Deputy Secretary of Commerce Robert Mallett and is composed of representatives of the public sector, financial services firms, foundations, and the minority business community. On November 16, 1998, the Task Force met to discuss the problems faced by minority entrepreneurs in obtaining capital to start and grow their businesses, and to individually propose possible solutions to this problem. This policy brief brief was prepared by the Milken Institute with the intention of reflecting these discussions and certain individual recommendations made by Task Force members. The Department of Commerce would like to thank each of the Task Force members, listed below, for their ongoing work on improving access to capital for minority businesses.

U.S. Department of Commerce Task Force Members Robert L. Mallett, Deputy Secretary Washington, DC Courtland Cox, Director Minority Business Development Agency, Washington, DC Heyward Davenport, Regional Director Minority Business Development Agency, New York, NY Ruth Sandoval, Deputy Director Minority Business Development Agency, Washington, DC Phillip Singerman, Assistant Secretary Economic Development Agency, Washington, DC Chester Straub, Deputy Assistant Secretary Economic Development Agency, Washington, DC Task Force Members Timothy Bates, Ph.D. Wayne State University Detroit, MI Ana-Mita Betancourt Overseas Private Investment Corporation, Washington, DC Ronald Blackwell AFL-CIO, Washington, DC Patrick Borunda ONABEN, Portland, OR Reverend Kirbyjon Caldwell Windsor Village United Methodist Church, Houston, TX Theodore N. Carter Department of Treasury, Washington, DC Daniel E. Coleman BankBoston Development Co., LLC, Boston, MA Slivy Edmonds Cotton The Edmonds Group, Tucson, AZ Rudolph I. Estrada Summit Group, South Pasadena, CA Charlynn Goins Consultant, New York, NY

Ernest Green Lehman Brothers, Washington, DC Jose Gutierrez U.S. Small Business Administration, Washington, DC Peter Hurst, Jr. Hurst Capital Partners, Inc., New York, NY Eugene Keilin Keilin & Co., LLC, New York, NY C. Robert Kemp Los Angeles Community Development Bank, Los Angeles, CA Deni Leonard DLA Financial, Inc., San Francisco, CA Richard McGahey, Ph.D. U.S. Department of Labor, Washington, DC Paul Pryde Capital Access Corporation, Arlington, VA Gail Snowden BankBoston, NA, Boston, MA Frederick Terrell Provender Capital Group, LLC, New York, NY John Wang Asian American Business Development Center, New York, NY Anne L. Van Dormolen Weingart Foundation, Los Angeles, CA Ted Van Dyk Milken Institute, Santa Monica, CA Daniel Villanueva Bastion Capital Corporation, Los Angeles, CA Glenn Yago, Ph.D. Milken Institute, Santa Monica, CA