Reference

• What Microloans Missby James Surowiecki, The New Yorker, March 17, 2008

Turning the tide in California
In 2000 Phil Angelides, California’s treasurer at the time, recognized the importance of the domestic missing middle. He highlighted the convergence of the two key elements – underfinanced mid-sized businesses and the domestic context – in launching The Double Bottom Line: Investing in California’s Emerging Markets⁴. Mr. Angelides built an irrefutable case that California's small-to-medium-sized businesses were suffering from catastrophic underinvestment, with dire consequences for its communities, cities, and the state as whole. And since California is the world’s fifth largest economy, its problems could also have harmful consequences for the national economy and beyond.

As part of this initiative, Mr. Angelides went out on a limb to point out that CalPERS, the California Public Employees' Retirement System, was neglecting domestic opportunities to support the missing middle. CalPERS provides pension fund, healthcare and other retirement services for approximately 1.5 million California public employees. With more than $250-billion in stock, bonds, funds, private equity, and real estate, it is the largest pension fund in the U.S. By the year 2000, CalPERS was investing more than $5-billion in overseas “emerging markets”. Meanwhile, California’s emerging markets, with their rich potential, were neglected and undervalued.

In 2001, CalPERS joined the state’s Double Bottom Line effort by launching the California Initiative. As of February 2008, the Initiative had invested or committed almost half a billion dollars in emerging domestic markets. While the program is young, returns are reported at a promising 18.2% since inception⁵.

Just as important, social returns promise to outstrip any possible comparable microfinance efforts in the U.S. More than 70% of the California Initiative investment portfolio is located in areas traditionally underserved by capital markets, resulting in the addition of an estimated 3,000 jobs. Employment at the Initiative’s portfolio companies grew by 7% in 2006 over 2005, compared to 1% growth in the state as a whole⁶.

California’s old pattern of sending its pension investment dollars abroad is mirrored in the flow of microfinance dollars, albeit on a somewhat smaller scale. Billions of dollars of capital pour out of the country to borrowers with minimal impact on economic growth, while businesses at home are struggling to find the support that might fuel our own economic stability.

Microfinance at home?
It’s true that attempts to bring the microfinance model to the U.S. are currently under way. As in other countries, however, the microfinance model will most likely sidestep the imagination gap in the U.S. It’s just not a good fit for the most promising U.S. businesses. For example, Grameen Bank – the highly successful, pioneering microfinance institution that brought the Nobel Prize to its founder, Mohammed Yunus – recently launched a traditional microfinance operation in New York City. Since opening for business in January of this year, Grameen has lent a total of $145,000⁷. While these loans will have an impact on the individual entrepreneurs who receive them, they will not make a scalable, sustainable difference in the local economy. Ironically, the businesses of the missing middle hold great potential to advance the aim of microfinance lenders to create jobs, wealth, and sustainable economic growth. Yet no relief is offered for them.

On the other hand, a new investment company created by the Soros Economic Development Fund, Omidyar Network, and Google.org takes an important step. This new firm will actually target businesses trapped in the gap between microfinance and commercial capital markets – but in India rather than the U.S.⁸ Similarly, the authors of a recent Brookings paper explored strategies for supporting small-to-medium-sized businesses, but focused all their attention abroad, with no mention of similar needs at home⁹.

So microfinance is finally coming to the U.S. but can’t help small-to-medium-sized businesses here. And while programs and initiatives are being developed for these businesses, they will not be available in the U.S. On both fronts, the domestic missing middle is left behind.

Building a model for the domestic missing middle
To be sure, I'm not advocating the elimination of microfinance; it has its place. Rather, Next Street is seeking to fill this imagination gap – to bring high-quality advisory and capital to the U.S. missing middle. Next Street’s for-profit model provides market-driven solutions to the challenges faced by inner city small businesses that are ready to grow. With annual revenues between $1-million and $100-million, our portfolio clients fly above or below the radar of potential investors at both ends of the spectrum: too small for institutional investors and too large for community-based investment vehicles.

In addition to the lack of financing, another primary barrier for addressing the needs – and tapping the opportunities – of these businesses has been the lack of practitioners who know this market. With so little of this expertise, potential investors often reflexively resist committing funds here. But Next Street’s experience and extensive proprietary research indicate that this is an overreaction. Broadly speaking, these companies are high-performing and rich in promise, as illustrated by key statistics. Debt investments in inner city small businesses default at half the rate of the average small business and one-third the rate of larger businesses. And inner city small businesses, while typically smaller, are more profitable than the average U.S. small business.

Here’s an example: Imagine a family-owned vendor of ethnic foods that’s been operating in an up-and-coming area of Queens for 10 years, building to annual revenues of $5-million. It’s poised for growth, with a strong history of fiscal responsibility and a committed owner who knows the market. He estimates that growth capital of $1-million would allow the business to expand to an additional site in a currently unoccupied storefront, adding 8 jobs and contributing substantially to the neighborhood’s ongoing revitalization.

Because of their reflexive bias against inner city small businesses and inflexible procedures, though, traditional financial services providers, such as banks, consistently turn down the owner’s requests for growth financing. Nor can microfinance help this business, despite its clear potential to change many lives and generate a solid return on investment. Ironically, a microfinance provider might extend funding to the same business if it operated on a much smaller scale, even though it would fail to generate new jobs or provide other support for local economic growth.

With our commitment to the “missing middle”, Next Street provides a highly integrated model that helps businesses like this live up to their potential. After carefully vetting a business, we work to form a long-term relationship with it, starting with a detailed, practical strategic plan and appropriate financing. As the business evolves, Next Street provides the Wall Street-quality advice that is badly needed for ongoing growth but rarely available in this market, as well as a full range of services related to real estate, talent management, and marketing, among many others. As the relationship builds and the business grows, the distinctions from microfinance grow more apparent: new jobs are created and the business contributes to local economic prosperity.

Perhaps microfinance has become so popular because it fills a niche: a donor niche. Microfinance is a perfect fit for many givers, especially those looking for short-term, visible, dramatic results, often in exotic foreign locales. Donors and funders, however, must not neglect domestic opportunities. We need to take advantage of the debate generated by the success of microfinance and redirect that attention to the needs of our domestic missing middle. If not, we’ll be missing an opportunity to create sustainable change on a much larger scale – right here at home.