Dear Mr. [ ]:
This responds to your inquiry concerning the treatment under the revised Community Reinvestment Act (CRA) regulation of an investment in a private equity fund [the Fund}, which will assist minority entrepreneurs to expand their restaurant franchise operations. As you know, the banking and thrift regulatory agencies have developed substantively identical CRA regulations which can be found at 12 C.F.R. parts 25, 228, 345, and 563e. Therefore, staff from all of the agencies have considered the issues you raised, and they concur in the opinions expressed in this letter.
You have asked whether institutions would receive favorable consideration under the CRA for investing in a private equity fund designed to assist minority entrepreneurs in expanding their restaurant franchise operations in order to remain competitive given consolidation within the industry.
As you explained, the Fund is designed primarily to assist qualified minority operators seeking acquisition financing or recapitalization funding; however, assistance would be provided to all qualified operators regardless of minority status. The Fund will make equity investments in these restaurant franchises. It will be managed by [XYZ, L.L.C.], which will also be responsible for securing the requisite debt financing for each franchise restaurant company. The Fund will be a closed-end fund. The funds will be invested over the first five years and terminated and wound down within 10 years.
You indicate that shares in the Fund would be offered to bank holding company subsidiaries and other institutional investors.1 According to your letter, the investor would receive a minimum targeted pre-tax annual internal rate of return of 20%.
You state that most of the franchise companies will meet the Small Business Administration's ("SBA") size standards for small businesses.
As noted in your letter, the Fund investment will gradually be paid down and the Fund's shares bought back in part by Employee Stock Ownership Programs ("ESOP"), which are to be put in place as part of the overall undertaking, after the franchisee companies establish themselves. Consequently, over time it is possible for the employees to gain ownership in these franchise companies.
In the CRA regulations, a "qualified investment" is defined as a lawful investment, deposit, membership share, or grant that has as its primary purpose community development. See 12 C.F.R. __ 25.12(s), 228.12(s), 345.12(s), and 563e.12(n). The definition of "community development" in the regulation indicates that the term means 1) affordable housing (including multifamily rental housing) for low- or moderate-income individuals; 2) community services targeted to low-or moderate-income individuals; 3) activities 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 (13 CFT 121.301) or have gross annual revenues of $1 million or less; or 4) activities that revitalize or stabilize low- or moderate-income geographies. See 12 C.F.R. __25.12(h), 228.12(s), 345.12(s), and 563e.12(r).
The third element of the definition of community development may address the Fund's purpose. To meet this element of the definition of community development an activity must meet both a purpose test and a size test. To meet the purpose test, the activity must promote economic development. An activity is considered to promote economic development if it supports permanent job creation, retention, and/or improvement for persons who are currently low- or moderate-income or supports permanent job creation, retention, and/or improvement in low- or moderate-income geographies targeted for redevelopment by Federal, state, local or tribal governments. An activity meets the size requirements if it relates to an entity that either meets the size eligibility standards of the Small Business Administration's Development Company (SBDC) or Small Business Investment company (SBIC) programs or if it has gross annual revenues of $1 million or less.
The agencies will automatically presume that all small businesses financed through the SBDC and SBIC programs (but not necessarily those financed through other SBA programs) promote economic development.
You state that most of the restaurants that will be built or upgraded using Fund proceeds are located in "low- or moderate-income geographies," as defined in the CRA regulation. You also state that by improving the appearance and service level of these restaurants, these investments will directly benefit low- or moderate-income communities. Finally, you state that the Fund strategy includes extensive training of employees and the opportunity for them to participate in an ESOP, with the possibility of eventually becoming a restaurant operator. Most participants in both the training and investment program will initially be low- or moderate-income individuals. The answer to Question 2 under .12(h) & 563e.12(g) Community Development in the Interagency Questions and Answers Regarding Community Reinvestment (61 Fed. Reg. 54,647, 54,650 (Oct. 21, 1996)) helps to clarify the definition of community development by describing what is meant by "stabilize or revitalize". The answer states, "Activities that stabilize or revitalize particular low- or moderate-income areas (including by creating, retaining, or improving jobs for low- or moderate-income persons) also qualify as community development, even if the activities are not located in these low- or moderate-income areas." The training and stock opportunities that you state will be provided to low- or moderate-income employees appears to be consistent with this answer.
Therefore, if Funds such as yours invest in companies that meet the size requirements under the SBDC or SBIC programs and those companies promote economic development as described above, the investments by financial institutions in the Fund would receive positive CRA consideration under the investment test, if the qualified investments benefit the institution's assessment area(s) or a broader statewide or regional area that includes the institution's assessment area(s). See 12 C.F.R. __25.23(a), 228.23(a), 345.23(a), and 563e.23(a).
You state that the Fund investment strategy is specifically intended to allow targeted firms to grow beyond the SBA cutoff so that they can remain competitive in the marketplace. Due to the fact that the initial investment is made in a company that meets the size eligibility standards it would not be our intention to discount the program if it succeeds in its mission of firmly establishing these restaurants and increasing their revenues. Therefore, the fact that the restaurants' revenue may grow beyond the size eligibility requirements will not affect the program from being considered a "qualified investment."
Finally, you ask how an investment in the Fund would be viewed under the remaining criteria of the investment test (innovative or complex, responsive to credit and community development needs, and/or not routinely provided by private investors.) These criteria are evaluated by an examiner in the context of an individual institution's business strategy, community needs, and other relevant performance context information. Therefore, it would be inappropriate to answer this question in a general sense.
I trust that this letter has been responsive to your inquiry. If you have any further questions, please feel free to contact me at (202) 452-3946.
Glenn E. Loney
Division of Consumer and Community Affairs
Board of Governors of the Federal Reserve System
cc: B.J. Norris, FDIC
A. Loikow, FDIC
T. Burniston, OTS
T. Stark, OTS
G. Loney, FRB
R. Frierson, FRB
M. Hesse, OCC
M. Harris, OCC
M. Bylsma, OCC
1 Your letter states that the investments will be structured to be permissible under the Bank Holding Company Act. The scope of this letter is limited to whether the investments in the shares of this Fund would receive favorable consideration under the new CRA regulations. This letter does not address whether an institution may lawfully invest in these shares. The CRA and its implementing regulations do not provide authority for institutions to make investments that are not otherwise allowed under Federal laws and regulations. Furthermore, the agencies do not endorse particular investment opportunities offered to institutions.