How would you like to get a loan with an interest rate 1% to 2% lower than you’d likely be able to get otherwise, with a seven-year term during which you don’t have to repay any principal — and even then you’ll have to pay back only 80% of what you borrowed?

You may be skeptical, but such loans actually exist — that is, for borrowers who need the financing to start or expand a business, or develop a project, that will provide economic, social, or environmental benefit to a low-income area.

The vehicle through which the advantageous leverage is available is the New Markets Tax Credit Program (NMTC), a complex federal undertaking that provides investors — usually banks and other businesses — with tax credits as incentives to bankroll such initiatives. The program addresses the fact that conventional investors typically overlook low-income communities.

The program, signed into law by President Clinton in 2000 and supporting such investments since 2003, has enabled more than $30 billion in financing to a wide variety of businesses, industries, and service providers that would otherwise have limited funding prospects.

Historically the program has been re-authorized every two years by each new Congress, but it was renewed for five years in the tax extenders package within the 2016 federal budget bill signed by President Obama on Dec. 21.

To be sure, for borrowers there are some additional catches beyond investing in low-income areas. One is that the program currently allows just $3.5 billion of such funding per “round” to qualify for the tax credits, while demand for the loans is typically several times that amount. (Each round is triggered by Congress’s renewal of the program, which has occurred at somewhat irregular intervals.)

Another caveat is the program’s provision that the business activity to which the financing would be allocated would not be able to proceed without it.

Further, because the complexity of NMTC transactions necessitates high legal and accounting costs that are about the same for both small and large loans, the financing is typically not made available for capital needs of less than several million dollars. On the other end of the scale, while a loan under the program may exceed $100 million, those are rare because of the NTMC funding limit combined with the strong demand.

But if you’re in the sweet spot, an NMTC loan can be the difference between winning and not even getting into the game. “These transactions are complex, and that’s a criticism of the program,” says Charlie Spies, chief executive of CEI Capital Management, LLC, or CCML. “But when the scale and timing are right, they can be very economically favorable to businesses, providing lynchpin financing to go forward where otherwise they couldn’t.”

CCML — a for-profit subsidiary of not-for-profit Coastal Enterprises — is one of approximately 250 Community Development Entities (CDEs) that the Treasury Department has authorized to allocate to investors rights to make investments that qualify for the tax credits. Each CDE must re-apply to the federal government for such rights — called “NTMC capacity” — with each new round following another renewal of the program.

The maximum dollar amount of NMTC capacity that a CDE can receive per round is $125 million. CCML, which according to Spies has won more NMTC capacity ($918 million) throughout the program’s history than any CDE, received $55 million in 2015. At press time it hadn’t yet learned how much, if anything, it will get in 2016. Most of the deals it works on are between $10 million and $20 million, Spies notes.

Not Just Peanuts

Because of the most recent NMTC transaction CCML was involved in, which closed last Oct. 30, things are looking up for a group of 225 peanut farmers in southern Georgia.

In the deal, Premium Peanut, a cooperative company formed in late 2014 and owned by the farmers, benefited from $20 million in NMTC capacity allocated by CCML and $3 million allocated by another CDE, Suntrust Community Capital.

The company’s aim is to stabilize the market for the owners’ crops. Historically, peanut farmers have had to be wizards at short-term planning and willing to regularly take leaps of faith. Contracts between growers and processors generally last no more than a year and vary widely in availability and pricing from year to year. That creates uncertainty in a farmer’s revenue stream, making it difficult to plan for crop rotation and capital needs.

Premium Peanuts’ new plant

Each of the 225 farmers purchased shares in Premium Peanut and committed to delivering a commensurate volume of peanuts annually. The company built a shelling plant that began operating in January just outside Douglas, Ga., has formed partnerships with seven peanut buying points, and is providing pricing that’s above the government-mandated minimum.

However, the co-op had difficulty obtaining enough conventional non-recourse financing to cover initial operations, says Karl Zimmer, CEO of Premium Peanut. That’s where the NMTC program came in, based on the assistance for the farmers plus an estimated 130 new jobs to be created in a low-income area where the poverty rate topped 28% and unemployment was at 9%.

“The transaction was amazingly complex,” says Zimmer, “but without it, we wouldn’t have been able to do all that we did. Now, the peanut farmers know that the company will take their peanuts every year at a certain level, and the company knows it has a reliable supply every year.”

“Like a Cure for Cancer”

Despite the great demand for the program, some companies that may qualify to receive loans under it don’t know about it until approached by an investor. That was the case for Darlington Veneer, a manufacturer of high-end hardwood plywood products based in Darlington, S.C.

A key subsidiary of the company, wholesale building supplies distributor Diamond Hill Plywood, almost went under following the recession as the building industry tumbled. Losses were heavy, debt was high, and interest costs were crippling for the small, family owned company. It was desperate to refinance the debt but was out of options.

“When the housing industry went south, traditional lenders didn’t want to have anything to do with a building supply company,” says Kennedy Breeden, CFO of Darlington Veneer. As a last resort, in 2012 he went to GE Capital, whose leasing division had been trying to work with the company for years but had offered higher interest rates than it could afford. To Breeden’s surprise, GE Capital came to his rescue.

“When they presented this to us, it was like a cure for cancer,” Breeden says. “We had already gone from 11 distribution centers down to five. We needed to keep those or our customers would have been hurt.” The company also wanted to protect its workforce of 200-plus, some of whom had been employees for 40 or more years.

Thanks to NMTC capacity that CCML allocated to GE Capital, the financing firm was able to refinance $13 million of Darlington Veneer’s debt at the low interest rate of 2.74% (GE Capital also provided a separate $2.6 million loan, outside the NMTC program, carrying a rate of 5.5%). With the windfall, and to satisfy NMTC requirements, the company actually added headcount. So in this case, the program both enabled jobs to be saved and others to be created in low-income, rural South Carolina.

How It Works

The Darlington Veneer transaction was what CCML calls a “direct investment,” where a low interest rate is the gist of the appeal. The tripartite bonanza described at the top of this article — a discount interest rate, seven years of interest-only payments, and repayment of just 80% of the loan principal — applies to a different model called a “leveraged investment.”

About 90% of CCML-supported NMTC transactions, including the Premium Peanut deal, are of the leveraged type, says Spies. Here is how a leveraged investment works, based on a hypothetical example of such a transaction provided by CCML:

1. The Community Development Entity (CCML or another one) awards, say, $10 million of NMTC capacity to an “equity investor,” which is incentivized by tax credits to invest in a particular business or project.

2. However, the equity investor does not provide all $10 million of financing, but rather a minority portion of it. A commercial lender or some other debt finance structure, typically lined up by the borrower, provides the rest at a commercial interest rate. (On occasion, the borrower may fund this portion from the balance sheet of an affiliated entity).

3. The equity investor then “buys” tax credits at a rate of $0.80 per credit (as per this example; the rate for any particular deal varies according to demand for NMTC loans at any particular point in time). The IRS does not call it “buying” or “paying for” credits, but in effect that’s what the investor is doing.

4. Since the amount of tax credit provided under the NMTC program is 39% of a deal’s total financing, the equity investor can claim $3.9 million of tax credits for the $10 million deal on its federal income tax returns over the seven years the transaction is in effect (5% of the total financing in each of the first three years, 6% in each of the next four years).

5. The amount provided by the equity investor in this example is $3.12 million — its $3.9 million in total credits times its $0.80 “price” per credit. The debt lender provides the other $6.68 million of the total $10 million of financing.

6. Both portions of financing are distributed to an investment fund that’s 100% owned by the equity investor. Thus, the investor’s equity is in the investment fund, as opposed to the borrowing entity.

7. The investment fund flows down to a special-purpose entity, a sub-CDE created by the CDE, that’s owned 99.99% by the equity investor and .01% by the CDE (in order to allow the latter to be classified as the manager of the sub-CDE). This entity then either provides a single, seven-year collateralized loan to the borrower, the equity portion having been converted to debt; or two loans representing the respective proportionate amounts contributed by the debt lender and equity lender. The final amount of the loan(s) is less than $10 million because of closing costs and a loan placement fee to the CDE.

8. The borrower’s overall interest rate in this transaction is in effect 1% to 2% below the commercial lender’s rate. That’s because it’s a blended rate, taking into account that the equity investor, having been fully paid back via the tax credits, charges little or, more often, no interest for its portion of the financing.

9. During the seven years, the borrower pays interest only on the debt.

10. The CDE gets an annual asset management fee, which is built into the borrower’s debt service payments, for managing tax reporting and auditing, reporting out to the involved parties, collecting and disbursing interest payments, and ensuring that the arrangement stays compliant with program and IRS rules.

11. When the seven years are up, the borrower must either repay or refinance the principal contributed by the commercial lender. “The idea [behind the loan] is to get the project stable so they can do that,” says Spies. “These projects need to be successful,” and most of them are, he notes.

12. However, the borrower typically does not have to pay back the debt that was converted from the equity investor’s contribution, which after taking out the closing costs and loan placement fee typically amounts to about 20% of the total financing. Just as the tax credits motivated the equity investor to do the deal, part of what motivates the borrower is the opportunity to pocket that 20%, without paying interest on it or returning the principal.

There’s little danger that the equity investor will suddenly demand to be repaid, because a set of put and call options agreed to at the deal’s outset functionally ensures that the borrower will retain that 20% piece. “That can’t be guaranteed, because then the [equity investor’s financing] wouldn’t be defined as true debt under IRS regulations,” Spies notes. “But the deal must be unwound after seven years, and the puts and calls force that to occur one way or another.”

For-profit borrowers will, though, have to understand and manage any tax consequences of the income they will recognize when they assume control of that portion of the debt.

Meanwhile, the equity investor comes out way ahead on the deal. While it walks away from the $3.12 million investment, it winds up with a gross gain of $780,000, the difference between that amount and the $3.9 million in tax credits. The net gain may be less than that, as the $780,000 is subject to federal income tax, but the time value of money and any return the investor realizes on the income could outweigh the tax.

In the Premium Peanut deal, Suntrust Bancorp acted as equity investor (in addition to the $3 million in NMTC capacity allocated by its subsidiary Suntrust Community Capital), and debt funding was obtained from an affiliate entity of Premium Peanut. The Suntrust financing that the company will have an opportunity to retain in seven years amounted to approximately $6 million of the deal’s $23 million total financing, according to CEO Zimmer.

For CCML’s part, while it’s a for-profit company, it shares the mission of its not-for-profit parent to improve conditions in low-income communities. “Premium Peanut is very important for is, because it’s hopefully going to stabilize pricing for those peanut growers,” says Spies.