Tax-Exempt Private Activity Bonds Offer Businesses Low-Cost Access To Capital

Dan, discuss how you facilitate the use of tax-exempt private-activity bonds and, in particular, industrial development bonds. What is the structure and how do they work? Walk us through it.

Basically state and federal laws allow us to ask a government entity-a city, county, or state-to use their name and their tax-exempt financing status to issue tax-exempt bonds, the same way cities and counties finance themselves. However, instead of using the proceeds for a public purpose or a public activity (streets, buildings, schools), we're allowed to actually use the proceeds of a tax-exempt municipal bond to benefit a private user, hence what we call a private-activity bond.

Private users that can benefit from these tax-exempt bond issues include: middle-market sized manufacturing companies, companies that are locate in federal empowerment zones set up by HUD, and companies involved in solid waste disposal, primarily recycling activities, along with non-profit organizations, private schools, and charitable organizations. Entities such as these can all borrow the proceeds of a low interest rate tax-exempt bond issue.

Although the bonds are issued by governmental entities to obtain their tax-exempt status, there is no guarantee by the city, county, state, or federal government-it's not a governmental loan guarantee program. Essentially it is a program set up to reduce the cost of borrowing verses guaranteeing loans.

Now, if the city or state is not guaranteeing these bonds, why is it that they are able to receive a tax-exempt status? Is there an economic development function here? What is the public good that allows them to maintain this tax-exempt status?

The tax-exempt status is obtained by virtue of having the government issue the bonds. Securities that the government issues, assuming they meet all the tax requirements, are exempt from state and federal income tax. What Congress and the states have done is develop a public policy overlay to say how we want private entities to benefit from these types of bonds. For example, they've set up policies and procedures that limit access to industrial development bonds (IDB) financing to small to medium sized manufacturing companies to promote growth and investment in that sector of the economy. Projects that create more jobs and jobs in low-income areas have a higher priority. So at both the state and federal levels there are policy overlays to prioritize how projects use this low-interest rate financing.

Describe how these tax-exempt bond financing programs differ from Small Business Association (SBA) loans?

That's actually a very common question. Often times, the companies that are considering bond financing are also considering an SBA loans. Bond financing and the SBA programs are at opposite ends of the incentive spectrum. At one end is the SBA loan program where the SBA is actually guaranteeing the loan or they're providing the loan themselves out of their own money. I refer to that as a "risk-sharing" incentive, where risk is shared between SBA and the company. So if the company goes out of business or there are not enough assets to be sold to pay back the loans, the SBA takes a write down on the loan.

The industrial development bond is an "interest-rate" incentive. The bond programs are at a lower interest rate, with no federal government risk sharing of the loan. The important structural element of the bond financing is that the bonds either have to be credit enhanced, where repayment of the bond is secured by a letter of credit issued by a bank or, in some cases, you can do a private placement where we sell the bonds to an investor directly, or we can even get a bond insured to ensure the issuance of the bond and repayment. The bondholders are rarely looking directly to the borrower or the project for repayment. There's always something in the middle to guarantee payment to the bondholders.

How much money is made available through the state? Is there a cap on how much is available? If so, who decides what that cap is? What is the distribution across the various sectors of the economy?

The private activity bonds that we put together: the industrial development bond, the pollution control financing for waste recovery, facilities, etc-they're all subject to an issuing volume cap in the state. That cap is about $3 billion of issuing capacity for projects statewide. Projects applications are submitted to the California Debt Limit Allocation Committee, or CDLAC. CDLAC has developed criteria for evaluating each category of projects whether it be manufacturing financing programs, or solid waste disposal or any other type of programs.

They have a scoring system to evaluate projects, and they publish those results. Generally speaking, in today's economy, there's abundant issuing capacity for projects statewide, and with the right advice and through the application process, the average project should be able to receive approval based on its merits.

And how much money are we talking about here projected for 2003? Does it change annually or is there a fixed amount each year? How does it work?

The entire amount of issuing capacity in the state is based on a per capita formula established by Congress - about $70 per person per state. In California, that turns out to be about $3 billion in issuing capacity. In the beginning of each calendar year, the Debt Limit Allocation Committee, which is chaired by the Treasurer, Phil Angelides, establishes the statewide issuing capacity and divides the total into "pools" for each financing program.

The industrial development bond pool gets about $100 million of issuing capacity annually. The last couple of years, we've been lucky to use about 50-75% of our pool. Near the end of the year, it gets folded into some of the pools that have been over-subscribed and gets distributed to other projects. The solid waste disposal pool is a similar size; about $100 - $200 million and other programs get more or less.

How are interest rates set on these bonds?

Because of the tax status of the bonds, private companies can now borrow with the same very attractive interest rates at which cities, counties, and states finance themselves using the proceeds of tax-exempt bonds. Currently, we use as a rule of thumb, all-in, variable tax-exempt rates around 3.00% with a long-term average of about 5.00%. It's very attractive to promote investment in projects when you say you can finance something right now at a 3% variable with a long-term average of 5% including all annual and ongoing costs and the amortization of the upfront fee. It's a very powerful tool, and frankly, over the long run, what we find through the use of these bonds programs, is that an average middle market business could probably finance themselves at a lower interest rate than General Motors or General Electric or Microsoft. It's very compelling and very powerful.

How well does CDLAC or the state or other organizations market the availability of these funds to their targeted industry sectors and what can be done to improve that?

Historically, the state has not done a great job of marketing these programs. They are really dependent on the private sector to go out and market the programs. That's primarily what I do-I go across the state. I've done projects from San Diego to Santa Rosa. The state relies on the local economic development professionals to get the word out that get these financing vehicles are available. Phil Angelides, the state Treasurer, has used the resources he has in the Treasurer's Office to really emphasize marketing. He's giving them marching orders to go out and make sure people are aware of these economic development tools going forward. He's actually started a series of seminars and different educational programs through these different areas in the Treasurer's Office. So it's starting at that level.

If the businesses are assuming the obligation to pay these bonds and there is little or no risk at the city level, how does that work? The city is issuing the bonds and the businesses are obligated to pay. How does it get the city off completely?

These programs are called "revenue, conduit bonds." When the bondholders see the word ‘revenue' associated with an issue, they know, and obviously the documents are very careful to point this out, that the source of repayment of the bond is something other than the entity that issues the bond. So the municipality lends its name and tax-exempt status to the bond issue to allow the financing access to the tax-exempt marketplace, but literally the second the bonds are issued, they assign all their rights and responsibilities for repayment of the bond issue essentially back to the borrower through a particular structure. So if there is a default, the city or the issuer of the bond says, "Hey, we did our part, we issued the bonds, we acted as a conduit, but hereafter, we cleanse our hands of this deal. Don't call us." Obviously the structure is, although complicated, something we do all the time, so we are rather comfortable delivering this product.

One of the more interesting developments the last few weeks here in downtown Los Angeles is the development of Center City East, and the Central Industrial Development zone set up by the CRA. How would this type of program complement this type of project with the redevelopment agency? In other words, how can businesses tap into this type of financing and work with empowerment zone environments? How do they work together?

The objective of these redevelopment project areas and the roles of the Community Redevelopment Agency (CRA) is to really lay a foundation for future growth. They are investing in infrastructure; they're trying to attract key investment into the community.

But, to the extent that, on top of the infrastructure being put together, there is a manufacturing facility or a distribution facility going in, or if there's something to qualify for one of those bond programs, we can use our bond program to finance those extra projects that make the community a viable economic area. There's going to be a lot of opportunity because people complain, particularly in downtown, that the infrastructure is inadequate, site assembly is difficult and few developable sites are available.

We're hoping that the activities of the redevelopment project areas will create the infrastructure, create the site assembly, so that people can come in and make investments and fund them with the bond proceeds.

Lastly, let's talk about the non-profit sector. How does the non-profit sector take advantage of these types of programs and give us an example of one where it's worked.

The non-profits, just by virtue of their unique status as a non-taxable entity, can borrow the proceeds of a tax-exempt revenue bond to fund their expansion programs, fixed assets, land building equipment, etc. Their access to these funds is a little broader in that it's not subject to limits at the statewide level.

Non-profits can finance as much as they want and as long as it furthers their mission, the nonprofit mission. We recently closed a $7.0 million revenue bond issue for SPCA Los Angeles, to further the dog and cat adoption and educational program. Most of that money will be used to fund a new facility in Long Beach, although some of those bond proceeds will be used to rehab the headquarters in Los Angeles and also a couple of facilities in Hawthorne.

Private schools also have been accessing the tax-exempt bond market consistently over the years. Oakwood school, Wildwood School, Crossroads School-these are all organizations that have used bond financing very successfully in the past.