Risky Business: Auditors and Economic Development
By Roger Zalneraitis and Michael Eglinski
Business is risky. That's why economic development can be risky business. We've identified some of the major risks related to the market, financing and reputation. We offer a few tips for auditors working on economic development audits.
Market risk occurs when lack of insight into economic conditions may cause a town or city to allocate resources toward projects that they would not otherwise fund. Some key market risks include changing economic conditions, workforce needs, and local market insights.
Changing economic conditions
The average age of a S&P company has fallen from 60 years old in the 1950s to under 20 years old today, according to Credit Suisse. Rapidly shifting economic environments affect both business and business models more than ever before.
Consider the case of warehouses. Twenty years ago, strategy focused on locations within a day's drive of one or more large metro areas. Today, companies like Amazon favor warehousing near major population centers, in order to create same day, or quicker, delivery. Remote warehouse and distribution centers may now be abandoned, requiring towns that once courted them to seek compatible uses for vacant space. The more unique the space is for your community, the more difficult it could be to fill.
Audit Tip: Look for clear policy goals you could use as audit criteria. Look for goals and objectives you could measure. Data on the current economic and business environment should support the policy goals. The goals should also identify alternative uses and industries if the future looks different.
Investing in the right priorities
Traditional economic development has tied policy goals to real estate development: sell it, build it, and provide incentives to get it done. However, the importance of real estate is changing. The challenge of online sales is well known, driving not only retail shopping changes but logistics and warehousing.
Consider also the impact of home and remote employment on workspace. The number of people working from home rose from 3.6% of the workforce in 2005 to 5.2% of the workforce in 2017 (US Census, ACS 1 Year Data). In addition, Gallup research has documented that the number of people working remotely has increased from 39% of all employees in 2012 to 43% in 2016, and that the time spent working remotely has increased as well.
These changes may be reducing the demand for commercial workspace. Exhibit 1 shows that the change in homebased workers plus the increase in remote working by office-situated employees may have resulted in 21% less commercial workspace being built than would have been projected in 2005. Rather than workspace, remote and home-based workers are increasingly focused on broadband access and air service.
Towns and cities that are not monitoring business trends like increased home-based workers may pursue real estate strategies rather than internet or air service development strategies, which could hinder their ability to attract and retain quality jobs.
Audit Tip: Economic development takes a long time. It is complex with risks and uncertainties. That makes it hard to audit outcomes. Instead, auditors can focus on the system an agency uses to ensure that they consider the long term. Long term considerations should look at market trends and common infrastructure items that benefit the economy broadly rather than only a single project.
Market insight on “but for” projects
Economic incentives were traditionally awarded to projects that would otherwise not occur without them (the famous “but for” clause in many policies). However, many communities either do not have the in-house capabilities or market insight to know what standard rates of return and capital costs are for projects. Lacking this information, it can be difficult to assess the appropriate amount of incentives for a project to occur.
Audit Tip: Economic development typically requires some analysis of the costs and benefits and/or the “but for.” Models to support the analysis can be complex. Ask the users (a) to explain the model and (b) to provide documentation that explains the model. Evaluating the models is complex, but use your professional skepticism to probe into the model’s assumptions, data sources and methods.
Financing risk occurs when the returns for a community are less than originally expected, reducing the tax base rather than expanding it. Some of the principle finance risks include long-dated rewards and project-financed infrastructure and debt.
Oftentimes communities will provide incentives upfront, either through cash payments or tax benefits that run for the first 5, 10, or 15 years of the project. These can result in a net cost during the initial time period of the project, but only show financial benefits for the community 10, 20, or even 30 years later. Risk of underperformance or even project closure increases over time. The longer a community must wait for an expected financial return, the less likely it is to happen.
Project Financed Debt & Infrastructure
Economic projects often require financing as part of the incentive package. Some projects will be financed through new incremental taxes the project is expected to generate (“TIF”). TIF may finance hard costs, or it may be used to pay back interest and principal on a bond. However, if the TIF financing is short of projections, towns or cities may find themselves on the hook to pay off the bond through general fund revenue or invest in the hard costs of infrastructure themselves. This could hurt the community’s ability to pay for core services such as safety or road maintenance.
Audit Tip: Read the details of any development agreements and bond covenants. For debt supported projects, focus on both the anticipated and actual debt coverage ratios. Stakeholders should understand how the agreements protect the city from risks. The stakeholders’ understanding should be reflected in the written agreements.
Reputational risk occurs when either the type of business, or business activity, jeopardizes the community in which it seeks to operate. Reputational risk can occur when due diligence, community values, fraud monitoring, or policies are not executed adequately.
Economic development struggles with due diligence. For example, a relocation project led by two midwestern states failed to discover that the company that they were wooing was actually bankrupt, and the company was seeking cash incentives to negotiate its way out of bankruptcy court. A local economic developer learned this by doing a simple Google search on the company’s name. If the project had been awarded, the winning community could have been exposed for offering millions of dollars of cash for little more than a court settlement.
Audit Tip: Look for written due diligence procedures. Look for evidence of compliance with those due diligence procedures. The due diligence procedures should be based on an understanding of risks. Be aware that staff completing due diligence may be facing pressures to get deals done.
Businesses may not always be doing the type of work that a community wants. Seeking “value added agriculture” could, for example, wind up attracting a slaughterhouse to a town that doesn’t want it. In addition, corporate relocations may be driven by politics. Gun manufacturers have been relocating from “anti-gun” states to “pro-gun” states, and some companies leaving California have cited employment laws passed in the Sunshine State for their move.
In economic development, relocations often do not state the specific nature of the business that is being courted. This raises risk of projects running afoul of community values.
Economic development fraud happens. One of the most famous examples of fraud in economic development was Mamtek, where an individual set up a shell company to steal millions of dollars from a town in order to avoid foreclosure on his house. Companies may also seek incentives to settle bankruptcy or may channel revenues from multiple locations into a location with an incentive package to illegally reduce tax liability. Fraud may be easy to detect if a company fails to do something, such as build a large new facility while collecting funds. More often than not, it is difficult to identify as there is little direct evidence of the company’s illicit behavior.
Audit Tip: Brainstorm about potential fraud. Put yourself in the shoes of a business seeking a subsidy. Put yourself in the shoes of an agency employee evaluating the proposal. Read news stories from other jurisdictions. A good starting point is to search the Internet for “Mamtek” and look for lessons learned from that project.
Following internal policies
Internal policies on economic development incentives are subject to be breached because of unknowns related to competing communities and the projects’ economic benefits.
Economic development prospects are often looking at more than one community in which to site a project. It is easy to second guess your own policies when it is not clear what other towns or cities may be offering, or because you don’t have clear insight into costs of doing business in other towns.
Moreover, prospects may not provide all the information your policies require. For example, one state in the intermountain west routinely sends out relocation requests that fail to include information on wages and benefits. If your community is seeking high paying jobs, projects like this are risky to offer incentives to.
Audit Tip: Auditors often focus on policies and procedures. That’s a good area to focus, especially given some of the risks we’ve discussed above. Begin with the city’s economic development objectives. Look at policies and procedures designed to reach those objectives. If the objectives are clear and the policies and procedures are well designed, make sure they are in place and followed. Exhibit 2 shows a framework for best practices for economic development.
Bonus Audit Tip: Build an understanding of the local economy. Use data to inform your understanding. Understanding the local economy will help you audit local economic development. Don’t be surprised to find data that contradicts the local conventional wisdom. The St. Louis Federal Reserve Bank provides a wealth of data through FRED and GeoFRED. FRED provides extensive data easy to graph and download. GeoFRED provides economic data in maps. Find these tools by searching for “St. Louis Federal FRED.”
Making informed decisions
- Clearly define rules, policies, procedures and guidance including goals, objectives, requirements, terms and processes.
- Establish a system to collect information and process applications. Applications should: summarize the project, demonstrate financial and professional capability, and summarize benefits and assistance requested. Collect all fees required by policy and document their collection.
- Evaluate the developer or business. Consider financial resources and seek disclosure of conflicts. Consider a 3rd party to evaluate finances and track record as part of due diligence. The finance director or budget officer should be included in the analysis of impacts, risks, and uncertainties.
- Establish procedures to address actual or perceived conflicts of interest for staff.
- Evaluate data and assumptions used to review proposals.
- Systematically identify and evaluate risks and uncertainties. Communicate the risks and uncertainties to stakeholders and citizens.
- Document all applications, supporting documents, agreements, compliance provisions, screening processes, risk assessments, term sheets, award decisions, etc.
- Clearly define specific goals and criteria for incentive recipients and actions taken if the outcomes differ. Ensure goals are defined and can be measured objectively. Take steps to validate data reported by developers and businesses.
- Establish a system to identify and manage performance agreement risks. Document and maintain records.
- Monitor and report on the overall economic development of the community.
- Make the results of monitoring publicly available.
Best practice themes
- Follow consistent, goal-driven approaches to using incentives.
- Evaluate and communicate risks and uncertainties.
- Monitor and report on the overall economic development of the community.
- Make the results of the monitoring publicly available.
Source: Performance Audit: Improvements Can Help Inform Decisions and Monitor Progress on Economic Development Incentives, City Auditor, City of Lawrence, KS, July 2016. The best practices were developed from Government Financial Officers Association best practices, select literature on economic development, and interviews with stakeholders. Lauber and Kaleko’s “Due Diligence and Risk Management Measures for Economic Development Incentive Approvals” Missouri Municipal Review, July 2012, was especially useful.
Being aware of these risks can help auditors complete meaningful work and help the community avoid unnecessary losses and black eyes, thereby increasing the value that economic development projects bring to the community and protecting public dollars to continue to support vital services for your citizens.
About the Author
Roger Zalneraitis is the Economic Development Manager for the Southern Ute Indian Tribe in Ignacio, Colorado. Previously, he served as the first Executive Director of the La Plata Economic Development Alliance in Durango, Colorado; the Economic Development Planner for Lawrence, Kansas; and as a Research Associate in the Community Development Department of the Kansas City Federal Reserve. He has a Bachelor's Degree in Economics from the University of Notre Dame and a Master's Degree in Urban Planning from Virginia Tech.
Michael Eglinski joined Johnson County Audit Services in July 2017. He has over 25 years of experience in local government auditing. He worked for the City Auditors Office and Mayor’s Office in the City of Kansas City, Missouri. He was the City Auditor for the City of Lawrence. He has a Bachelor of Science degree in economics from the University of Kansas and a Masters of Social Sciences from Stockholm University.