Pay for Success Bonds

16 Nov

Image from Darby / John-Michael Maas:

Governments are looking at new financing tools to entice private investment to fund social service programs. The financing scheme, in theory, works like this: (1) a social service innovation promises to ameliorate a social ill in a way that reduces costs for government agencies and taxpayers; (2) an investor, wooed by the promise of said program forks over cash to fund the effort; (3) the program promises to deliver results at a minimum quantitative threshold (e.g., reduce chronic homelessness in a neighborhood by 5%); (4) if the program meets the minimum threshold, then investors recoup their initial investment; and (5) if the program exceeds the minimum threshold, then the investor sees a return, based on the overall savings to the government. In a nutshell, that’s how Social Impact Bonds should work.

Social Impact Bonds (or SIBs) are financing models that direct funding to successful social interventions – think homelessness, preventing recidivism, workforce development, providing preventative health services, and the like. Proponents argue that this model is a welcomed departure from our current approach to social intervention funding, which tends to emphasize inputs (for example, the number of individuals enrolled workforce training program). Instead, SIBs shift the emphasis to measured success at achieving program objectives (e.g., the number of individuals successfully placed in employment).

A Social Impact Bond structures a typical government contract as a “pay-for-performance contract.” Intermediary groups gather capital from private investors and identify qualified service providers to administer the program. The intermediary also works with the appropriate government agencies to mutually determine the monetary “return” on an investment should a program succeed. Returns are calculated based on government savings achieved through the program.

Intermediaries also determine metrics for “success” of a given social intervention program. For example, one program’s goal may be to achieve a 10 percent increase in the number of job placements for participants in a workforce training program. In this case, the investors would see returns only if the program meets or exceeds the 10 percent metric.

The first significant trial of social impact bonds occurred in the United Kingdom in 2010. A non-profit advisory organization and the U.K. Ministry of Justice signed a SIB contract aimed at reducing recidivism among inmates at Peterborough prison in Cambridgeshire, England. The program’s goal was to cut recidivism by a minimum of 7.5 percent. If that minimum threshold were met, then investors would recoup their initial investment, but nothing more. Gains on the investment are realized only if the recidivism rate is cut by more than 7.5 percent, with the maximum return capped at 13 percent.

In New York, Goldman Sachs is putting up $9.6 million to create one of the United States’ first Social Impact Bonds. The program will be aimed at reducing recidivism among inmates at Riker’s Island Correctional Facility. Their investment is being backed by Mayor Bloomberg’s foundation, who will repay the bulk of Goldman Sachs’ investment should the program fail to meet set metrics.

These pilot projects are evidence that SIB programs are beginning to gain traction, and it’s no surprise. As governments struggle to provide basic social services, preventative programs are often the first to go, even though they could result in huge cost-savings in the long run.  Social Impact Bonds transfer the financial risk and burden away from the government and taxpayers. When successful, Social Impact Bonds not only fund key preventative services but can also help save the government money down the road [PDF].

Since private investors are interested in seeing a return on their investments, intermediaries are motivated to find the most effective intervention programs, ensuring that tested, replicable models are financed. For untested, but promising innovations, philanthropic investors can use the returns on their successful SIB investments to fund promising pilot programs. An investment in a failed pilot program would leave the philanthropic investor no worse off than if the investor administered a traditional grant. For successful projects, Social Impact Bonds can reward service providers who manage effective programs, and help “scale up” successful social innovations.

As with most social innovations, the kinks are still being worked out. Critics of the financing structure point to the difficulty in coming up with a defined set of measurements that will trigger a return on investment. Standardized measures across sectors aren’t likely to make sense. Differences in demographics, established programs, and the overall scope of social issues means that thresholds that trigger returns will have to be tailored to each situation. You’ll need a different set of metrics for workforce development programs than you would for homelessness programs. And the targets for workforce development in Boston are likely to differ from those in Chicago. But standardization around contracts, reporting, performance, and measurements can increase investor confidence in the SIB market.

According to a report published by the McKinsey Company, government involvement is crucial to the success of a Social Impact Bond. The Obama Administration has responded accordingly [PDF], pledging to support Social Impact (or “Pay for Success” projects) pilot projects in 2012. Mounting interest in this financing tool has led to a monthly news release by the Nonprofit Finance Fund on all things SIB.

As more pilot programs get underway, we hope that social innovators learn from their efforts and continue to improve the efficiency of this model. The financing concept holds potential to bring about cross-sector collaboration to provide much needed services to the communities that need it most.

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