High Risk, Low Risk
March 4, 2014 Mark Hrywna
Investors raised $13.5 million and could see an annual return of more than 12 percent. It’s not the latest Initial Public Offering (IPO) of a sexy stock such as Facebook or Twitter. The funding will expand an employment program for recently released prisoners in New York. The potential returns would be generated from state and federal grant funds, if certain benchmarks are met.
In a Social Impact Bond (SIB) offering, New York State officials announced recently that it will expand work by the Center for Em–ployment Opportunities (CEO) over four years in Rochester and New York City, focused on comprehensive reentry employment services.
Investors could earn 12.5-percent returns (but more likely single-digit gains) if certain benchmarks for the program are reached. The Rockefeller Foundation is back-stopping 10 percent of their investment ($1.3 million) if the program does not.
“It’s a replicable amount going forward,” said Kippy Joseph, associate director of innovation at the Rockefeller Foundation in New York City. “It’s actually quite low, when you think about others,” she said.
The foundation is backstopping 10 percent for investors because it’s a commercially realistic amount that could be raised as part of any deal, according to Joseph. “Ten percent is not an unusual guarantee to see in commercial transactions that don’t have anything to do with Social Impact Bonds or social impact,” she said.
Since the SIB is not yet a proven model, early investors are taking a risk and “peace of mind, in and of itself is worth something,” Joseph said. There will be no investor who seeks primarily financial return with no social value because SIBs are not a generic commercial deal. “It needs to be someone interested in a double bottom line. That has to be there to have interest to you,” she said.
A guarantee is still required at this stage of the game for SIBs, but eventually there will not be need for a guarantee once several are in the market, Joseph said, adding that it’s the most “rapidly scaling innovation” in recent memory. One of the reasons for that is Rockefeller’s work with the Social Impact Bond Technical Assistance Lab at Harvard University’s John F. Kennedy School of Government, which places technical assistance fellows in governments around the country. The lab estimates a potential pipeline of 12 to 15 SIBs during the next two years, valued at $500 million.
“It doesn’t mean the Social Impact Bond will be proven to be an effective mechanism for financing social services,” Joseph said, because it will be two years before there are only preliminary results from the first SIB, a $9.6-million deal with Goldman Sachs and New York City.
Despite the enthusiasm, it’s still not known what will come of SIBs. “What’s so interesting to the Rockefeller Foundation is that we hope it will open doors for the next set of innovative financing mechanisms to help fund needed programs that currently aren’t getting the budget that they need,” she said.
“There’s real potential to spark government reform in that many governments see the opportunity to use private capital in a Social Impact Bond as a mechanism to fund programs that they actually work better than the services they are providing but just don’t have the political will to fund it upfront themselves,” Joseph said. “If you fund prevention, you save the cost of remediation down the line,” she said.
In February, Massachusetts announced a seven-year, $27-million SIB, also sometimes referred to as a Pay For Success (PFS) initiative. Not only is it the largest SIB to date but it’s the first non-guaranteed transaction. Massachusetts has authorized $50 million launch PFS initiatives. In addition to this $27-million effort, others are planned to address chronic individual homeless and possibly adult basic education in the future.
Chelsea, Mass.-based noprofit Roca, Inc., will expand an intensive four-year program for nearly 1,000 young men in more than a dozen Massachusetts cities with a goal of reducing the number of days of incarceration by 40 percent. Roca has deferred $3.3 million in fees and another $18 million has been raised in private financing, secured by Third Sector Partners:
- $9 million in loan financing from the Goldman Sachs Social Impact Fund;
- $1.5 million in loan financing from The Kresge Foundation;
- $1.5 million in loan financing from Living Cities;
- $3.7 million in grants from The Laura and John Arnold Foundation;
- $2 million in grants from New Profit, Inc.; and,
- $300,000 in grants from The Boston Foundation.
Unlike other deals, the Massachusetts transaction is not guaranteed by foundations or other nonprofits. “We’re investing in the deal the same way everyone else is,” said Tripp Jones, managing director of Boston-based New Profit, Inc.
One of Goldman’s other SIB efforts included a 75-percent guarantee from Bloomberg Philanthropies. That guarantee was necessary because it was the first in the United States and the first by a financial institution, with an unknown risk associated with it, according to Andrea Phillips, vice president in Goldman Sachs’ Urban Investment Group.
Massachusetts will pay 5 percent annual interest to Goldman Sachs during the life of the initiative and 2 percent annually to junior lenders Kresge Foundation and Living Cities. At higher levels of impact, Roca and Goldman also could receive up to $1 million and Kresge and Living Cities up to another $300,000 each – but not until the final year.
Social Impact Bonds work on the premise that traditional sources of philanthropy and government funding are insufficient to address social problems, according to Tracy Palandjian, chief executive officer and co-founder of Boston-based Social Finance Inc. Growth-ready nonprofits can receive capital to scale while government would only pay for positive results, she said.
CEO is a provider of evidence-based training and employment programs to recently incarcerated individuals in New York State. The funding will cover the full cost of the programmatic work and core costs. CEO will be able to rely on a flexible, predictable source of funding to expand its program while providing investors an opportunity to align their portfolio and social values.
The U.S. Department of Labor will provide outcome-based payments for the benefit of investors for the first half of the program (the first 1,000 served), while New York State will make such payments for the second half of the program (the next 1,000 served). New York received a $12-million grant for the project, the largest award made by the U.S. Department of Labor under its national competition for Pay for Success. Additional funds were included in the 2013-14 state budget.
If the project achieves all performance measures, the public sector would realize $7.8 million in savings, according to Social Finance. For investors to be repaid, the project must reduce recidivism by at least 8 percent and/or increase employment by at least 5 percent. If the program performs better, investors can earn a positive return on their investment that is proportionate to the savings and benefits achieved by the public sector.
The maximum return possible to investors will be 12 to 12.5 percent annually but more likely to be in the high single digits, according to Andrew Sieg, head of Global Wealth and Retirement Solutions for Bank of America Merrill Lynch.
No payment is made if the program does not meet goals, ensuring that taxpayer dollars are only spent if a meaningful impact was attained. Investors could lose all of their investment. Chesapeake Research Associates will validate the result of a Randomized Control Trial (RCT) that measures outcomes for participants.
“The investment is focused on directing resources toward prevention, tackling the source of the problem rather than treating the symptoms, and equipping people with training to help them lead productive and healthy lives,” Palandjian said.
To Antony Bugg-Levine, New York State’s SIB is significant because it’s the first in which capital is largely from private investors, organized through a mainstream institution. “It’s a real landmark for Social Impact Bonds” because it taps into a different pool of money, said Bugg-Levine, the CEO of the Nonprofit Finance Fund (NFF) in New York City.
“It’s another step forward when you have a mainstream brokerage firm selling to clients just as they would be selling stocks. Now it lights the path for how we can tap into trillions sitting in those privately held investment assets,” said Bugg-Levine, who used to run the Rockefeller Foundation’s program-related investments before taking the helm at NFF two years ago.
“Many other deals are done with foundation money or other banks’ money. To be able to sell to a client group is a bit of a milestone,” he said. “It’s exciting that Bank of America through this deal helped to show we can mobilize different pools of money that are not sitting in foundation assets, and frankly are much larger than foundations,” he said.
The Rockefeller Foundation will provide a guarantee to protect up to $1.3 million of investor principal, about 10 percent of the total investment, and The Robin Hood Foundation committed early to a similar $300,000 investment.
The investment was available only to qualified high net worth and institutional clients of Merrill Lynch and U.S. Trust, as well as other investors identified by Social Finance Inc. Investors were required to have investable assets of at least $10 million, with a minimum investment of $100,000, according to Sieg. Among the more than 40 private and institutional investors were former Treasury Secretary Larry Summers, James Sorenson and the Laura and John Arnold Foundation of Houston, Texas.
The average investment is about $300,000, with an even split among individual and institutional investors, he said, adding that institutional investors were largely personal foundations or established foundations.
The United Kingdom launched the first Social Impact Bond several years ago and since then there have been about 20 globally but only one in the United States, according to Palandjian. This transaction is the first state-led SIB but also the largest capital raise globally to date.
Based on the number of active and expected government procurements and the average contract size, Palandjian said the market has been estimated by experts to be $300 million during the next five years.
The U.K. social bond ended up with a 15-percent reduction in recidivism rates among participants while at the same time overall rates were up 3 percent, so it was a 20-percent improvement compared to the control group. If that trend continues, Bugg-Levine said investors will be paid back with a profit.
There’s quite a bit of momentum in the world for SIBs, with nearly two dozen in the U.K., in addition to the first in Holland, Australia and Israel. New York State could have three or four more deals this year, Bugg-Levine said.
NFF announced that, with the help of $2.5 million from The James Irvine Foundation, three to eight leaders in California will be selected to help incubate and develop potential SIB deals in the Golden State. They will form an active learning group and have opportunities to share experiences, challenges and results with the goal of further testing the concept and expediting additional agreements.
The effort aims to locate at least three projects that are furthest along in the process, according to Jessica LaBarbera, director, strategic innovation, adding that the goal would be to get two or three projects to completion in the next two years. The majority of work will be to assess the viability of potential projects, providing technical assistance and connecting people, while also examining data and cost-benefit analysis to determine if significant populations are reached and savings generated.
“The money we do have available in government and philanthropy, a lot of people are interested in seeing how that money can be spent on things that are proven,” Bugg-Levine said.
Politically, it’s difficult to fund programs that address issues such as prisoner recidivism, he said. Until a track record is established, private investors have an important role to take that risk and step in. That shifting of risk can change the political conversation away from special treatment for prisoners, or some other group, to investing in saving money, he said. “At the end of the day, it’s much easier to fund programs directly by government if government is willing to do so,” Bugg-Levine said.
“It’ll be interesting to see how it plays out,” said Phil Buchanan, executive director of the Cambridge, Mass.-based Center for Effective Philanthropy (CEP). “We should watch these early experiments and see how it works before we hail this as the answer to all our problems – but that’s the way I feel about everything.” There’s a tendency, he said, to think that there’s this new “shiny thing that unlocks” social problems. “It isn’t going to be the panacea for everything.”
Buchanan is a little wary about the involvement of firms such as Bank of American and Goldman Sachs, which invested in New York City’s first SIB, around juvenile justice recidivism.
“I’m not sure that taxpayers necessarily want to be contributing to Bank of America’s profitability,” Buchanan said, questioning whether it might be better off if Bank of America’s foundation made SIBs a priority instead of the for-profit bank. E