Social Impact Bonds Set Up Unique Venture Capital Market

Massachusetts became the first government entity in the United States in 2011 to issue a request for proposals for “social impact bonds.” The bonds are a fledgling financing strategy that ex­perts believe could help take effective social programs to scale by tapping into private capital, with government paying investors back only if the programs produce results.

Based on a social impact bond model launched in 2010 in the U.K. with the goal of reducing prisoner recidivism, Massachusetts is exploring preventive interventions in the areas of juvenile justice and chronic homelessness.

At least 10 other government entities in the United States are considering or gearing up to issue social impact bonds. The Mas­sachusetts initiative is being closely watched in government, philanthropy, social finance, academia and the nonprofit sector. Many financial leaders believe the strategy might offer an effective, financially feasible and politically acceptable way to scale the impact of preventive social programs that have proven effective but are not widely applied.

“Philanthropy has been the source of risk capital for social innovation — funding research, prototyping, piloting and assessment of new approaches,” said Laura Callanan, a senior consultant in the Social Sector Office of McKinsey & Company in New York City and a member of the consulting firm’s social innovation practice.

“Philanthropy will never have the resources to fully scale the successful programs it helps incubate,” she said. “We need the budget power of government to bring the best of what we know — these evidence-based solutions — to scale.”

In New York City, as another example, the foundation of Mayor Michael Bloomberg posted a $7.2 million loan guarantee to en­tice investment house Goldman Sachs to invest $9.6 million in a program to reduce recidivism rates. The Goldman Sachs money is paid to a service provider that will administer the program.

The problem

In addition to its core function of supporting the safety net of social services that nonprofits provide, philanthropy traditionally has underwritten the sector’s research-and-de­vel­opment role. But even when innovative so­cial programs that philanthropy funds dem­­­on­strate successful results on a pilot ba­sis, supported by evidence to show how and why they work, private philanthropy lacks sufficient capital to invest in expanding those programs.

And while it controls vastly greater resources, government is not known for making big changes when it might be years before that investment produces demonstrable results, particularly in an ailing economy.

Callanan and other experts in the nonprofit, for-profit and public sectors are bullish on social impact bonds, which they believe can provide the critical financing to bring proven social programs to scale. With the struggling economy fueling an increase in demand for social services, while also straining the resources of government, nonprofits and private philanthropy experts believe social impact bonds represent an in­no­vative way to attract private investment capital to support social strategies.

“Social impact bonds help structure the hand-off from philanthropy — the risk capital of the social sector — to government — the scale-up capital of social sector,” explained Callanan, co-author of a recent McKinsey study on the potential for social impact bonds.

Tracy Palandjian is CEO and co-founder of Social Finance US, the Boston-based sister organization of Social Finance Ltd., which launched the first social impact bond in the U.K. in September 2010. She believes the new financing vehicle has emerged in the face of unprecedented challenges for government and nonprofits, and unprecedented opportunities for private investors. With severe budget cuts in recent years, governments have less to spend yet face increasing demand for services fueled by the troubled economy, she said.

And in tough economic times, she said, government tends to invest in essential “safety-net” services, making the investment in preventive social programs a “real luxury.”

What’s more, because politicians tend to operate on short-term deadlines, typically focusing on the next budget cycle and the next election, investing in preventive programs is tough because “it’s hard to justify spending a lot of money today when the rewards from that investment come a couple of years later, sometimes longer,” Palandjian said.

Investing taxpayer dollars in preventive programs also can be tough, she said. Effective programs run by one agency, such as one that provides supportive services for homeless people, can mean savings and avoided costs for another agency that serves that same population, such as Medicare coverage for emergency room visits that serve as the default healthcare solution for chronically homeless people. It dampens the incentive for the first agency to expand its preventive programs.

Among the more than 1 million charitable nonprofits, 80 percent operate with annual budgets less than $100,000, and they typically count on philanthropic and government funding. “The problems ahead of us are far greater than these two sources of capital,” Palandjian said. And nonprofits that operate the more effective programs might lack the best fundraising pitch, while those with the best fundraising pitch might not operate the most effective programs. A goal of social impact bonds, she said, is “to allow great nonprofits with a track record to access a new source of capital from the capital markets beyond philanthropy.”

The lynchpin of social impact bonds is private investment. During the past decade, in the wake of the global financial crisis, “a new class of investors has emerged,” Palandjian said. “They are really looking for a double bottom line — doing good while doing well.”

Those investors include foundations, high-net-worth donors and some institutional investors, although she expects that mainly foundations and high-net-worth investors initially will be willing to take the risk of investing in social impact bonds.

How the bonds work

Social impact bonds are not debt instruments but a partnership in which philanthropic funders and private investors shoulder the “financial risk of expanding preventive programs that help poor and vulnerable people,” according to From Potential to Action: Bringing Social Impact Bonds to the U.S., a report from McKinsey. “Nonprofits deliver the program to more people who need it; the government pays only if the program succeeds.”

The bonds structure a “government contract for social services as a type of pay-for-performance contract,” with seven “stakeholder groups,” including the direct beneficiaries of the social services, government, nonprofit service providers, investors, intermediaries responsible for managing the bond project, evaluation advisers to help monitor and retire the program, and independent assessors to determine if the social targets are met.

Investors in the bonds provide capital that pays up front for the services of the nonprofit service provider, and pays over the life of the bond for the intermediary, the evaluation adviser and the independent assessor, according to the McKinsey report.

The intermediary raises capital from the investors, picks the service providers, contracts with government, works with the evaluation adviser and the independent assessor to set and measure performance targets, and teams with the evaluation adviser to track and assess interim results and suggest “midcourse corrections,” according to the report. “If the program meets performance targets, the government pays the intermediary an agreed amount. … The intermediary is responsible for repaying the investors their capital plus a return on investment.”

In addition to filling a “critical void” by pro­viding a “structured and replicable model for scaling proven solutions,” social impact bonds can help government “move toward paying for results rather than paying for activities,” and can reward nonprofit service providers that create effective programs.

Kristina Costa, a research assistant at the Center for American Progress in Wash­ing­ton, D.C., who has studied social impact bonds, explained that the bonds still are “immature” financial instruments and that the federal tax code has no special provisions dealing with them “It’s not really a bond at all in the traditional sense of what a bond is,” she explained. “It’s much more like an equity relationship. There’s no fixed rate of repayment or fixed time for repayment. If the agreement fails, investors potentially stand to lose all of their capital.” The incentive for investing, she said, would depend on the investors. “It’s going to be a fairly modest rate of return. This is for investors who want to have a positive social outcome resulting from an investment.”

Focus on outcomes

Jeffrey Liebman, a professor of public policy at the Kennedy School of Government at Harvard University in Cambridge, Mass., has provided pro-bono assistance to Mas­sac­husetts and other states considering social impact bonds. He said a key challenge for state governments is figuring out how to measure outcomes in a rigorous way, “how to divine evaluation methodology so that at the end of the day you know what you actually achieved” and whether an organization achieved the objectives.

“Mostly, we have no idea what we’re getting for our social spending,” he said, “and people would like to know which programs are working and which are not, and having a funding mechanism tied to results is very appealing.”

Another key impetus for the new strategy is that “we’re not making fast-enough progress solving social programs,” he said. “Social impact bonds give a mechanism by which government becomes a partner in scaling up something that is successful. It’s like having a money-back guarantee for taxpayers.”

Costa at the Center for American Progress said the financing strategy appeals to socially-minded private investors because they “want to know their money is doing some good in the market, not just making them some money.”

Social impact bonds, she said, represent “a really exciting, innovative opportunity for a lot of people to address social problems in a more flexible way, and particularly to address the kind of preventive issues that can save government and the public a lot of money down the line, but can be difficult to justify in the annual budget cycle.” E

Todd Cohen publishes Philanthropy North Carolina at www.philnc.org and is a contributor to The NonProfit Times.