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The Social Impact Bond: A Private Sector Funding Mechanism to Address Social Ills

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Cash-strapped municipal and state governments across the country are increasingly looking for novel ways to access private capital to finance what were once taxpayer funded initiatives, including those that address intractable social ills. One such innovation, the social impact bond (SIB), is structured to transfer the risk of investing in a given preventative social program from taxpayers to private investors through its “pay for success” feature. SIBs will potentially provide funding for exemplary social services programs that might not otherwise be implemented. It is hoped that they will also create more rigor in the measurement of program outcomes. Yet some critics worry that SIBs may have other, more problematic unintended outcomes, if they result in the transfer of the responsibility for addressing social ills from the public and not-for-profit, to the for-profit sector.

Under the SIB structure—and it should be noted here that SIBs have more venture-equity-like than bond-like characteristics—a government entity contracts with an intermediary to raise capital from investors. The proceeds are funneled to a designated service provider over a period of years to design and deliver large-scale interventions aimed at preventing an anti-social behavior, such as prison recidivism or homelessness. The program is monitored by an independent advisor while in progress, and by an independent assessor at the conclusion of the SIB contract.

At that point investors may be returned their original investment, less than it, or more than it, depending on how well the program performed against a negotiated benchmark. The UK, for example, launched a SIB in September 2010 to address recidivism in the Peterborough prison, which was running at a rate of 60%. Investors in the Peterborough SIB may earn between 2.5 to 13% at the conclusion of its term, depending on the performance of the program with the population that it serves, versus a control group.

In its own variation on the SIB theme, the City of New York announced this August that it was contracting with Goldman Sachs in a SIB deal aimed at reducing recidivism among the younger male population in the city’s Rikers Island prison. The State of Massachusetts is also exploring two social impact bonds, one to address recidivism among youth who age out of youth services, and another to address chronic homelessness.

The Goldman deal represents the first time that a major capital markets player has participated in a SIB deal. (Investors in the Peterborough SIB, for example, were primarily impact investors and philanthropic organizations.) The Goldman deal works as follows. The bank lends $9.6 million to MDRC, a not-for-profit organization, to oversee a four-year program in which educational, training, and counseling programs are offered to Rikers inmates between the ages of 16 and 18. At the end of four years, if reincarceration is reduced by 10%, MDRC pays Goldman $9.6 million. If recidivism drops more than that amount, MDRC pays Goldman more, capped at an additional $2.1 million if recidivism drops 20%. However if recidivism does not drop by at least 10% Goldman loses $2.4 million of its original investment. (Goldman’s loss is capped at that amount by a $7.2 million loan guarantee from Bloomberg Philanthropies.)

For its part, the City of New York pays nothing if the program does not reduce recidivism by at least 10%. If the program meets or exceeds that target, the city will pay MDRC an increasing amount on a sliding scale until a cap is reached, based on the savings the city calculates it will realize on the reduced recidivism.

Critics of SIBs worry that if they are used inappropriately or “overengineered” they may contribute to the neglect of society’s most vexing social problems. When profits are tied to social outcomes, these critics contend, there may be a tendency to “cherry pick” the least intractable social challenges for these private investor schemes, leaving the more intractable problems to be tackled by a diminished public sector.

Although the SIB’s pay-for-success structure is intended to create more accountability in the measurement of program outcomes, the details are subject to manipulation, especially when the cost drivers of those outcomes are not so easy to track, or when the outcomes themselves cannot be so easily quantified. Michael Lewis, a prominent critic of what has become known as “philanthrocapitalism,” is generally uneasy with attempts to measure social outcomes in financial terms. In “Why 'Social Capital Markets' Could Be a Really Bad Idea,” published in Philanthropy Central, a publication of the Duke Sanford School of Public Policy, he maintains: “There are no reliable measures of the ‘social return on investment,’ only estimates of the financial value of those aspects of social change that can be quantified, which are relatively few. That’s because social impact is so complicated, unpredictable, and lengthy that it can’t be captured in a set of numbers.”

Not-for-profit mission investors will certainly monitor SIBs closely, as will those organizations in the business of measuring social outcomes, government entities, and a growing group of private investors who desire to invest for purpose beyond financial returns. If they perform as their advocates anticipate and are responsibly managed, SIBs will transfer from taxpayers to investors the upfront cost and at least a portion of the downside risk of funding programs aimed at preventing certain negative social behaviors. However they will be applicable only to those select intervention programs whose outcomes can be clearly translated into measurable financial savings to society. If they deliver on their promise, society, the targeted population, and SIB investors will be the beneficiaries.

—Susan Arterian Chang

Susan Arterian Chang is a contributing writer to The Finance Professionals’ Post and the director of Capital Institute’s Field Guide to Investing in a Resilient Economy project.

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