Social Impact Bonds: Should there be a Profit on Positive Social Outcomes?

State and local governments struggle to address social problems in their jurisdictions due to the expense and the fact that many issues like homelessness, criminal recidivism, and differences in school readiness are persistent and long-lasting.

Imagine if there were some alternative funding method that allowed a government entity to attack a chronic social problem that allowed flexibility to try new methods and achieved a measurable result with potentially more money than current tight budgets allow? If that outcome seems to be only a pipe dream, than you might not have heard of Social Impact Bonds (SIBs) or as they are sometimes called “Pay for Success” initiatives. Describing the process in “Social Impact Bonds”: Paying for Results, Alex Masucci notes that these plans “create an incentive structure within which for-profit institutions and philanthropic organizations bear the risk that normally falls on taxpayers in financing initiatives. Initiatives such as these have the potential to provide much-needed funding to human service providers that aim to establish innovative new programs or expand current programs. Under the standard SIB model, private investors and nonprofit philanthropic entities provide capital to a service provider. The funders and the government then enter into a contractual agreement in which the government will pay them a “success payment” based on the extent to which two primary goals, cost avoidance and outcome improvement, are achieved.” (Policy & Practice, December 2013, Vol. 71, Issue 6, p. 26-27). Up until now the main formula by which a public entity would pay a non-profit it might contract with would be to pay them based on numbers of clients served with (only) the hope that the funding was making a difference in the social ill being addressed.

Jacob Wascalus writing in the Federal Reserve Bank of Minneapolis’ Community Dividend journal expands on the “ABCs” of SIBs by discussing the roles of the primary participants in pay-for-success plans. He identifies an intermediary, government entity, service provider, private investor(s), and an independent evaluator.  (Community Dividend (FedGazette), July 2013, p. 4) The intermediary or go-between receives an agreed upon contract or memorandum of understanding from the public agency to tackle a social ill. The objective, for example, could be counseling at-risk youth who have been in foster care or the juvenile justice system to achieve independence, finish schooling, or avoid recidivism. A positive outcome might mean specifically agreed targets of more at-risk youth having a positive employment record, less social service agency casework, or a defined drop in youth arrests. The intermediary will only receive payment from the government if goals are met. The decision on whether goals are accomplished is determined by an impartial evaluator or arbiter after the conclusion of the contract or at certain key junctures of the initiative. The government pays the intermediary after the services have been delivered based on the theory that funds will be forthcoming since cost savings will have been realized. At the beginning of the process the intermediary has to raise funds of its own in order to operate its duties. It can raise capital most quickly by selling bonds (SIBs) to private investors who are in agreement with the prospectus of the aims the go-between is trying to fulfill. Once the funds are raised many intermediaries then align with providers who do the direct work with the service population. These providers generally would be those who have the most experience, local knowledge, and contacts to realize the objectives outlined in the prospectus to investors, and agreed upon between the government and intermediary. When the go-between is successful and receives payment from the public agency it pays the provider and the bondholders. Depending on the incentives placed into the original contract and the cost-savings in providing a better social service, the investors might make a sizeable profit.
The drive for success that SIBs depend on is what may be the most provocative aspect of these new vehicles, namely that they introduce to the non-profit world what have been successful traits in business ventures such as risk, innovation, and a commitment to the bottom line. In the SIB model no intermediary, service provider, or investor will receive remuneration from the government unless their efforts are successful. So, while there is an element of risk-taking there is also a competing demand for the organizations involved to show level-headedness and identify steps and processes to mediate a social problem by which they can achieve measureable results that an arbiter can concur with. The ultimate winner would be the community benefitting from the desire to “do good by doing well”.

Wascalus notes that one of the greatest challenges toward getting a “Pay for Success” effort off the ground is indeed the amount of planning and interaction between the organizations involved and government to negotiate a contract or memorandum of understanding detailing what will be attempted, the desired outcome(s), and how the initiative will be evaluated. The public agency contracting with the innovators may require additional staff time to monitor benchmarks along the way and provide some sort of oversight. Given the nature of some of the intractable social problems the service providers are trying to address, some SIBs may take years to determine whether they are achieving the objectives being sought.

The first pilot program using a “Pay for Success” model to come to the public’s attention was attempted in 2010 in the United Kingdom. The Conservative Party’s “Big Society” idea was among the planks that appealed to voters when they were ushered into the majority in Parliament in 2010. The stated ideological goal of Big Society was to devolve power to local communities and organizations to tackle problems through local knowledge, social solidarity, and voluntarism, and away from London bureaucrats. It has hallmarks of some of the efforts attempted under the banner of “compassionate conservatism” early in the George W. Bush presidency. Although the Big Society initiatives have had a choppy voyage so far, one attempt has set the stage for the growth of SIBs elsewhere.  Social Finance Ltd. entered into an arrangement in Peterborough, England to reduce the rate of recidivism among adult male prison inmates who had served terms of less than one year. If they could deliver services to that population that would ultimately lower the re-offense rate by 7.5% or more for a period of six years, Social Finance would receive some of the monies that would have otherwise gone towards the cost of jailing the former offenders, up to a limit of £8 million. Last month, Social Finance reported on their website that, based on an analysis of 1,000 ex-inmates, there has been an 8.4% drop in recidivism. The organization expects to return a profit to its investors. [1] Social Finance’s positive experience in addressing ex-offenders through a variety of counseling, job training, and substance abuse treatment regimens has had them turn their attention to other social concerns like early-child intervention, health care, and housing.

American cities and states are currently attempting “Pay for Success” initiatives in a variety of ways. New York City entered what will likely be a landmark test case for SIBs with the mammoth Goldman Sachs raising $10 million and working with Bloomberg Philanthropies and its service provider MDRC to launch ABLE (Adolescent Behavioral Learning Experience). ABLE will attempt to reduce youth involvement in the city’s correctional system by at least 10%. How much more than 10% it is reduced will determine if Goldman Sachs’ seed money will return a profit. For a chart showing the city’s potential cost savings and return on investment see this link at Forbes.  

Meanwhile the city of Fresno has attempted to reduce the incidents of emergency situations involving youth with respiratory conditions like asthma which can lead to expensive treatments and a lesser quality of life for those afflicted. They will be working with intermediaries who will perform in-home assessments to identify asthma triggers and better management of the condition, which will hopefully lead to fewer emergency room visits and eventually lower costs to the city. [2]

Goldman Sachs, with investor J.B. Pritzker, is bankrolling another type of “Pay for Success” initiative in Utah: the High Quality Preschool Program. The Beehive State will be able to enroll 3 and 4 year olds in a targeted curriculum developed to get them on track for success in the classroom. Salt Lake City’s Deseret News commented in May that the “program has been in effect since 2006, and tracking data over a three-year period shows that without high-quality preschool preparation, about 33 percent of low-income children would be in need of remedial education programs before they finished school. With the preschool program in place, that number is reduced to 5 percent, saving districts and taxpayers an estimated $2,600 per student for up to 12 years.” [3]  

A number of commentators in the social sciences have noted that investment in resources at the early childhood stage appears to have a long-term salutary effect on youth development and away from factors that might lead to poor social indicators. Perhaps youth initiatives might be the most fertile ground for SIB innovations.

The buzz about social impact bonds has been growing exponentially in philanthropic, corporate, and government circles despite (or perhaps because of) little in the way of measurable successes so far to stoke such enthusiasm. As noted earlier, the majority of SIBs are multi-year projects intended to assess whether social gains appear long-lasting. In this sense the “bond” is like the traditional investment vehicle promoting a long-term strategy rather than a hot stock or temporary Band-Aid on a community. 

In June, in a shocking outburst of bipartisanship, Representatives Todd Young (R-Ind.) and John Delaney (D- Md.) introduced legislation in Congress called the Social Impact Bond Act in order to appropriate $300 million into a fund in order to allocate pay-for-success ventures by states and localities. As recently as last week, Rep. Young made the case for SIBs to the House of Representatives’ Ways & Means Committee, which can be viewed here.  

Goldman Sachs’ prominent foray into funding SIBs led to a number of private investors inquiring about opportunities to put their money into the mix to pay for success initiatives. Enough interest has been generated that the bank has created the Goldman Sachs Social Impact Fund which has a goal of capitalizing $100 million on a variety of “impact investments” including SIBs. [4]  Other financial service companies are considering developing funds as an extension of capturing the socially-responsible or “green” investor. According to Forbes, public policy institutes on the political Left (Center for American Progress) and Right (American Enterprise Institute) have issued positions in support of pay-for-success programs. When one considers the continuing failure of the two-party system to address a multitude of social problems and economic equality, and Goldman Sachs, which was one of the leading bad actors in the financial crisis from 2007-12, should we be more suspicious of the big celebration for social impact bonds?

Writing in The Chronicle of Philanthropy, Nicole Wallace notes that some non-profit leaders are concerned that there may be an “irrational exuberance” (in Alan Greenspan’s famous phrase) for SIBs. Jon Pratt of the Minnesota Council of Non-Profits chief concern is "You're definitely creating incentives that would be considered corruption pressures." [5] (note: subscription required)  The specter of cheating or otherwise fudging numbers to show measureable results that might not have been truthfully achieved will be an important aspect to the work of the independent arbiter when SIBs are evaluated. We’ve seen rogue school districts fake test scores of public school students when academic accountability has been tied to standardized testing. There is a potential for similar activity with such high stakes multi-year efforts where investors could realize a profit or lose their investments.

More prosaic of a problem is that states and localities attempting a pay-for-success effort will likely need to change the way their public service agencies operate, particularly in the ability to negotiate and track multi-year contracts with intermediaries. In referring to a Massachusetts proposal to lower recidivism among youth offenders, Wallace writes that it took a year and a half to develop the benchmarks and how outcomes would be measured. "It's like building a fine Italian shoe, one at a time," says Ben Hecht, chief executive of Living Cities, which invested $1.5-million in the Massachusetts deal. "They're costly to produce," he says of the early pay-for-success contracts. "Those who work on them, like us, are investing the money and time because we want to create the market and accelerate its development, not because we think they're smart and efficient transactions right now." But many observers believe that over time the experience gained by both go-betweens and government entities will allow memoranda to be hammered out more efficiently and quickly.

Social Finance’s experience in the U.K. suggests that the lessons it has been learning with recidivism can be applied to other social ills. The organization has opened an American affiliate. Harvard University’s prestigious Kennedy School of Government has seen the potential of advising neophytes on the impacting investing front by opening a Social Impact Bond Technical Assistance Lab. [6]

There is no doubt that as SIBs go mainstream, this potential new model could involve a potential sea change in how communities address difficult to solve social problems. Government entities will theoretically save taxpayer money on each SIB proposal since the innovator will either reduce the problem or not get paid. Of course, if they fail, the problem will still exist, and officials will need either to consider an alternate pay for success initiative, or return to the “business as usual” approach.

It remains to be seen if social solidarity is maintained in communities under the SIB model as the government would be hiring out its role in alleviating social problems. But there would be a benefit in hiring providers that have presented a well-developed plan that would be analyzed over time for results. Human service agencies that assist needy demographic groups now might be operating with reduced staffing and budgets with only the hope of maintaining the status quo on a social problem rather than having the ability to truly arrest it. In many cases, the funding that would be raised by investors would eclipse that which could be gathered through regular taxation. Although increased money alone won’t solve social justice issues, the opportunity to combine capitalization of funding while contracting with service providers, which would probably have deeper knowledge of local conditions than a state agency might, is a tantalizing opportunity to extend the reach of the hand of assistance.

Another possible positive outcome to the SIB horizon is that after a period of gross malfeasance by the financial sector of the U.S. economy which led to the financial crisis there may be a legitimate opportunity for banks like Goldman Sachs to make some sort of amends by taking a lead role in providing the capital to states and localities trying to address social ills that in many cases were exacerbated during the crisis. Perhaps there is an opportunity too for a flowering of individual investors to get interested in socially-conscious investing and see the impact their contributions, as opposed to the current system in which taxpayers may only have a vague idea on how their government is allocating their dollars. It would mean a greater realization of the direct (as opposed to an indirect means) of putting capital to work for the good of society.

Pope Francis toured an impact investing conference at the Vatican earlier this year [7] and said that "markets must serve the interests of peoples and the common good of humanity." In a recent article in the Archdiocese of Portland, Oregon’s publication, Catholic Courier, John Burnside, a financial adviser who serves on the archdiocese’s investment council, notes that "[c]orporations need to care not just for shareholders but for stakeholders—the community and workers…investors and corporations need to lead the way.” [8]  Burnside commented that it would be a better investment to donate $4,000 to a local urban farm set-up than to simply search for a mutual fund that divested from, say, BP. Social impact bonds, along with other impact investing opportunities, may provide the grist of concentrating efforts to produce the bread of better social outcomes closer to home.

Kirk G. Morrison

Kirk Morrison is chairman of the National Committee of the American Solidarity Party.