Everything You Need to Know About Social Impact Bonds

Social impact bonds are all the rage in the non-profit sector, but do they actually work?

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In the non-profit and social sector the "new, new thing" is social impact bonds, also known as pay for success contracts. In the last two years, for example, the Stanford Social Innovation Review has published more than 50 articles about social impact bonds, and in 2011 the term was one of the top ten philanthropy buzzwords according to the Chronicle of Philanthropy.

Major players like McKinsey, Goldman Sachs and the Rockefeller Foundation have all jumped in. Huge numbers, like $600 billion of potential investment, get bandied about. All of which makes it sound like a great new source of financing except that only six deals have been financed. Is this a flash in the pan or the next big thing?

The Basic Concept

Social impact bonds bring together four parties – private investors, a knowledgeable intermediary, a government body and a social service provider. They create a contract in order to achieve a specific social outcome.

The social outcome for the first social impact bond involved reducing the 60 percent historical recidivism rate for prisoners. Under the terms of the contract, Social Finance (the intermediary) raised capital from foundations and high-net-worth individuals to fund nonprofit organizations who worked with the prisoners while they were in prison and after they got out. During the six year life of the contract, if these organizations can reduce the recidivism rate by at least 7.5 percent, the investors will receive their money back plus a return. For example, if the recidivism rate drops by 10 percent, the return would be 7.5 percent per year. If they have greater success, the return could be as much as 13 percent per year.

On the other hand, if the service providers do not improve the recidivism rate by at least 7.5 percent, the investors lose their money. Essentially the government is paying for results, and the savings from housing fewer prisoners (less recidivism) should more than pay for the social impact bonds.

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The Attraction of Social Impact Bonds

One of the attractive features of social impact bonds is that, like the Low Income Housing Tax Credit program, it is a public-private partnership where the private sector invests the risk capital and provides significant due diligence. Social impact bond investments should also be cost effective because they generally fund prevention programs, like immunizations, and should provide significant cost savings for the government.

From the government's perspective, social impact bonds protect taxpayers by only requiring payment when the program is successful. Most government grants pay for a certain amount of activity, but effectiveness can be difficult to measure. A key facet of the social impact bond program involves an objective evaluator who determines if the program achieved the desired outcomes.

From the non-profit or service provider perspective, the program fosters innovative approaches. The government does not dictate how they will perform the service. In theory, it rewards innovation and efficiency. Social impact bonds will also allow non-profit organizations to do their work at a greater scale because the bonds are designed to fund large, multi-year contracts.

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The Challenges of Social Impact Bonds

One of the reasons that social impact bonds have not taken off, despite all the favorable press, is their complexity. Measuring outcomes in a simple, objective way is very difficult. In its purest form, one would need double blind experiments with control groups to see if the service provider actually made a difference. Many potential contracts have foundered over the inability to articulate simple, clear, objective measures. Similarly, the cost savings often accrue to several government agencies, complicating the question of who pays and what gets measured.

Creating social impact bonds is expensive. With multiple players, it is time consuming and expensive to create the contract, raise the money and establish the measures. During the life of the social impact bonds, there are heavy costs in collecting data, monitoring the outcomes and then hiring an evaluator to determine if the outcomes have been met.

With any new program, there is also considerable uncertainty and risk. For example, will the government meet its obligation four or five years from now if there is a change of administration? What happens if the service provider goes out of business or runs into serious financial problems? What happens if the landscape changes and related programs or policies are terminated?

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The Future of Social Impact Bonds

Perhaps the greatest reason for being optimistic about social impact bonds is that they fit nicely with two current trends. First, there is growing demand for investments that have a social impact. Foundations are looking for ways to use their investment funds to serve their mission, and many individuals are looking for investments with a double bottom line. Second, there is increasing emphasis on accountability. Donors not only want to know how their money is being used, but insist on seeing data-based results. The best nonprofits are getting better at documenting their outcomes.

In the most favorable scenario, intermediaries will figure out how to navigate through the complexities, as they have with the Low Income Housing Tax Credit, and social impact bonds will become a major source of revenue. The most effective nonprofits will be able to use these bonds to take their programs to scale. We will finally have a capital market mechanism that allocates capital based on performance and not on idiosyncratic fund raising appeals.

Thus, social impact bonds hold great potential both for reshaping the sector and for solving problems like homelessness and recidivism. That is why so many of us have written about them despite their limited use. Like any new product, there are lots of bugs that will need to be worked out. It will be interesting to see if they become a sleek, new funding mechanism for solving social problems, or whether their sheer complexity relegates them to a small cottage industry that is more hype than reality.

John Vogel is an adjunct professor at the Tuck School of Business. Georgi M. Klissurski is a Dartmouth 2014 Paganucci Fellow.

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