Anytime Goldman Sachs’ is speculating on investments linked to broader societal outcomes, we should probably take notice. As NPR noted recently, New York City has signed a Social Impact Bond (SIB) deal that would allow Goldman “to profit by helping troubled teens.” Ironically enough, other jurisdictions across the world are looking at replicating the financial creativity in New York City to solve the budget problems precipitated by pre-2008 financial innovation. A closer examination recently conducted in Maryland should give pause to other governments and nonprofits looking to take the leap.

Originally conceived as part of the UK’s “Big Society” agenda, SIBs are a new type of performance-based contract. Their innovation is to include third-party investors who provide money upfront to fund the operations of a social service program. If targeted outcomes are achieved, the government agency holding the contract pays for the program by reimbursing investors. If the program does not meet its targets, the investors lose their entire investment. This, in theory, shields service providers and governments from performance and outcome risks.

How a Social Impact Bond for a criminal justice reentry program works.

The fact that investors are providing upfront capital has led many to believe that the government’s upfront budget obligation will also decrease. Proponents note that in the SIB model, the government will only have to “pay for success.” Even better, success saves the government money because the model changes the focus of programming to outcomes and their measurement, stimulating innovation for programs directed at high-cost individuals.

After conducting research for the Maryland General Assembly, I found, however, that this last paragraph is built largely on myths:

  1. Myth #1: New capital for social programs. This myth ignores the fact that if successful, the government will have to pay for the program. In addition to the fiscal imprudence of accruing debt for social services, states are generally restricted from creating liabilities in their operating budgets without providing matching funds. Thus, it should be no surprise that Massachusetts, like the UK national government, is pre-funding its pilot SIB program. In New York City, Bloomberg’s personal foundation is providing a grant on behalf of the government to cover the payments.

    Given the costs of attorneys, consultants, program evaluators, the potential for a return on investment to third-parties, and a second tier of program managers, using an SIB relative to direct financing will therefore increase pressure on the budget, as the government must set aside more funds than even the investors provide to the program.

  2. Myth #2: The programs will save the government money. An independent evaluation by RAND Europe of the first SIB pilot program in Peterborough, UK, found that the prison reentry program “is too small to deliver substantial ‘cashable’ savings” for the government. My analysis found that even for a relatively large reentry pilot program in Maryland, a 10 percent reduction of reimprisonment for treated individuals would at best produce a 6 percent discount to the cost of operating the pilot program—using highly optimistic assumptions. If the costs do not stack up in criminal justice, it seems unlikely they would materialize in other types of programs.

  3. Myth #3: The government pays only for success. This assumes that governments and nonprofits will actually be able to enforce the byzantine contracts in the event the program does not meet its targets. As with every attempted SIB implementation, which have uniformly noted the complexity and difficulty of designing a contract, RAND Europe found that in Peterborough, “complexity in some instances meant that the actual transfer of risk is not clear.” 

    This complexity is inherent to the model. Attempting to manage social service through contract attorneys, consultants, program evaluators, and an all-or-nothing payment model will inevitably produce a contract that is extremely complex, and therefore more likely weak. As the United Kingdom’s prior fiasco with the London Underground demonstrated, financial creativity does not prevent the government from holding the bag on failed projects, even when the risk appears to be on the private sector.

  4. Myth # 4: A focus on outcomes will encourage innovation in programs. Given the high-stakes nature of the outcome payment, investors will be more likely to select programs with a proven record and with evaluation techniques that maximize the chances of demonstrating a positive outcome. In the case of Peterborough, the project skimmed providers and the prison location based on unique locational advantages and a long-standing record of provider accomplishment. Even more problematic, the evaluation technique cannot control for (or estimate) these advantages. Thus, in Peterborough, the government is likely to pay a risk premium to investors for a program that is already known to work but may not be replicable or scalable.

Although the benefits commonly associated with SIBs are undoubtedly appealing to cash-strapped governments and nonprofits still recovering from the Great Recession, without an understanding of how social impact bonds actually work, these endeavors in financial creativity may become expensive experiments that leave governments with the ultimate risk and providers with broken or contested contracts. Before leaping, nonprofits and governments should evaluate SIBs as a public private partnership, with an eye toward their own financial and operational risks relative to the efficiencies of direct government financing.