Funding Revolutions in Pay-for-Success

Those following the development of pay-for-success (PFS) contracts, or social impact bonds, know the field is evolving rapidly. The first detailed, market-level research for the United States and United Kingdom is now available, and leading intermediaries such as Third Sector Capital Partners are proposing significant model restructuring, looking to use the efficiency of public capital deployment while still transferring risk to private insurers (what it calls the “Social Impact Guarantee”). Meanwhile, both Democratic- and Republican-controlled jurisdictions launched PFS projects earlier this year. We believe this living laboratory is set to continue. Building on interviews with public sector officials, social policy leaders, and our own experience supporting the development of PFS projects, we propose another opportunity for experimentation: a PFS Revolving Fund.

Most PFS projects launched to date have focused on prevention and early intervention. Enabling prevention and early intervention provides services to those in need today and reduces the need for more-acute services down the road, but despite strong recognition of its value, support for interventions such as alternative response—which comprehensively assesses child and family needs so that service organizations can tailor their approach to specific situations—have been severely underfunded across the public sector. As a first step in addressing the shortage of preventive services, we identified five challenges that contribute to the lion’s share of this underinvestment:

1. The wrong pocket—where an investment pays off across an organization but is uneconomic for the individual agency that’s required to make the investment. For example, an investment in addressing homelessness may stand to create savings for both the health care system and police services, but may not be justified by either organization when only looking at their individual budget impacts.
2. Cash timing—where economic and monetary benefits accrue over a long time horizon, in some cases across political administrations. An early childhood development intervention, for example, may result in significant savings over decades but not sufficient savings in the immediate four-year political term to motivate decision-makers.
3. Cash savings—where the fixed costs of the current high-cost system make extracting benefits difficult. For example, preventing a single ex-offender from returning to prison won’t allow a prison to close; many fixed costs will remain.
4. Uncertainty—where the evidence base from evaluative research and economic study is too unreliable to overcome tendencies toward “business-as-usual” funding. Given the many contextual factors that can influence results, it’s hard to have confidence that previous program evaluations can be replicated.
5. Budget process—where previous years’ budgets are used as starting points, reinforcing the status quo. When the previous year’s budget is treated as a baseline, and all new funding requests compete against each other, it limits the pool of available funding for new preventative programming. 

Given these challenges, privately financed PFS contracts have often proved useful to fund preventive services. However, there are legitimate worries about how to maintain the positive dynamics of PFS as the market scales. (Tracy Palandjian and Jane Hughes of Social Finance US have done considerable analysis of this topic.) Challenges include:

1. Political risk—the inherent political risk of the public perceiving these transactions as a move toward privatization, limiting the domains in which they can be applied.
2. Costs of capital at scale—the necessity to pay market returns when philanthropic support for PFS diminishes, which may happen as it becomes more routine and is no longer a standard bearer for innovation, and as deal sizes increase.
3. Mission lock—civil society and public sector stakeholder demands that the resources generated from improving public services are recycled toward ongoing public benefit.

We believe the social sector needs a complementary structure that circumvents these issues, while retaining the benefits of PFS. We envision a PFS Revolving Fund—a separate, publicly capitalized, and arms-length fund in a given jurisdiction, such as a state or province. The fund would invest in PFS transactions and be replenished through outcomes payments if and when those projects succeed in producing agreed outcomes. Like privately financed projects, the PFS process would begin when a public sector commissioner identifies a population in need and the positive outcomes desired—such as successful employment for underprivileged youth. Unlike privately financed projects, the revolving fund would be a ready potential investor for immediate engagement and would avoid costs associated with soliciting private investors. It could finance a service provider deliver employment outcomes, for example, using the same agreement as a typical PFS transaction. If the project succeeded, the commissioning agency (say, a department of community services) would ultimately replenish the revolving fund, contributing capital that would ultimately be recycled and used toward more preventative and early intervention programming in the jurisdiction.

The ability of a revolving fund to catalyze large reforms toward evidence-based policymaking would also justify the fund’s upfront cost. Unlike many decision-making processes in government departments, where existing funding allocations year-over-year are difficult to change, the executive branch of government often has more will to make discretionary funding available when it can justify the spending as a one-time cost with systemic benefits. The number of states and counties involved in the Pew MacArthur Results First Initiative speaks to how government decision-makers can marshal resources in support of reforms for evidence-based policymaking. A revolving fund would influence decision-making towards evidence by giving internal champions a clear mechanism to advance reforms through PFS. Additionally, the revolving fund would be designed to capture benefits from systems reforms, including cash savings for government. In the absence of such a mechanism, legislators often worry that existing budgets will absorb any savings from reform. While legislators are often reluctant to lock in recurrent spending, a revolving fund would be funded only once, and then self-sufficient through its own activity.

While various jurisdictions would govern a revolving fund differently, we envision the fund as an arms-length public institution. Successful institutions such as the Washington State Institute for Public Policy, which provides rigorous policy cost-benefit analysis to the Washington State Legislature, show that governing institutions can develop the skill sets needed to assess possible investments and operate in a semi-independent relationship with government. Community experts from the philanthropic, social, and public sectors could also be brought onto an advisory board to vet opportunities and capacity on the ground. Meanwhile, the public sector commissioner—whether a department or municipality—would retain ultimate control over whether to develop a PFS contract for revolving fund financing.

By creating a centralized, public sector-owned funding pool, government could deliver significant improvements in prevention and early intervention initiatives. As a mission-based institution, the fund could champion and lead internal conversations on PFS better than outsiders (including intermediaries like us) and could support PFS investments in core government services with far less backlash, including in areas such as criminal justice and health care. Finally, by capturing benefits from preventative programming in a fund that would redeploy them toward greater prevention, the revolving fund could ensure that the benefits from prevention don’t disappear into the system, but could be reinvested and compounded on, creating opportunities for change at a much more systemic scale. That’s something we can all be excited about.

Read more stories by Lars Boggild & Mark Hlady.