Private Investment in Social Impact Bonds

This past week marked the introduction of social impact bonds to the United States. Government officials, businessmen, and academics who have been working diligently to develop this policy innovation have announced progress on two social impact bonds (SIBs), one in Massachusetts and another in New York.

The Massachusetts contract, announced in the Boston Globe last Wednesday, was the next step in a procurement process for two social impact bonds, also known as pay-for-success contracts. One contract addresses recidivism among youth who age out of the jurisdiction of the Department of Youth Services. The other contract addresses chronic homelessness among individuals in Boston and other cities in the Commonwealth.

Last week the state invited intermediaries and service providers to start negotiating the terms of these contracts. No deadline for negotiations has been announced, although participants probably prefer to sign a contract this fiscal year.

The New York deal, announced in the New York Times last Thursday, was the first public statement about a social impact bond by the Bloomberg Administration in New York City. This contract addresses recidivism among adolescent men in Rikers Island jail. (Note: These contracts often do not target women because women have a smaller presence in prisons and lower recidivism rates.)

The New York City SIB marks a turning point in the financing of social impact bonds. Until now, SIB efforts have received attention and significant capital from philanthropies and impact investors, but have not attracted sophisticated capital market participants (although these investors may have expressed interest in private). Investments into the only operational social impact bond, in Peterborough, UK, were limited to foundations and high-net-worth individuals. According to the New York Times, however, Goldman Sachs has agreed to invest $9.6 million into the New York City SIB.

Goldman’s careful investment is cushioned on either end. The Michael Bloomberg Foundation has agreed to issue a 75 percent credit guarantee, limiting Goldman’s downside to $2.4 million. The Bloomberg Administration has capped payout, limiting Goldman’s upside to $2.1 million. This puts the internal rate of return on this four-year deal at about five percent.

The Goldman deal is an important validation of social impact bonds. The SIB financial mechanism transfers the risk of program failure from governments to investors. This risk oftentimes hinders government officials from purchasing social service programs that have uncertain outcomes. Program failure may damage the political standing of government officials who authorized the deal. And the government would have ended up buying services that fail to achieve their intended outcomes.

With SIBs, government officials who face reduced program implementation risk have a greater incentive to approve programs that offer experimental approaches to tough social problems—especially when such experiments are tied to rigorous learning of what worked. Thus, the transfer of risk to investors increases government innovation in social service delivery.

But investors differ in their ability to manage risk. Philanthropic organizations such as charities and foundations have been established—by law and in practice—to give away money with no expectation of financial return. Foundations receive exemption from corporate taxes in return for disbursing at least five percent of their endowment each year. Without the incentive to increase upside financial return, these organizations are insufficiently incentivized to manage downside risk. In philanthropies, no owners will oust management for excessive risk taking.

Some innovative philanthropies organizations are changing their practices. They are creating risk analytics departments and hiring MBA graduates with Wall Street experience. They are promoting, and occasionally creating, philanthropic financial instruments such as program-related investments.

Although these venture philanthropies are growing, they remain a small portion of the financial market. Program related investment comprises a tiny portion of total philanthropic giving. Most philanthropic activity is centered on identifying and funding good programs—rather than managing risk to maximize return in a portfolio of investments.

The Goldman deal changes this equation. Goldman Sachs, a member of the financial elite that has received public blame for excessive risk-taking associated with the financial crisis, nevertheless remains a global leader in managing financial risk. Its sophisticated risk management mechanisms analyze social impact bonds as financial deals and as part of a portfolio of financial assets.

Goldman’s investment furthers the vision of social impact bond participants who seek to develop a marketplace for financial investment into social programs. Two additional and interrelated components will help progress that vision. On the one hand, additional SIBs that address a greater number of social interventions will add definition to government savings and the risk-and-return profiles of the SIB instruments. (Existing applications have been limited to adult recidivism, youth at risk, and the chronically homeless.) On the other hand, once market participants discover more sources of savings that SIBs can capture, and financiers understand the risk profiles of SIB instruments, more governments will be able to issue these contracts.

News from Australia, the US, and the Development Impact Bond Working Group in the UK, which aims to adopt SIBs to resource-poor settings, suggest that serious SIB participants are working on these components.

Read more stories by Michael Belinsky.