A year after the British Ministry of Justice piloted social impact bonds to reduce the 60 percent recidivism rate for the 3,000 criminal offenders who passed through the doors of a private prison in Peterborough, UK, the innovative funding mechanism captured the imagination of many social entrepreneurs. These bonds, also known as pay-for-success contracts, promise to transform the relationship between governments, nonprofits, and funders. “Social impact bonds” became one of the top ten buzzwords of 2011. And local governments in England, Australia, Canada, and the US have started exploring these contracts. As state governments at home and abroad prepare to pilot these bonds next year, the processes have already yielded some lessons from the field.

The first lesson is that pay-for-success contacts may ultimately encompass several ways of engaging pure for-profit investors, impact investors, and foundations in producing social returns. Steve Rothschild, an Ashoka Fellow and CEO of Twin Cities RISE! has had some success in Minnesota with one form of pay-for-success contract, which he calls human capital performance bonds. In this mechanism, a state raises funds by issuing general obligation bonds, directs those funds to nonprofits that have generated positive social outcomes and created government savings, and uses cash unlocked by those savings to repay the bondholders. Because the full faith and credit of the state backs these bonds—and no state since World War I has defaulted on its bond obligations—these bonds will allow social entrepreneurs to access capital markets.  The $10 million designated toward human capital performance bonds in Governor Mark Dayton’s July 2011 budget made Minnesota the first—and so far the only—state to pass legislation on pay-for-success contracts.

Social Finance, Inc., in Massachusetts is exploring a different approach to engage capital markets. Like its sister organization in the UK, Social Finance might front working capital, raised from investors with a range of risk-return appetites, to nonprofits in return for a government promise to pay when those nonprofits achieve predetermined outcomes. Unlike the UK operation, which attracted only philanthropic investment for its Peterborough bond, Social Finance here might slice the expected revenue stream into tranches, offer the lower-risk tranches to foundations, and pitch the premium tranche to investors with the highest appetite for return. (This idea might also work for UK’s second social impact bond, which plans to target troubled families.)

The New South Wales (NSW) Government in Australia, which plans to enter into a social impact bond in late 2012 to address either recidivism or foster care, is exploring attracting for-profit investors by offering to share some of the bond’s downside risk—essentially buying the lowest tranche of its own bond.

The second lesson is that the very process of implementing social impact bonds yields valuable returns for the government that engages in it. Governments that start thinking about how much return taxpayer dollars generate in one area may take that thinking to its other investments. The process of paying a service provider based on outcomes pushes the government to introduce data monitoring and evaluation systems above and beyond the ones it may be using today. Monitoring systems that it needs to set up to track leading indicators, as well as final outcomes, may then be used to track outcomes for populations not engaged through the pay-for-performance contract. And evaluation systems that rigorously compare outcomes to counterfactual scenarios help push the conversation around performance measurement.

The social impact bond is ultimately a learning tool for a society that is still discovering best practices. If governments already knew the most efficient uses of taxpayer money, they would not need to ask the service provider to find the best solution, as pay-for-success contracts do. And if service providers delivered known or similar outcomes, then delaying payment until we observe performance would be an unnecessary burden.

Therefore, perhaps the largest lesson, and greatest success, of this young innovation has been its ability to anchor the conversation of governments, social entrepreneurs, and impact investors around measurement, metrics, and outcomes. Nick Hurd, Britain’s Minister for Civil Society, recently lamented the “massive culture of risk aversion in the public sector,” that his use of social impact bonds has revealed. Impact investors across the board are starting to hold their investments to more rigorous standards of social returns. And as governments innovate, they are rewriting the social contact with their citizens and businesses, as Westminster has done this month.

The next half-dozen pay-for-success contracts that come online in 2012-13 will expand the number of social services, types of investor, and bond structures that will, in turn, increase the size and complexity of the nascent social impact bond market. And, as that market evolves, we will come closer to that transformational promise of a new social contract in which taxpayers, entrepreneurs, and governments hold each other accountable for performance and impact.

Update: On January 18, the Commonwealth of Massachusetts issued a series of requests for proposals to use pay-for-success contracting to address youth recidivism and chronic homeless in the state.

Read the follow-up article, “Social Impact Bonds: Lessons from the Field