Will social impact investing finally pay dividends?

A new social impact investing project in the US which aims to reduce recidivism in prisons has taken the original model further.

In April last year I wrote in The Conversation about an innovative financial investment mechanism called Social Impact Bonds, that was designed to address some of society’s wicked problems by engaging government agencies, not-for-profit organisations, private investors and financial institutions.

At that time only one of these SIBs was operating in the United Kingdom. After what seems to have been a long pause, the increasing levels of interest and rhetoric have turned into some tangible products, including here in Australia.

In the last weeks two new SIBs have been launched in the United States - one in New York and the other in Massachusetts. Meanwhile in NSW, three SIB propositions are now under negotiation.

The most interesting aspect of these new initiatives is how the basic SIB concept developed in the UK has been adapted in different jurisdictions.

As I have explained in my previous story, the way a SIB works is by a bond-issuing organisation raising capital from investors, based on a contract with government, to deliver improved social outcomes that generate future government costs savings.

As well as repaying the principal, investors are paid a reward if the agreed outcomes are achieved.

The growing interest in SIBs is driven by a number of factors. Firstly, Governments are developing long-term outcomes focused “payment by results” or “payment for success” mechanisms to replace inefficient and ineffective mechanisms such as contracts, fee-for-service or grant-in-aid mechanisms.

Secondly, not-for-profit organisations are increasingly focused on delivering long-term social impact. However, many not-for-profit organisations are “permanently failing” - with demand for services outstripping supply, they are under-capitalised, use a short term revenue funding model, and rarely use debt finance.

Thirdly, investors of all shapes and sizes are increasingly seeking to achieve an appropriate balance between commercial returns and the social and environmental value created.

There is now a shift from ethical and socially responsible investing - based on screening out investments associated with social and environmental damage – to social impact investing where commercial returns are blended with the creation of social and/or environmental value.

This shift chimes with Professors Michael Porter and Mark Kramer’s vision of creating shared value.

SIBs offer the potential to harness these three drivers and re-engineer the traditional relationships between government agencies, not-for-profit (NFP) organisations and investors to create social benefit

Given this positive analysis it might have been safe to assume that first UK SIB focusing on recidivism would be rapidly replicated in other jurisdictions and across other policy fields.

However, the UK experience showed it takes a long time to develop a SIB proposition and measuring success is not only complex, but absolutely essential in order to find a point where all partners will agree to proceed.

The first UK SIB is reportedly progressing well and is on schedule to deliver the target outcomes.

But it’s most striking attribute is that it is an “all-at-risk” investment; where the failure to achieve the target reduction in recidivism leads not only to investors losing the reward payment for use of their capital, but also losing the principal.

Government has therefore achieved a complete transfer of risk to the private investor - although it has to be acknowledged that it is difficult to assess risk in such an innovative mechanism.

It is therefore unsurprising that all the investors in this innovative mechanism are philanthropic institutions - trusts and foundations – which can rationalise the downside risk as a donation as well as a failed investment.

Trusts and foundations traditionally use the financial returns on their investments to provide grants with the goal of achieving social value. The SIB mechanism offers them a mechanism to also use their corpus to achieve social value. However, if accessing commercial investment capital is a SIB goal, then arguably the UK SIB has failed.

The deal was formulated by a specialist intermediary – Social Finance; they hold the contract with government to deliver the agreed outcomes and are responsible for the ongoing management of the SIB.

Social Finance sub-contract the delivery of the intervention programs to a number of not-for-profit organisations. Finally, the reward payment and repayment of the investors’ capital will come from an innovation fund rather than the mainstream service delivery budgets.

The New York SIB is also in the field of recidivism, but with some significant adaptations to the original UK SIB, particularly around the nature of the risk sharing and the involvement of a commercial investor.

For instance, in the NY SIB, the prime investor is investment bank Goldman Sachs, along with with Bloomberg Philanthropies - the charity of New York major Michael Bloomberg - which is providing a credit guarantee that limits losses to a quarter of the invested capital. A further adaptation is a research centre - the MDRC - is coordinating the delivery of the recidivism program.

In Massachusetts, two “payment-for-success” based initiatives are under development which relate to recidivism and homelessness.

At this stage it is not clear what structures may be used, but it is interesting to note that the process is being driven by government and is following a traditional procurement process.

This is also the case with the Social Benefit Bond (aka Social Impact Bond) trial in NSW.

Three proponents are now involved in a negotiation process and while the full details aren’t known, at least one proposition includes two mainstream financial institutions, another involves a specialist intermediary, and all three have on-board very large not-for-profit organisations.

An overarching conclusion is that in these early stages, social impact bond propositions will need more “trials” to better understand stakeholder behaviour as well as how to optimise incentives.

In these early stages the costs of the measurement and research must also be borne outside of the SIB mechanism, or else transaction costs will undermine their financial viability.

In the UK there are a range of institutions and funding sources, including BIG Lottery, NESTA and Big Society Capital. In the US, President Obama established a fund of US $100 million to develop “payment for success” mechanisms.

But in Australia there are no similar sources of funding to support measurement, research and development. If SIBs are to become more widely used here, this is a significant gap that has to be remedied.