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In 1994, Steve Rothschild resigned from his post as executive vice president at General Mills to found Twin Cities RISE!, a Minneapolis nonprofit that provides job training to unemployed adults and helps them find jobs that pay a living wage. Ever the figures-focused executive, he immediately began wondering how the economic benefits of TCR! could be quantified, and whether any of those cash savings could be funneled back into his nonprofit somehow.

“I started with the assumption that social improvement would lead to economic value,” Rothschild says. “Economic value is the same as cash; it’s no different than economic value for a business.”

The next year, Rothschild approached the deputy director of the Minnesota planning agency with the seeds of an idea for a radical new social services financing structure: What if the state made TCR!’s funding contingent upon its success, assuming that its success could be shown to save the state money? The state’s economist crunched the numbers necessary to undergird the pay-for-success model, and determined how much the state would gain in tax revenues and save in welfare subsidies, food stamps, and other subsidies if TCR! helped one person move from an annual income of, for example, $10,000 to $20,000. The legislature approved the pay-for-success model in 1996, TCR! implemented it in 1997, and since then, Rothschild says, the state has invested $4.6 million in his nonprofit and has received $34 million back in economic value. That’s a return on the state’s investment of 624 percent.

Despite the economic and social benefits demonstrated by the model, Rothschild has hit a wall in his push to grow his successful nonprofit. “Even though we’re getting great returns, we can’t convince the legislature to invest more money into the possibility of earning it back because they just don’t have the cash,” he says. Like many states facing outsize budget shortfalls, Minnesota has been forced to slash spending across the board. In July, the state’s legislators slashed its $5 billion deficit only after a 20-day government shutdown.

“It became clear to me that we have to find new sources of revenue beyond what the state can appropriate through current revenue sources,” he says. 

Rothschild has fixed his hopes most squarely on one particular source of capital: institutional investors. He believes that if an investment product could be designed to allow investors to finance successful public social programs like TRC!, those nonprofits would finally be able to scale up, presumably expanding the reach of their social and economic benefits. Investors’ funds would only be tapped by a social program when an independent assessor determines that program’s outcomes to be a money-saving success, and investors would be repaid their principal, plus a return, from the same government coffers that are presumably benefiting from higher taxes and fewer subsidies and other costs.

Rothschild has entreated the state to issue a new type of municipal bond focused on social impact, which he’s calling the Human Capital Performance Bond (or HuCap). His HuCap legislation passed into law in Minnesota in July, with $10 million of bonding authority approved for a pilot program.

Suddenly, the pay-for-success concept is catching on in the U.S., at least among state governments. A stagnant economy, a $1.3 trillion federal deficit, and serious budget pressures across various states and localities are all conspiring to heat up legislatures and demand a change of tack in approaches to social spending, and early pay-for-success language is popping up like popcorn from coast to coast. The state of Massachusetts formally sought out information about pay-for-success contracting over the summer, and this winter will issue a request for proposals from pubic social programs interested in the model. In New York City, a pay-for-success system will soon be applied to a program that works with the adolescent portion of the adult justice system and seeks to lower the chance that they’ll recidivate. New York State is also exploring the concept, and hopes to present a concrete pilot to test pay-for-success in six months to a year. Similar signs of interest are springing up in Virginia, Michigan, Indiana, and parts of California.

The federal government, too, is taking steps toward an embrace of the new financing model. In his proposed 2012 budget, President Obama designated $100 million across five agencies — Education, Labor, Justice, the Social Security Administration, and the Corporation for National and Community Services — to employ a pay-for-success design. Though Congress failed to approve that budget, the administration’s interest remains undiminished, and in late October the White House hosted a meeting of officials from federal, state and local governments, as well as nonprofits, philanthropists, academics and intermediaries to discuss pay-for-success contracting. Though the language in Obama’s proposed budget never proved binding, the October convening served as a “green light to the agencies to begin looking at where the opportunities are” to integrate pay-for-success into their structures, says Marta Urquilla, senior policy adviser to the White House’s Office of Social Innovation and Civic Participation, which co-hosted the convening with the New York–based Nonprofit Finance Fund. “What was important about the convening was the agencies were hearing from administration officials” — like Melody Barnes, Director of Domestic Policy Council, and Robert Gordon, executive associate director of the Office of Management — “that there is an interest and expectation that they begin to implement pilots in 2012.”

A pilot program in the U.K. is offering the first concrete glimpse of what pay-for-success investing would look like in practice, and has helped to generate the excitement that’s been spreading in the U.S. The U.K. model introduces a few notable differences to Rothschild’s system, and is designed like this: At HMP Peterborough, a prison about 75 miles north of London, three nonprofits will be implementing programs designed to reduce the likelihood that prisoners will re-offend upon their release. The money to fund the upfront costs of these programs will come from a £5 million ($8.21 million) pool of investor capital that’s been raised from private individuals and charities by London-based Social Finance U.K., an investment bank focused on the social sector. Independent assessors will keep track of recidivism rates among offenders released from Peterborough, and will compare the rates to those of a control group from another prison.

If the final analysis shows that re-offending rates among prisoners from Peterborough are at least 7.5 percent lower than the control group rates, the national government will pay investors a return of between 7.5 percent and 13 percent (depending on the actual rate of reduction). But if the Peterborough program fails — or, in other words, it doesn’t reduce recidivism by the aimed-for threshold — investors receive nothing. Despite the fact that, in this pilot program, the investment product is called a Social Impact Bond (SIB), this all-or-nothing risk profile means it’s not actually a bond at all (unlike Rothschild’s HuCap). One expert I spoke with joked that the Social Impact Bond should really be called the Social Impact Derivative.

Interest in pay-for-success and its related investment products may be broad, but it’s also nascent, and the model is largely seen as yet-to-be-proven. The investors who will step in to finance the first few rounds of pilot programs will be philanthropists, high-net-worth individuals, and foundations — in other words, those who care more about the social impact of an investment than its risk profile, and are unbound by a fiduciary responsibility to maximize returns. But despite this early stage, several of the intermediaries who are helping to lay the infrastructure for a pay-for-success financing market are already actively focused on the eventual engagement of institutional investors. They say that that group will be crucial to achieving a sea-change in the way social programs are evaluated and funded.

“We’re very mindful of making sure that the investment instrument is built such that we’re able to attract institutional assets over time,” says Tracy Palandjian, CEO and co-founder of Social Finance U.S., a Boston-based nonprofit (and sister organization to Social Finance U.K.) founded in January that acts as a kind of investment bank for the social sector and is currently entirely focused on developing investment products connected to pay-for-success. At the Clinton Global Initiative Annual Meeting in September, Social Finance U.S. pledged to develop $100 million in such products over the next two years. “We can’t get to $100 million with just foundation money,” Palandjian says.

Palandjian confirms that she’s had early conversations about the potential of pay-for-success investments with a handful of pension funds, and is generating the most interest from schemes with Economically Targeted Investment programs, which encourage a focus on investments in the pension fund’s geographic region that offer strong risk-adjusted returns in addition to some economic payoff in the pension fund’s geographic region — a snug fit for pay-for-success products, says Palandjian. It’s still too early for any of these funds to comment publicly on their possible interest in these investments.

Antony Bugg-Levine, CEO of the Nonprofit Finance Fund — a New York–based organization that received a $400,000 grant from the Rockefeller Foundation along with the charge to organize a conversation around pay-for-success in the U.S. — says that he believes institutional investors will find more to like about these new investment products than simply their risk-reward profiles.

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