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The Appeal of the Social Impact Bond

Antony Bugg-Levine, managing director at the Rockefeller Foundation, explains what institutional investors can expect from a market around SIB-type products.

A compelling new investment product that ties social outcomes to financial returns is being piloted in the U.K., but will it ever fit into the portfolios of institutional investors?

Antony Bugg-Levine, managing director at the Rockefeller Foundation – which has provided grant funding and early investment capital to the new product, called the social investment bond (SIB) – believes that it will.  However, he concedes that much needs to happen before the SIB will be ready for the broad institutional investor audience.

SIBs organize a system in which private investors pay the upfront costs of nonprofit social providers’ programs. Investors see a return on that initial investment (paid to them by the government) if an independent assessor judges that the social programs in which they invested were successful, benefiting not only the individuals in the programs, but the government as well. Investors would ostensibly see cost savings from, for example, lower recidivism rates, less dependence on low-income housing, or fewer high school dropouts, depending on the particular program. 

If, on the other hand, a social provider’s efforts are deemed unsuccessful, investors receive nothing.  The SIB design ensures that governments only pay for social programs that are successful, by shifting the risk associated with a program’s failure from government bodies to private investors.

Rockefeller invested $500,000 in the pilot SIB, and provided grants of $400,000 each to London-based Social Finance, the socially focused investment bank that issued the first SIB, and to New York-based Nonprofit Finance Fund, which has been charged with organizing the conversation around bringing the SIB concept to the U.S.

Institutional Investor reporter Katie Gilbert recently spoke with Bugg-Levine about what institutional investors can expect from a market around SIB-type products, and how they might eventually be able to get on board.

Where in the portfolio would an institutional investor put this?

It’s really not a bond – I joke that they should call it the “social impact derivative,” because it really is a derivative in some ways.  I think most impact investors we work with put investments like this into their alternatives.  I don’t see where else you would put it.

What would it take to make the social impact bond appealing to an institutional investor risk appetite?

Here’s my sense of how the market will develop: I suspect that the first few deals, much like in the UK, will be capitalized largely through foundations and family offices who are thinking of these as pioneering impact investments and whose principal motivation for making the investment is to participate in this innovation.

It’s going to take a few of those deals before we have a track record and an understanding of the risk that would allow a more mainstream institutional investor to feel comfortable underwriting the deal. 

When it does finally become more institutional, I think one interesting characteristic is that this really does offer the promise of being a very non-correlated asset for an institutional investor, because really there are two main components of risk in the SIB: 1) The performance risk of the programs – are the nonprofits receiving the funding going to be as effective as they need to be in helping prisoners stay out of prison? That’s classic business model execution risk. 

2) Counterparty risk, in that the government ministry that signed the contract – in the U.K.’s case, the Ministry of Justice – will they honor that commitment in five years, when the money’s due? That’s a political risk. 

That second one is a risk that I think institutional investors should be pretty comfortable underwriting, and the first is an interesting new risk that most mainstream institutional investors are not yet conversant in, in terms of understanding which nonprofits are going to be effective in solving social problems.  But there are going to be organizations like Social Finance in that market that are going to be very effective in underwriting that risk.  Once you do that, I think it’s really interesting to think of this as a non-correlated asset. We don’t have a track record to prove that yet; I suppose some might say it’s premature to make that claim.

The SIB model in the U.K. pilot program is an all-or-nothing investment – investors get a return if the nonprofits succeed, and they receive nothing in the event of failure. Could that appeal to the average institutional investor, or will something need to be tweaked?

The model will need to be innovated.  This might start sounding ominously like 2007 thinking, but I could imagine a future where you could put a few of these together and try to collateralize the risk.  The other thing that will be interesting is the use of guarantees.

Would it be possible to put a capital preservation guarantee wrap around a SIB, which would take that risk of losing capital away, and find a guarantor who’s highly motivated from a social perspective?

Or it could be a government, the same way that in the U.S., OPEC puts guarantees in for investments that U.S. investors make abroad.  That’s a role that foundations could play. 

Eventually there could be a secondary market for positions that you have in a social impact bond, where you offer a higher return for someone that comes in early, but as the bond gets closer to its deadline and appears that it will meet its targets, that position could be sold off to a more conservative investor willing to take a lower return.  These are our collective pipe dreams.

Of course, none of that’s going to happen unless we make these first few pilots successful. And I think it would be overselling this to claim that institutional investors will be lining up to invest in the second or third ones. But we certainly think that once the pilots allow us to demonstrate with actual data what the track record of the SIB is, we envision that they could be a really powerful tool institutional investors could invest in.

 

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