Social Impact Bonds: The Blending of Social and Financial Returns

A brand-new investment product that links reduced recidivism rates to financial returns may represent the next step in an ongoing investment industry evolution.

“The investment community is evolving to a point where investors don’t feel the need to bifurcate financial and social returns,” says William Pinakiewicz, director of the New England office of the Nonprofit Finance Fund, which provides loans and other financial services to nonprofits. “They believe that they should be able to find investments that combine the two, and that you don’t have to sacrifice financial returns to get social returns. There’s a generational movement in that direction.”

The social impact bond (SIB), currently being piloted in the U.K., is a particularly pure illustration of how social and financial returns can be blended to the point where they are indistinguishable.  SIB investors receive their projected returns only when a social program achieves its projected social benefit – and saves the government money in the process.

The SIB pilot project in the U.K. is designed like this: At HMP Peterborough, a prison about 85 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 not from the government, but 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, an investment bank focused on the social sector. For a year, 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 federal government will pay SIB investors a return of between 7.5 percent and 13 percent (depending on the actual rate of reduction). The logic is that the capital that pays for this return is coming from the same government coffers that are benefiting from the successful social intervention at Peterborough (since lower recidivism rates mean fewer court cases, less policing, smaller prison populations, and other public-sector savings).

But if the Peterborough program fails – or, in other words, it doesn’t reduce recidivism by the aimed-for threshold – investors receive nothing.

The social impact bond’s novelty comes from the fact that it: 1) pulls new private investment capital into government-funded social programs, 2) necessitates the quantification of social outcomes and seeks to monetize them, and 3) shifts the risk of social programs’ failures from the government to investors (since the government only pays for a program when it is successful and can be shown to demonstrably cut government costs).

The excitement around this new investment model has spread stateside. The Nonprofit Finance Fund, mentioned earlier in this article, has received a $400,000 grant from the Rockefeller Foundation along with the charge to organize a conversation around how to adapt the social impact bond concept to the U.S.

Also helping to galvanize attention and interest in the U.S. around the SIB design is that fact that in his 2012 budget proposal, President Obama included a $100 million carve-out for “pay-for-success bonds” – a shiny new term that refers to the same basic model that the U.K.-born SIB embodies.

It’s important to clarify that the social impact bond is, confusingly, not a bond at all.  A recently published report on the Peterborough pilot program’s progress so far sums up the investment structure this way: “While [the term ‘bond’] has now been widely adopted to describe the current initiative, [it] is not entirely accurate as the payment is not guaranteed. Social Finance describes [the SIB] as ‘a hybrid instrument with some characteristics of a bond (e.g. an upper limit on returns) but also characteristics of equity with a return related to performance.’”

Arguably, the all-or-nothing risk profile that comes with SIB investments will appeal only to a relatively limited subset of investors. For this reason, a similar model under development in Minnesota more closely models a true bond, and shifts program-failure risk to participating nonprofit service providers, rather than to investors. 

Steve Rothschild, who’s driving the development of what he’s calling the “human capital performance bond,” argues that any financial product that aims to pull private capital into the social sector will be much more successful if it takes the form of a plain-vanilla investment product. That way, he says, it’ll be marketable to the broadest possible base of institutional investors.  He believes he’s found a way to make the SIB model fit this description.  Read the full II article about human capital performance bonds.

That said, there might be other ways to make the SIB model attractive to the institutional investor market, says Antony Bugg-Levine, managing director of the Rockefeller Foundation.  Read an II Q & A with Bugg-Levine about what an SIB market aimed at institutional investors could look like.