Background

Around the world, innovative financing methods are being used to tackle social issues. Programs and organizations typically funded by grants are constantly at the mercy of governments who have trouble thinking past the next election cycle.

As a result, when spending cuts need to be made governments typically look for the quickest fix – cutting social services.

What’s wrong?

Think about it. In your city, you may have a $100 million budget allocated primarily to:

– Schools: $60 million
– Emergency services: $15 million
– Public works: $15 million
– Human services: $10 million

Tax receipts are expected to decline by 10% next year. What do you do?

The majority of the first several categories (schools, emergency, and public works) are used on an as-needed basis. They are there to serve public needs in the moment.

Human services, on the other hand, typically comprise both rehabilitative (immediate things like food banks or homeless shelters) and preventative (down the road things like job training for unemployed or after-school activities for at-risk youths) benefits.

Now back to our problem of decreasing tax receipts. Aside from broad reductions, you’re not typically going to close a school, or cut back on your police force – they’re much too important to a town’s immediate value (not to mention the unions involved…).

As a result, you would turn to social services as an area to cut. And all things being equal, the preventative services are viewed as a relative “luxury” compared to rehabilitative services…again, because they provide benefits down the road, as opposed to right now.

So you’d cut those preventative services. After-school programs, job training, and collaborative work spaces would get the ax before food banks, homeless shelters, and unemployment benefits. They’re simply easier things to cut.

Now imagine this scenario playing out in thousands of cities and dozens of states across the U.S. each of the past 8 or 9 years. Naturally, many health and human service organizations struggle due to lack of funding. So despite the fact they do quality work, they are unable to provide the full potential value of their work.

Bottom line: Results are determined not by the quality of the organizations doing the work—but by the amount of funding governments are able to grant them.

Governments fund short-term services over long-term ones. They favor less complexity to more. And they reward risk aversion at the expense of seeking out truly innovative and high-quality programs.

The root of the problem

Social services are funded by tax dollars (typically through government grants) and donations. They are often provided by nonprofit organizations (if not governments directly). Why is that?

They offer value in a down-the-road or not immediately profitable manner.

Take a business that sells computers. It makes a product. People need the product. They pay immediately for that product. Value is created instantly upon receipt of the computer. And because that value is created instantly, it is easily quantified and paid for by a customer, making the value realized by both seller and buyer at the same time.

Now take a mental health organization. It provides a service. People need that service. They often can’t pay for that service, even though society deems it necessary for the overall good (through increased tax revenues, lower prison costs, etc.). Value is provided instantly to a patient but not realized instantly by society. It happens “down the road.”

Naturally, investors flock toward ideas that provide easily quantifiable returns. There are demonstrable data that prove the returns they can reasonably expect, corrected for risk of course, even though some investments are extremely long-term in nature (think of real estate or long-term bonds).

The further an investment is from concrete, quantifiable returns, the further it is from attracting funds. Something like mental health service is extremely hard to quantify. We know there are tangible benefits to providing this service. But who exactly benefits financially from it?

This creates the great divide in funding. There needs to be a way to bridge the gap from social returns to commercial returns on investment.

How do we solve this?

Traditional methods of funding lead to services delivered in isolation from each other, with inadequate focus on preventative services known to produce better outcomes.

Coupled with inadequate resources and rising need, many cities and states are seeing rising poverty, growing need for job training, and a host of other negative social outcomes, many of which could be prevented with adequate investment in prior stages of these problems’ development.

Introducing: pay for success.

Also known as pay for performance, this describes service payment models that offer financial reward to providers who achieve or exceed specified quality, cost, and other benchmarks. In other words, you only get paid if you do good work.

These models offer a blended return, accomplishing both financial and social payback.

Return on taxpayer investment

Governments spend billions of taxpayer dollars each year on crisis-driven services. These programs help a great number of people, but fail to make much headway in solving social problems that have become too complex for one-dimensional, prescriptive solutions. Although they recognize the economic and social benefits of prevention, government agencies generally cannot afford early intervention services as their funds are already committed to high-cost remediation programs.

Even if they fund prevention, governments risk having to pay for both prevention and remediation if their chosen prevention programs fail to improve participants’ outcomes. The short-term imperatives of the election cycle exacerbate this tendency to shy away from potentially risky, longer-term preventative investments.

Source: U.S. Department of Energy

Economic recession and shrinking budgets have forced governments to cut many programs providing prevention services, and as a result, nonprofit providers and their clients are struggling to survive.

The social impact bond

The social impact bond (SIB) is a financial device that integrates the needs of governments, service providers, and charitable investors under one concept: pay for success.

The bond is an outcomes-based contract in which government officials commit to paying private service providers for significant improvement in social outcomes (such as a reduction in offending rates, or in the number of people being admitted to hospital) for a defined population.

Funds are raised by charitable investors looking to make a difference, and their return on investment is defined by the degree of success in the program invested in. If a program is successful, the government repays the investment plus a variable rate of return based on performance. If the program fails, no payment is earned.

The government repays investors only if the interventions improve social outcomes, such as reducing homelessness or the number of repeat offenders in the criminal justice system. If improved outcomes are not achieved, the government is not required to repay the investors, thereby transferring the risk of funding prevention services to the private sector and ensuring accountability for taxpayer money.

By leveraging SIBs, governments can transfer the financial risk of prevention programs to private investors based on the expectation of future recoverable savings. They also provide the incentive for multiple government agencies to work together, capturing savings across agencies to fund investor repayment.

– Common belief that prevention is less expensive AND more effective than remediation

– Prevention also takes longer to realize tangible benefits and is naturally harder to measure

– SIBs transfer the risk of funding preventative programs from the government to private investors – government (and taxpayer) payment is contingent on success

See the complete list of all active social impact bonds going on today.

The mechanics

Source: Social Finance

1. An intermediary issues the SIB and raises capital from private investors.

2. The intermediary transfers the SIB proceeds to nonprofit evidence-based prevention programs. Throughout the life of the instrument, the intermediary would coordinate all SIB parties, provide operating oversight, direct cash flows, and monitor the investment.

3. By providing effective prevention programs, the nonprofits improve social outcomes and reduce demand for more expensive safety-net services.

4. An independent evaluator determines whether the target outcomes have been achieved according to the terms of the government contract. If they have, the government pays the intermediary a percentage of its savings and retains the rest. If outcomes have not been achieved, the government owes nothing.

5. If the outcomes have been achieved, investors would be repaid their principal and a rate of return. Returns may be structured on a sliding scale: the better the outcomes, the higher the return (up to an agreed cap).

How it works

Future State wants to invest in programs to reduce prison recidivism – the number of people who re-offend and end up back in prison once released.

The obvious benefits include:

– Lower prison costs. Obviously fewer prisoners means lower expenses spent on prison facilities, staff, services, etc.

– Increased income tax revenue. Fewer prisoners means more people available in the workforce. Ultimately this benefit is realized only if the majority of those released from prison do in fact re-enter the workforce, instead of staying unemployed.

While not necessarily easy to quantify, you can ballpark it. Say each prisoner has a variable unit cost of $25,000 per year when behind bars. Say also that Future State loses out on $1,000 a year in income tax with each prisoner not working. These figures alone equal a net $26,000 per year cost of a prisoner.

The state releases 2,000 of its total 10,000 inmates each year. Those released have a 50% chance of re-offending and ending up back in prison within 3 years. Reducing one year’s released inmates’ recidivism rate to 40% would reduce the number of people returning to prison by 200 by year 3.

This carries with it an additional 200 people eligible for work in the state. Assume in this case that everyone who remains out of prison becomes employed.

JobTraining Corp has a program that promises to reduce recidivism by the nominal 10% described above. This includes job training and re-integration services for prisoners. The annual cost to run such a program at the scale required to achieve this 10% reduction is $3,000,000.

Every 10% reduction ends up benefiting the state $5,200,000 over three years. That equals a 20.1% annual return on a $3,000,000 investment.

What this means

In this example, the net benefit to society, or in this case the government, is 20.1% per year.

These benefits are tangible from a financial perspective. They just take multiple years to materialize. That’s why these programs are typically funded by governments in the first place.

Take an outside investor now. Say they want to invest $3,000,000 into this prison recidivism program. For a social investor like this one, they may be enticed by a 5% return on investment for their funds.

By year 3, with Future State realizing $5.2 million in total benefits, it can afford to pay out an investor the 5% annual return plus initial investment for their efforts. This equals $3.5 million.

This leaves $1.7 million net profit (in the form of higher tax revenues and lower prison costs) to the government.

The beauty of this arrangement

Circling back to the earlier concept, pay-for-success, this kind of deal only gets paid out by the government if the program succeeds. No matter what happens, the investor fronts the money to a service provider (in this case, JobTraining Corp). The service provider has no other obligation in the financial workings of this deal—merely to provide a service.

The government then reimburses the investor if, and only if, success is achieved.

Because in this case success was defined by hard outcomes with real financial rewards attached to them, it is easy to see that the government will realize the gains in its own bottom line.

The government can subtract from these gains and pay out the service provider a cut of the “profit.”

If on the other hand, the outcome isn’t achieved (in this case, recidivism doesn’t drop 10%), then the government is off the hook. Nothing is returned to the investor. The funds remain with the service provider.

The service is still provided, which means positive outcomes could still be achieved, but probably at a lower rate of return. In this case, the government still earns some financial benefit without being required to reimburse the investor.

See the numbers in an alternate scenario. Download a PDF of both scenarios here.

The investor is on the hook for any risk associated with delivering on these outcomes.

In other words…a government can fund a public service with no up-front capital. Additionally, it needs only to actually pay for such a service if the financial reward it sees is tangibly greater than the cost. A classic win/win.

Looking ahead

This example is a very simplified form of a social impact bond. It assumes a straight yes/no basis for successful outcome triggering repayment. In reality, a social impact bond will have a scale of returns an investor can achieve based on a sliding scale of outcomes.

As more of these deals pop up across the United States, it is important to determine how effective they are at not only providing a social service, but also providing a return on investment.

The more success that is achieved on the ROI side, the more investors will eventually flock to these types investments.

Governments, if planning properly, can fund outcomes completely risk free. If they have good data to support the financial impact of social outcomes, they can prove to investors a financial return on their end.

Until data exist in the quantity and quality that support these outcomes though, investors will bear a greater risk in funding these types of deals. In these early stages of this industry, it is more likely to be seen as a donation than an investment. But once deals start proving financially viable for all sides, the social impact bond industry has the chance to really take off and make a difference across the world.

It is very easy to look at pay for success as the next great innovation in public service. It’s also easy to look at it as the next great weapon of Wall Street greed. That’s the problem. There are still far too many unknowns about the real potential of these projects, and it is far too easy to write off early failures as proof that these concepts will never work. And while the concept is interesting, the current process of studying and marketing these opportunities is being executed in a wrong way.

Small number of deals

Although they are certainly gaining traction, the limited volume of pay-for-success deals in this country (and the world) is an issue. Since they were introduced in 2010, there have been roughly 10 social impact bonds created each year, and have now expanded to 15 countries. Each deal takes months of planning, feasibility studies, and collaboration among at least three different parties. Much of this planning goes around underwriting the actual services and how their results will lead to financial rewards—results based on very specific programs offered by very specific organizations. While appropriate for a piloting process for this mechanism, this is a massively inefficient way to build momentum for a scalable model.

Additionally, most of these deals take 3-7 years to provide any sort of finished program data. So even if all these initial deals become major successes, it would take years to prove that this mechanism should be scaled up (not to mention the potential disaster if even some of them fail). At this pace, it will take decades to build any substantial database around program outcomes that can be leveraged on a larger scale. Successful programs will submit their program data and performance metrics, as well as how they map their activities to outcomes, but no two service providers necessarily records results in a uniform manner. There is no GAAP for nonprofit activities, which will make any comparison among programs time consuming, if not impossible.

All results are not created equal

The most influential factor of a program’s success is the provider’s execution. But throw in any number of external variables and the numbers can be thrown off and outcomes not achieved—even if the results are still better than a baseline scenario. You never know when the economy is going to turn upside down—or when riots will erupt in the streets—or when a new virus spreads across the country. But when any of these things happens, they can influence results for any types of programs or activities.

Imagine a health initiative designed to decrease the number of hospital stays in a local community. The program performs as expected, closing in on the desired numbers. Suddenly a new virus sweeps across the community, wreaking havoc on the reported numbers. Despite the program’s real success (real being defined as net difference between reality and a baseline scenario, which in this case must be altered to include the virus), the deal will be designed to not reward investors.

Who gets the credit?

When pay-for-success initiatives succeed, the provider is often recognized as the reason. Future funders will look to fund this same provider because: A) they’re clearly effective at what they do, and B) they have experience measuring a very specific set of outcomes now (reducing the need to pilot more studies and set up another organization for similar data capture). This newly deemed “successful” provider essentially owns a monopoly over an outcome and will be able to scale up; but it gets no easier for similar organizations to do the same unless they copy the methods of the first one, which may divert them away from activities they traditionally excel at. Does program success merely lock in future funding to a specific set of providers?

Alternatively, when these initiatives fail, it is often an indictment of the flaws found in these types of financing mechanisms altogether. It is much easier to blame the mechanics of the deal than to blame the execution of the program or flaws in data analysis. This creates a discouraging environment to pursue these types of arrangements, further contributing to the long timeframe of putting together a solid base of data and understanding needed to scale these things up.

There must be a better way

Instead of waiting for some magical database to be populated decades from now, what if we started with a more generic outcomes database? The fundamental goals of most nonprofits (and governments for that matter) are similar in nature, and they all strive to achieve similar outcomes. There is no reason these outcomes can’t be defined in a way that maps them to specific activities. These activities, in turn, can be mapped to resources that can perform them. This simple map allows the alignment of activity performers to outcome providers.

The hard part is quantifying the relationship between activities and outcomes. What sort of graduation rate improvements can be achieved if 50% more kids went to pre-school? What sort of recidivism rate improvements can be achieved if 50% more prisoners went to job-training programs? And so on…

Basic government budget and audit data provide some baseline of resources expended on public activities. Other public records such as labor, census, public health, and crime data provide some baseline of outcomes. Connecting the dots between activities and outcomes becomes simpler when you look at it this way. Simple statistical analyses could possibly provide correlations between resources spent and outcomes, allowing for some sort of predictive calculation to be done (e.g., 10% more per-pupil spending leads to 10% better college enrollment rate).

Fund outcomes…not organizations

Assuming some database like this was created, nonprofits could be publicized on a more universal basis. Their activities will be on display and attached to outcomes without even providing any program data. Of course, as program data becomes more available, their inclusion in this sort of database would only add to the calculations’ accuracy, making it an even more powerful tool.

If a potential social investor wanted to fund a health initiative in his hometown, he could search this database for specific outcomes (life expectancy, quality of life, etc.) and a list of activities will show up (extracurricular education, preventive screenings, etc.). The investor could then select whichever activity fits his mission and a list of possible providers will appear. This process allows funding to flow through to outcomes rather than specific organizations—not the other way around, as is the case in setting up a traditional pay-for-success deal.

Looking ahead

Building a database is not easy. Sure, there are plenty of public data sources, but they are often inconsistent or outdated. An activities-to-outcomes map is very conceptual in nature and may require assumptions and arbitrary values in the beginning. But as programs pile up and more data become available for inclusion, the accuracy of the database will improve. And then it can truly be a sustainable and useful tool for providers, governments, and funders alike.