5.3 The Social Impact Bond Market: Three Scenarios for the Future
- Social impact bonds (SIBs) are a novel way of finding economic solutions to social problems and, as such, have tremendous potential for channelling resources to programmes that work.
- Development of a mature, well-organized SIB market based on a solid infrastructure is still very much a work in progress.
- A roadmap outlines the steps needed to build a successful SIB market, where success is defined by a robust pipeline of SIB-ready projects, an ecosystem and a blended-value investor pool.
Social impact bonds (SIBs) are among the newest and most promising innovations within the impact investing space. As financial instruments that mobilize investment capital to tackle social challenges, they have the potential to create shared value – financial returns for investors, social benefits for underserved communities and individuals, and enhanced efficiency for governments and social service providers. Until their promise is demonstrated, however, the future of SIBs is far from certain.
How Do Social Impact Bonds Work?
- SIB begins with a social challenge. Take, for example, the issue of prison recidivism in the US. Over the past 40 years, the country’s total incarcerated population has grown by more than 700% to 2.24 million mostly minority and poorly educated men. After their release, 50% of former prisoners are unemployed and more than 50% will return to prison within three years.
- Based on a desire to ameliorate this problem, a partnership forms to include an intermediary, best-in-class service providers, government and investors.
- Partners agree on an investment structure, including desired programme outcomes. In the recidivism example, targeted outcomes could include the number of prisoners staying out of jail and finding gainful employment over a period of time.
- Private investors provide upfront working capital to service providers. The funds can be used, for instance, to scale up prisoner re-entry services, including workforce skills coaching, stable housing and employment services.
- Independent validators conduct a rigorous programme assessment to determine whether the target outcomes have been achieved.
- Government pays back principal and provides a rate of return to investors based on the programme’s successful delivery of pre-agreed outcomes; if these outcomes are not achieved, investors risk losing their capital.
Social Finance UK launched the world’s first SIB in 2010 to fund interventions aimed at reducing the rate of recidivism among ex-offenders leaving Peterborough prison.40 In 2013, New York City launched the first US SIB in partnership with Bloomberg Philanthropies and Goldman Sachs.41 While many SIBs are in the pipeline, this is still the only SIB on the ground in the US today. In contrast, there are now 16 operational SIBs in the UK, and more are planned.
The reality is that the US SIB market is untested, with plenty of potential pitfalls and much work to be done before a stable and efficient market is in place. Demonstration and early-stage projects are getting underway, but the fundamental market ecosystem and infrastructure are in the process of being established. Participants still quibble over terminology (is a SIB the same as pay-for-success financing? Is a SIB really a bond?), while each SIB requires high levels of start-up and development costs. Serious doubts remain about the ultimate efficacy of SIBs and their potential to fund social interventions at scale.
At Social Finance, we recognize these challenges; indeed, we live them every day, but remain optimistic about the market’s ability to learn and adapt so that it can reach its full potential. Nonetheless, we have identified three possible scenarios (“doors”) for the US SIB market over the next decade, as well as a roadmap to market success.42
Door Number One: Boom-Bubble-Bust
SIBs are the latest craze, but the heightened attention stands in sharp contrast to the modest number of transactions on the ground. In fact, in a recent survey of US market participants, we found that deep concern exists over the level of hype surrounding the SIB market.43 Overblown expectations and deep pockets of misunderstanding are prevalent and threaten to derail the market’s evolution if left unchecked.
Under this scenario, enthusiasm for the concept could lead to an influx of players over a fairly short period of time. Combined with a lack of education and the eagerness to get deals on the ground, poor-quality transactions could result. For the next few years, SIBs could look like the impact investing industry’s version of “beanie babies” or “pet rocks” – a fad with lots of hype, high costs and little value. Poorly designed transactions, in turn, could taint the entire industry. For example, one SIB could result in a loss of capital for investors because of impossible-to-achieve outcomes or targets, or sloppy execution, while another could result in negative, unintended consequences.
The World Economic Forum report From the Margins to the Mainstream: Assessment of the Impact Investment Sector and Opportunities to Engage Mainstream Investors (September 2013) notes this danger within the impact investing sector as a whole: “A risk in attempting to accelerate the supply of capital into impact investments is the potential for good capital to chase bad deals and potentially create a bubble.”44 Overexcitement around SIBs, underestimation of risks and overestimation of returns could create just such a bubble in the SIB market, as too much money chases too few good deals. In the end, the bubble would end just as all of them do – with a painful pop. Investors would walk away, and the SIB concept would be relegated to the same historical attic as the telex machine.
Door Number Two: SIBs Are the Wave of the Future – and They Always Will Be
Under this scenario, the SIB market continues to limp along; it always appears promising but never comes close to realizing its potential. A small number of deals would be launched in the next few years, but each deal would be highly individualized, entailing high transaction costs. Heavy philanthropic support would be needed to subsidize these deals, which would never appeal to mainstream impact investors without substantial credit enhancements from charitable foundations.
This scenario mirrors to some extent the decades-long challenges of developing a large-scale market for social entrepreneurs. Hype and inflated expectations have characterized this market at times, especially when contrasted to the scarcity of viable, investable projects. It is often said that you can’t push on a string in financial markets; in other words, you can’t create impact investments unless investment-worthy entrepreneurs and business-builders are already on the ground.
In the SIB market, this would translate into a dearth of service providers with the capacity to scale up evidence-based work, and/or a dearth of government officials with the will or ability to engage in such work.
Door Number Three: A Successful Market for Social Outcomes
This scenario would feature a number of well-structured, well-managed projects that will prove the SIB concept in the next few years. These deals would lay the foundation for a much broader-scaled market, with appeal to blended-value investors beyond the philanthropic community. Within 5 to 10 years, SIBs would be a well-established, widely-accepted option for funding effective social interventions at scale.
What factors will determine which door to go through? There are two intertwined facets to this question: deal flow and investor demand.
The supply of high-quality, SIB-ready projects – or deal flow – is currently limited, and could remain limited due to a number of constraints:
- A lack of knowledge of SIBs exists among many government decision-makers, compounded by silos across government levels and agencies, which hinder market growth.
- A lack of capacity among service providers is similarly constraining, especially in their ability to provide an evidence base of solid, measurable outcomes.
- Ideological objections about the role of private investors in funding social services can create caution and even negativism around the concept.
- Early-stage transactions have been defined by fairly narrow criteria, such as a five- to eight-year time span to measurable outcomes, and a relatively narrow focus on results that can be easily quantified.
Investor demand for well-designed SIB projects, while also not assured, may be less challenging than deal flow. A growing consciousness of social and environmental goals exists among the investor community, fuelling greater demand for blended-value investments. Examples illustrating this point include the following:
- According to its 2013 Insights on Wealth and Worth, U.S. Trust found that 6 in 10 wealthy individuals feel that they can have some influence on society by how they invest, and 45% agree that how they invest is a way to express their social, political and environmental values. Nearly half (46%) feel so strongly about the impact of their investment decisions that they would be willing to accept a lower return from investments in companies that have a greater positive impact. Moreover, the U.S. Trust study found that 44% would be willing to take on higher risk.45
- SIBs are also a viable investment vehicle for foundations that engage in programme-related investments.46 Such investments are an alternative way for charitable organizations to use their grant dollars or mobilize “the other 95%” of their funds to serve their mission, as well as earn financial returns.
- Investors, of course, are usually concerned with preservation of capital. As the SIB market learns and grows, better risk assessment and management techniques should bring perceived risk into line with actual risk around the preservation of capital. And, in the early stages of the market, philanthropic foundations may be willing to offer a guarantee of some portion of investors’ principal to attract private capital into the sector.
The Roadmap to Door Number Three
At Social Finance, we believe that the vision behind “door number three” can be realized. We also believe, however, that this future is by no means assured; to set it on this path, the market will need a steady supply of experience and learning from projects on the ground over the next few years. In particular, developments in three areas – a robust pipeline of SIB-ready projects, a market ecosystem and the blended-value investor pool – will be critical for setting the market on the path to success.
Importantly, this proposed action plan requires coordinated work among all market stakeholders. Market research and education, as well as the development of widely-accepted standards, will only be effective if intermediaries, financial institutions, government representatives and leading service providers pool their efforts. In all likelihood, this coordination will only occur if spearheaded by an industry network leader – suggesting that cohesion around an industry-wide network is the all-important first step in any action plan.
Build a robust pipeline of SIB-ready projects
- Educate and drive service providers to incorporate rigorous data collection practices and assessment of outcomes into their work
- Broaden the scope of potential SIB applications to encompass longer-term and more widely varying areas such as early childhood education, health and family services
- Support the growth and development of strong market intermediaries with the ability to launch and manage well-designed SIB programmes
- Launch demonstration projects to prove the concept of prevention-based interventions in early childhood, health and family services
- Design projects that incorporate both payments for long-term social value and payments based on savings within the investment horizon, to accommodate longer-term interventions with high social value
- Conduct educational outreach to service providers, investors and government, including publication of research and analysis, webinars, training sessions on pay-for-success principles, data collection and analysis
Build a market ecosystem
- Commit to high standards of transparency and information-sharing among market participants
- Ensure that foundations remain engaged in the market to provide leadership and expertise
- Develop a new regulatory framework for impact investing and SIBs
- Create, at the federal level, new divisions at the Internal Revenue Service (to develop tax policy) and SEC (to define the role for non-profit intermediaries as separate and distinct from that of broker-dealers)
- Help to build the pool of impact investment capital by providing guidance on fiduciary duty for institutional investors, and incentivizing foundations to increase their use of programme-related investments
- Create a federal insurance fund to backstop state governments in the event of a failure to appropriate
- Enact “full faith and credit” legislation at the state level to address appropriations risk
- Create a legal working group, at the level of the American Bar Association, to develop a legal and legislative framework and standard contracts for SIB transactions
Build the blended-value investor pool
- Engage leading financial institutions in the design and distribution of SIBs to mainstream impact investors
- Reduce transaction costs, through scaling up and standardization, to provide higher returns for investors and government
- Explore risk-sharing models to distribute risks among stakeholders, align incentives and enhance efficiency
- Research and develop models for management and pricing of SIB risks associated with performance, data, sovereign immunity, financial markets, demographic shifts, reputation, force majeure and legal contracts
- Create templates for contracts, private-placement memoranda and other legal documents to reduce transactions costs and perceived risk for SIB investors
SIBs: A Work in Progress
The field of impact investing is far more established than the narrower subset of SIBs; microfinance and community investing, for example, are decades old. The development of a mature, well-organized SIB market based on a solid infrastructure is still very much a work in progress. We have learned valuable lessons from impact investing pioneers, and continue to learn and evolve with every demonstration project and every deal. These lessons, properly applied, should guide us on the path to “door number three” – a successful financial market for social outcomes.