Pay for Success and Social Impact Bonds: What’s Next?

By Carolyn Kim Allwin & Julia Kurnik

Since 2014, ten Pay for Success (PFS) instruments have launched in the US. Although these PFS/Social Impact Bonds (SIBs) have been lauded as one of the most innovative ideas to emerge in finance meets philanthropy, are they really as promising in practice as they are in theory?

So far, the financial and social results are mixed. Goldman entered the SIB market in 2012 and since they haven’t scaled by 2017, we have to question whether there is a legitimate concern. Many of these vehicles have proven less successful than initially envisioned. Are they losing favor? Or are they still a work in progress, struggling for the right atmosphere and projects so they can scale and gain the necessary traction?

Or, perhaps it’s simply hard to judge too much too soon. Just two PFS bonds have reached their end date in this country. The first, the Goldman Sachs recidivism SIB, failed to reduce recidivism rates by 8.5 percent and no payout was triggered. A rate decrease of greater than 8.5 percent would have triggered a repayment of the original capital and anything greater than 10 percent would have generated a profit for investors. Goldman’s original payment was largely guaranteed by Bloomberg Philanthropies, meaning the bank lost a little, the foundation lost a bit more, and the public might have lost out the most since this innovative model is looking perilous.

In contrast, another Goldman bond was lauded as a success. In Utah, of the 110 pre-school students flagged to potentially need special education, only one child needed special ed after the bond provided the capital needed for high quality preschool. This is fantastic news for all involved, but it’s entirely possible that this SIB wasn’t really any more or less successful than the Goldman recidivism bonds, but simply utilizing a pre-existing program and better metrics. Either way, with just a couple projects completed, it’s too early to draw too many conclusions, though we will still do our best to extract a few lessons.

There is still a lot of good to like. Perhaps most importantly, “SIBs not only correlate financial and social returns, but they make financial returns dependent on the amount of social returns being generated by the investment.” This is unique, even in impact investing. With so many other impact investments, investors are asked to accept a lower financial return in exchange for a social return. One has to choose where on the spectrum they wish to reside. SIBs disrupt the spectrum, so that the more good is accomplished, the more money is saved and earned. This has opened up entirely new avenues of investment and interest, and is perhaps the reason why groups like Goldman, BlackRock and TPG are so interested in finding out more.

Yet, as positive as SIBs are on paper, three impediments come to mind. First, transaction costs. With the number of parties involved (e.g., the outcomes payor, financial intermediary, investor etc) negotiating each instrument separately becomes cumbersome (not to mention the legal fees that quickly rack up). Second, measurements. It is incredibly difficult to create, report and meet measurement standards. Since bonds can tackle different problems, it means having to uniquely determine if the right things are being measured and with the right thresholds for repayment. Finally, we are not even marketing these in the right way. These so-called SIBs aren’t actually bonds in any way, so, hamstrung by a false name, they may not be reaching the right audiences.

The most significant obstacle to these “bonds” are the high transaction costs both in time and cash — the time required by stakeholders to negotiate these instruments and to negotiate all their competing interests plus the legal fees to document all of these negotiations. A Merrill Lynch exec noted that it took 7–8 months to negotiate a SIB before it was executed. The solution? It won’t be easy — but we need some type of standardization. Instead of creating each new instrument from scratch, a best practice framework is needed so that SIBs can be off the rack instead of couture.

These same standardization and best practices guidelines should be applied to metrics as well. More and more metrics are popping up to measure social enterprises. Could some of these be adapted to the SIB world? Instead of deciding that 8.5 percent or 10 percent is the magic number, we should set standard thresholds. Perhaps these bonds aren’t succeeding or failing due to the program itself but because of how outcomes are being measured.

Or, is it all about the name? We’re not the first ones to notice that these aren’t actually bonds — or to call for a change. Perhaps we should take a lesson from this article and rewrite these instruments as “impact securities.” As someone so immersed in this world, it is easy to forget that to an outsider, when they hear bonds they will be expecting regular payments and a conservative investment when in reality SIBs function far more like equity. Perhaps a better name will lead to better positioning and a bigger reach.

So how can we move beyond these hurdles? Traction. We need more SIBs. With only one new project initiated in 2015 after what the Nonprofit Finance Fund calls a “flurry of activity” at the end of 2014, these instruments have stagnated at approximately $100m market capitalization. Yet, more instruments means more chance for standardization, more data to streamline outcome measurement, and a chance to rebrand SIBs as something different — leading to better results and more impact dollars. But how do we herd the cattle in this direction? Let’s start with addressing these three main hurdles and see if we can start small and build up, overhauling this potentially game-changing instrument to achieve the innovation and promise it has been holding just out of reach.

We should not give up, especially since assets under management allocated to impact investing are estimated to grow to $400 billion to $3 trillion by 2020. Impact investors will need a home for their impact investment dollars. And perhaps within the next few years — the kinks can be ironed out. BNP’s 2016 New Philanthropy Report predicts that “Impact Investing” and “Collaborative Philanthropy” are the top trends to achieve sustainable outcomes. SIBs may not be the end-all solution but they are an innovative financial social impact product which should not melt away into oblivion. So let’s roll up our sleeves and dive into SIBs to make change happen.

Carolyn and Julia are Co-Founders of Elysian Advisers. At Elysian, we are committed to connecting capital with purpose. We advise organizations on maximizing their revenue and impact potentials as we aim to build purpose driven ecosystems through the companies, organizations and funds that we advise.

You can follow Carolyn and Julia on Twitter.