Careful readers of my posts about the Pay For Success program have noted that I never used the phrase “Social Impact Bonds”. Social Impact Bond is the phrase used to describe the program in the UK that inspired the Pay For Success program. It is also frequently used in the US as a catch-all phrase for Pay For Success-like programs.
I think the phrase is misleading and could limit the potential for private investors to finance Pay For Success-like programs.
As I described in my column about Pay For Success, the primary innovation in the model is a contractually agreement between the government and an intermediary (which would then contract with nonprofit service providers) for the delivery of specific results. Instead of paying for program execution, the government instead would pay for results (such as higher test scores, a lower rate of ex-felons return to jail or a higher rate of welfare recipients reentering the work force).
Since government payments would only be triggered when certain results-based benchmarks were achieved, the intermediary would need to finance the program execution prior to receiving payment. In addition, the intermediary might never receive payment since successful results are not guaranteed. This means that the intermediary would need to raise capital (unless the intermediary was an endowed foundation, which I’ll discuss in another post) and this is where the “social impact bond” concept comes in.
In the case of the UK model, private financing was provided to the intermediary. If no successful results are achieved, the private investors will lose all of their money. If success is achieved, government payments will be triggered that will result in a return of capital plus an additional rate of return to compensate the investors for the risk they took. The rate of return will increase as the level of success increases.
This framework is not a bond. A bond is a loan that the borrower promises to repay along with interest payments. The mechanism used in the UK program is a performance based contract. This might sound like semantics, but if the Pay For Success program ever hopes to attract private financing at scale, it will need to look to Wall Street. When Wall Street looks at this framework, they will immediately recognize it as a high risk investment that has a significant potential of total loss of principal and bears no resemblance to a bond. Frankly, calling it a bond would be false and misleading advertising. A Wall Street firm marketing these instruments as “bonds” would be inviting an SEC investigation.
Now, I don’t believe at all that the UK program used the phrase Social Impact Bond in an attempt to be misleading. I’m certain that the private investors fully understood the type of investment they are making. But as these sorts of programs attract national interest in government and Wall Street, it is imperative that the financing aspects of the program be described correctly.
The Pay For Success program doesn’t only create a format for performance based contracts. It also specifically allows for outside financing to be obtained by the intermediary. But these two aspects should be understood as separate and distinct aspects of the program.
If the Gates Foundation acted as a intermediary, they could participate in Pay For Success and self-finance the deal. Enterprising intermediary may, over time, create a multitude of financing approaches to pre-fund their program costs. Some of these approaches may very well come in the form of loans or bonds. Theoretically, a for-profit intermediary entity could emerge and seek to raise equity financing (selling shares in itself to outside investors) to create the capital it would need.
Some day we might see true social impact bonds that are used to finance Pay For Success programs. But the phrase is incorrect and misleading when it is used a catch-all phrase to describe Pay For Success-like programs.